Quality of Earnings Part 3: Cash Flow

In the past few weeks we’ve discussed how quality of earnings audits look at your income and expenses, and their impact on company value.  Since Revenue less Expenses equals Profit (P=R-E), you could be forgiven for thinking that we have picked apart your earnings as much as possible.

Unfortunately, that’s not the case. Merely dissecting your customers, lines of business, contracts, one-time expenses and unrecognized liabilities isn’t enough. Quality of earnings also examines how your cash flows.

Accounts Receivable

Just selling at a decent margin isn’t enough. That margin suffers from invisible erosion if your customers don’t pay on time. I’ve heard plenty of owners say ” They are our biggest customer, even if they don’t pay for 90 days.”

Buyers may look at that as “financing” the customers average balance. Even if you aren’t borrowing for working capital, that is money that might be more efficiently used elsewhere.

The math of earnings quality assigns an interest rate to those funds. If the customer takes three months to pay, and maintains an average over-30 balance of $500,000, a 6% cost-of-funds calculation could lop $30,000 from your earnings. If the offered multiple is 5x, that’s $150,000 deducted from your sale price.

Working Capital Needs

Another oft-heard claim by sellers is “This company could grow a lot, if only we had the capital.” Don’t be surprised if an experienced buyer tries to use that to lower their price.

I don’t think this one is necessarily fair. If your valuation is based on past performance, then what the buyer plans for the future is his problem. It has little to do with the numbers underlying your value. None the less, some buyers will put it on the table as a negotiating tactic.

On the other hand, if your selling price includes projections of future performance, or there are obvious issues of deferred maintenance (all your computers still run on Windows 7 for example), then expect an attempt to deduct the additional cash needed right after closing from the purchase price.

Run Rates

Most of us anticipate that a fast growing company will demand a higher multiple than a slow-growing or flat business. That doesn’t mean a buyer won’t try to “double dip” by offering a lower multiple and discounting for performance in the post-LOI due diligence period. Angry sellers will exclaim “But you knew my numbers before you made the offer!” True, but if an outside auditor emphasizes a lack of revenue or profit growth in his report, expect it to be on the table again.

It will absolutely be an issue if your growth rate falters during due diligence. It’s hard to go through the machinations of a transaction and pay attention to driving the company at the same time. Just be aware that taking your foot off the gas will be noticed, and accounted for.

The bigger issue is when growth on your top line isn’t equaled or exceeded on your bottom line. It may indicate that you are “buying business” with discounting. Failure to increase margins with additional volume may point to a lack of scalability. Either will become a part of the discussion on final price.

Quality of Earnings

In my three columns in this topic, we’ve examined eight major areas where a buyer can claim your earnings are worth less than they seem to be. I’m not an auditor. I’m pretty sure they could point to a few more.

The biggest single point I’d like to drive home is this. Most business owners consider the Letter of Intent to be the end of a negotiating road. When it comes to savvy buyers, it may just be the beginning.


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One Response to Quality of Earnings Part 3: Cash Flow

  1. Marsha Kelly says:

    Great detailed advice. Cash flow can make or break a small business. I know from my own experience and that of my clients. Run rates are a complex but necessary calculation.

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Quality of Earnings Part 2: Hidden Expenses

In my last post we discussed quality of earnings audits from a revenue perspective. Customer concentration, marginal lines of business and contracts are the three most common revenue traps. If you are comfortable with your company’s strength and stability as regards to revenue, it’s time to look at your expenses.

There are two expense categories that trip up owners in due diligence, one-time (out of the ordinary) expenses, and unrecognized liabilities.

One Time Expenses

A few years ago I worked with a client who owned a wholesale distribution business. He presented his financial statements to me to determine the practicality of obtaining third-party financing for an employee buyout. His recast statements showed over 10% free cash flow after owner compensation. That’s a respectable number in most wholesale distribution business.

As I examined the prior year’s financial records, I noticed that the adding back of a one-time expense accounted for almost 75% of the cash flow. I inquired, and found that the expense was for a conversion of the company’s enterprise information system, including consultants’ and employee costs for implementation.

Digging further, I found that 50% of the prior year’s adjusted cash flow number resulted from reversing a one-time expense associated with converting the delivery fleet from owned to leased vehicles. The year before that, half of the cash flow came from a one-time manufacturer’s buyout of some inventory, which was replaced under generous payment terms.

There are legitimate reasons to account for one-time expenses, and doing so can give a better picture of a company’s ability to make money. When there are such add-backs year after year, however, it begins to look like an attempt to count normal operating costs as profit. The bank determined that the company did not produce sufficiently dependable cash flow to finance the LBO debt.

This is a case where a lender was considering profitability, but the same rules apply to buyers. It’s hard to sell someone on applying a multiple to profits that have never actually been produced.

Unrecognized Liabilities

The other expense category that will impact the quality of earnings opinion is unfunded liabilities. These most frequently are unearthed in employee benefits and service agreements.

The first is accrued vacation or PTO. It is customary to keep records of this liability off the balance sheet, but professional buyers don’t see it that way. The benefit was earned while producing for the seller. They buyer has no reason to pay it out for work that wasn’t done for him.

Pension benefits are another area replete with land mines. Don’t try to show earnings that would otherwise have been shared through an employee profit-sharing plan. A buyer will insist (rightly) than future profits should maintain traditional benefit levels.

Sloppy plan administration is also a liability. If your 401K, for instance, has a backlog of orphan accounts or other potential compliance issues, expect fixing them to be considered as acquisition costs in negotiations.

Do you have annual service agreements with your customers? The appropriate accounting method is to amortize the income over the life of the agreement. Many smaller businesses, who keep records on a cash basis, recognize the income as it is received. That may lead to adjustments in earnings.

Expect that quality of earnings auditors to also look at the service flow through the agreement. If you expend a lot of effort at the end or the contract (say to update software of position for a contract renewal) they may want to accelerate recognition of those expenses.

Not Done Yet

Remember, a quality of earnings examination has one purpose; to find areas where a purchase price merits deductions. The firms hired for these reviews command five and six figure fees for the work. They are expected to produce savings in proportion to their fees.

When you’ve run the quality of earnings gauntlet of your revenue and expenses, you’re not done yet. We have one more challenge; cash flow adjustments.  More on those in the next post.

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Quality of Earnings Part 1: Revenue Traps

This will be the first of several columns on quality of earnings. While a formal, third-party Quality of Earnings Study is more often seen in mid-market transactions, even small business owners should be aware of the factors that can cause discounts to a selling price long after they thought it was settled.

There are few things as exciting as receiving a Letter of Intent to purchase your company. It may specify a dollar amount, or (as often happens with Private Equity Groups or PEGS) it may set a target range for a price based on multiples of profit. The exact profit, or earnings, that will be multiplied to calculate the price may seem obvious to you, but you shouldn’t be too sure.

Every letter of intent has a clause subjecting the transaction to due diligence. Most sellers are unconcerned about the diligence process. They’ve run a clean set of books. The assets listed on their tax returns are present and accounted for. Revenue and expenses are recorded accurately. A quality of earnings study, however, will look deeper than that.

We’ll look at earnings quality as it is affected by revenue, expense and cash flow factors. First, we will look at revenue-related issues.

Customer concentration

The first, and often the biggest item affecting purchase price is the presence of one or more key customers, without whom the business would have to downsize its operations. Just as stock pickers look at a public company’s beta, or risk factor, large customers are the chief beta influence on the value of privately held businesses.

A single customer who accounts for 10% of your business may not warrant a price discount, but one who controls 20% or more of your revenue almost certainly will trigger renegotiation. You may have a decades-long friendship with that business, but a buyer has little confidence that he or she can maintain the same relationship.

Instead of accepting a discount, you may want to offer your services in transitioning the account. Consider making some of the original price contingent on a an agreed measurement for a successful transfer.

Revenue by line or service

Most businesses do or sell more than one thing. I see this when we try to assign a National American Industry Classification System (NAICS) code to a client for valuation purposes. Many companies sell a product, but also offer service and repair. Some provide skills in several similar, but different industries. Others may have entire departments or divisions that work almost autonomously.

A quality of earnings study (their practitioners don’t call them “audits” although almost everyone else does), will parse revenue and profit by line of business. If 75% of your employees are engaged in something that provides 30% of the profits, you may be looking at another attempt to reduce the purchase price.


This area has two components that are subject to due diligence; where you have contracts, and where you don’t.

If you don’t have written agreement with both vendors and customers, expect more strenuous examination of those relationships. How are price changes handled? What if the other party unilaterally changes payment terms? Do you carry inventory that is for a specific account, without any guarantees that it will be purchased? Can your right to distribute a product be terminated without recourse?

I was recently given the opportunity to prepare a family business for a third-party sale offering. It made white-label commodity products, and owed 75% of its revenue to one, publicly traded customer. That customer had given them orders consistently for the last 40 years, but refused to sign any agreements, project future needs, or buy in any way other than one P.O. at a time, as needed. I declined the engagement.

If you do have contracts, expect them to be examined diligently (thus the term) for dangers. While specific purchasing terms are desirable in any agreement, look them over before you start the sale process. See if they should to be updated to reflect current practice. Often conditions and processes have changed by verbal agreement, but that can be tough to explain to someone who is holding a contract in hand that doesn’t match your actual business relationship.

Contracts with public entities or large corporations may also have “change of control” provisions. These call for cancellation or automatic rebid of the business if the supplier changes. In some cases this is a key reason to consider a sale of stock, rather than assets.

First revenues, then expenses

Whether or not your buyer gets a professional quality of earnings study, these are factors that will trip you up in the due diligence process. Next time we will look at how recorded and unrecorded liabilities affect a purchase price.

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After the Exit; “Nothing Will Change”

“Nothing will change.” It is almost de rigueur for an acquirer to include that in his or her opening comments to the incumbent staff of a just-purchased business. Sometimes it is the seller’s attempt at making folks feel better. “Don’t worry. They promised me that nothing will change.”

In the moment, it seems like a calming thing to say, a confidence builder for the employees who have just been informed that they have a new boss. In the long run, it can cause more problems than it solves.

Everything Changes

In any company, change is ongoing. Employees are asked to learn additional skills. Systems are upgraded. Procedures are rewritten. People are promoted or terminated. Customers leave, or (hopefully) big new accounts with new requirements are landed.

No experienced business owner in his or her right mind would ever promise employees that “Nothing will change.” Change is part of the landscape, and adjusting to it is inherent in keeping the business growing and relevant. Employees accept that fact unconsciously, because it’s always been part of the landscape.

Of course, when an acquirer says “Nothing will change,” he means today. There will be new procedures. New reporting relationships will have to be worked through. Software will be modified, or even discarded for the acquiring company’s preferred systems. And eventually, some employees will be promoted or terminated based on their ability to accommodate those inevitable changes.

“Nothing will change” is a license for employee dissatisfaction. They have to learn a new telephone system. (“He lied. This is a big change.”) All invoicing will be done through the central office. (“She lied. This is a massive change.”) Job descriptions and incentives will be adjusted to match the parent company’s. (“He lied. Everything is changing!”)

Demystify Change

The appropriate soother for acquisition anxiety is the truth. “I know this is a big change. You’ve faced great changes in this company before (get some examples from the seller) and your ability to adjust and succeed is what makes us so excited to be teaming up. We’ll take things slowly to start, and work with you so that our integration will be as painless as possible.”

There are no magic words that can completely eliminate employee concern. Dealing with it by promising something that isn’t true is just incurring a long-term cost for a very short-term benefit.


Posted in Building Value, Exit Options, Exit Planning, Exit Strategies, Incentives, Leadership, Life After, Managing Employees, Selling a business | Tagged , , , , , , , , , , , , , , | 2 Comments

2 Responses to After the Exit; “Nothing Will Change”

  1. John Hyman says:

    Yeah, and I promise to spend the night! This is a terrific observation and the counsel to be upfront and smooth the anxiety is spot on.

  2. Marsha Kelly says:

    You tell the truth. Things should change when a business is sold so it can grow on to new heights, in new and different ways. http://best4businesses.com/legal/legalzoom-referral-code-review/

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Exiting a Family Business: Three Questions

Transitioning a Family Business has special issues. This interview was reprinted last week in the newsletter of Steven Bankler, CPA.

We asked San Antonio business consultant John F. Dini, one of the nation’s leading experts on business ownership and exit planning, for his advice on handing down the family business. As the author of Hunting in a Farmer’s World, Beating the Boomer Bust and 11 Things You Absolutely Need to Know About Selling Your Business, Dini literally “wrote the book” on succession planning. He recommends that Baby Boomers and other business owners with an eye on retirement carefully consider the following questions.

What will your role in the company be?

Dini says that many owners “hand off” their companies without a real succession plan, especially when the business is destined to stay in the family. In those cases, ownership is often passed on while control remains—officially or unofficially—in the hands of the original owner, which can cause significant problems.

“Discuss what you want your level of activity to be, and what your successors think it should be,” he advises.  “Keeping your old office, or showing up every day to ‘just check on things,’ cripples your successor’s authority and ability to implement his or her own vision for the business.”

Is your successor ready, willing and able to handle change?

Many second-generation owners are indoctrinated to run the business exactly as they were taught.  However, as Dini points out, that may not be the best course of action.

“Markets, products and technology evolve,” he says, recommending that you consider: “Is your successor ready to adjust to changes in the business? Does he or she have any experience in dealing with major disruptions, such as the loss of a key customer or employee?”

Also understand that you cannot replicate your own mix of skills and talents in a successor, especially when it comes to the experience and “battle scars” you’ve gained along your entrepreneurial journey.

“It’s often impossible to train a successor as a ‘utility infielder’ who can handle finance, operations and sales,” Dini explains. “If key employees are critical to supplement certain areas of running the business, they should be included in a family business succession plan with long-term incentives for retention.”

Does the company have the financial strength to thrive without your personal signature?

“As a family business expands, an owner’s ability to personally guaranty its liabilities usually grows with it,” cautions Dini. He recommends taking an honest, comprehensive look at how your departure will affect finances from both the business and personal sides.

“Can the company maintain necessary credit facilities if you don’t back them up? If not, consider talking to your bank about how to limit your exposure,” he advises. “Many parents have lost their savings because they stopped watching the business until the calls started coming from its creditors.”

Succession in family businesses is often a balancing act between the desire to give the children appropriate freedom to run the company and protecting the assets of the parents. Planning should encompass timing, authority and financial responsibility, with all parties agreeing on the parameters.

Do you know the owner of a family business? Please share!

Posted in Exit Options, Exit Planning, Exit Strategies, Leadership, Strategy and Planning | Tagged , , , , , , , , , , , | 3 Comments

3 Responses to Exiting a Family Business: Three Questions

  1. David Basri says:

    I have read these columns for years. Enough with the exit planning already. Most of us are out here trying to succeed, not leave,

    • John F. Dini says:

      Thanks David. I know you’ve been a loyal reader for years, and I appreciate your comments. They’ve always been well-considered and erudite, if not necessarily in agreement with mine!

      I guess you missed my post on February 12th. I read somewhere that “A particular strength is using a variety of technologies to bring separate systems together into a coherent solution.” In my case, I was fielding requests for articles and speaking on multiple topics, blogging on a variety of subjects, developing planning tools for advisors and consulting on ownership transitions. Too much work for diffused results. It was time to get focused.

      I’d hate to lose you, but exit planning is what it’s gonna be…

  2. Ron Bento says:

    Wow – good article and good comments in response. Exit planning is very similar to planning a football game. One can not just field a team and see what happens if the intent is to win. One must anticipate the opponent. Plan and execute a play script at the start to see if your player skill and play strategy can adequately defeat, and with how much difficulty. Personally, I really enjoy reading about exiting regularly because it is practice. I remember Coach Lombardi mostly for saying, “It is not practice that makes perfect – it is perfect practice that makes perfect.” This is how we succeed today – by anticipation of and preparation for the leave.

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