Last year I presented a seminar titled ‘How to drive Value Before Value Drives Away’. The program focused on the process of preparing a company for sale. The core question on the table was ‘how do I as a CEO build value that will survive the closing negotiations and give me a bigger payoff’. Most of the participants were CEOs of mid-market government contractors. Needless to say, they were highly interested in what the panelists had to say.
The panel was typical of my seminars. They represented a wide range of experiences and backgrounds. One was a recidivist entrepreneur who had founded and built five companies. Another was one of the top M&A lawyers in the DC-Metropolitan area. The panel was rounded out by an investment banker and the CEO of a company that provided outsourced financial services. Each was tasked with giving the audience six major areas that they should focus on in order to build enduring value. I’d like to review just a few of the areas that they focused on – in this part, focusing on the revenue side of the income statement:
- Diversity That is Good: The question is not only how much annual revenue you generate but the nature of the revenues as well. If too much of your business is concentrated in few customers, a buyer will discount the value heavily. After all, if a major customer is lost, the results will be very damaging indeed. Most acquirers get nervous if more than 5% of total sales comes from any one customer. Concentrate on building a diverse revenue stream and as broad a customer base as possible.
- Free & Open: This area breaks down into two. The first is ‘how much of the revenue do you directly own as a prime contractor?’ The second is ‘how much of the annual revenue is from free-and-open contracts and how much is through set-asides?’ Buyers will more heavily discount set-aside revenues than those derived from being a sub on a contract without the set-aside benefits. This is most often because the combination of the companies will remove access to such programs. Build your revenue stream with an eye towards its value to a potential buyer.
- Conflicts: An important question to most buyers is ‘how much of the business that we are buying will give us conflict of interest problems?’ At a recent M&A seminar, one CEO actively in the acquisition hunt made it clear, ‘We don’t pay much attention to the valuations put forth by the investment bankers anymore. We need to discount their calculations – taking into consideration the revenues we will have to offload because of conflicts.” Some discounting will occur because of things outside of your control. Remember, it is the buyer’s valuation that rules in the end.
- Diversity That is Bad: Buyers like to see a diverse customer base but they get nervous when the revenues are being generated by a wide range of products or services. The proverbial ‘mile-wide-and-inch-deep’ syndrome can cost you a lot by the time you get to the closing table. Buyers refer to this as ‘spreading the jam a bit thin on the bread’. Buying a lot of one thing can produce real value for the acquirer. Buying a little of a lot of things can be more trouble than it’s worth. Focus your value proposition and business development efforts. The tighter the pattern, the more likely the value will survive the closing.
- Recurring Revenue: Buyers will study your revenue sources closely. If the stream is made up mostly of task orders, they will heavily discount future revenue projections. Companies that sell products and generate little recurring revenue from the sale will be heavily discounted. A single disruptive innovation could put them out of business. Generally speaking, revenue dollars from a contract for annual maintenance, annual licensing fees, a recurring retainer fee, technology license, etc. are much more powerful value drivers than projected sales revenue, time and materials revenue, or other non-recurring revenue streams. Remember, a dollar of revenue that generates many dollars of additional revenue in the future is more valuable than one that does not.
A good rule is that a seller begins to lose leverage as soon as they accept a term sheet. The buyer will employ lots of experts on the diligence team – often at great expense – and will look to have the purchase price reduced to cover them if at all possible. Closing a transaction involves engaging in and winning the chess match that is always involved. Like good chess masters, it isn’t what happens when the pieces are on the board and ready to be moved that is important – it is how well the contestants have prepared for the match.
© Dr. Earl R. Smith II