What to Look For When Buying or Selling a Business | Ep 180

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Buying or selling a business can go wrong fast. Pay too much as a buyer and you’ll regret it. Sell too soon and you might leave millions on the table. In this episode, Steve Coughran shares a CFO’s perspective from years of buying, building, and selling companies worth over a billion dollars. 

He breaks down the three main ways businesses are valued, the four factors that drive valuation up, and the eight hidden risks that drag it down. Whether you’re looking to acquire a company or prepare for an exit, this episode shows you exactly what investors look for—and how to maximize the value of your business. 

Disclaimer:   
BYFIQ, LLC is a wholly owned entity of Coltivar Group, LLC. The views expressed here are those of the individual Coltivar Group, LLC (“Coltivar”) personnel quoted and are not the views of Coltivar or its affiliates. Certain information contained in here has been obtained from third-party sources. While taken from sources believed to be reliable, Coltivar has not independently verified such information and makes no representations about the enduring accuracy of the information or its appropriateness for a given situation. 

This content is provided for informational purposes only, and should not be relied upon as legal, business, investment, or tax advice. You should consult your own advisers as to those matters. References to any securities or digital assets are for illustrative purposes only, and do not constitute an investment recommendation or offer to provide investment advisory services. The Company is not registered or licensed by any governing body in any jurisdiction to give investing advice or provide investment recommendations. The Company is not affiliated with, nor does it receive compensation from, any specific security. Please see https://www.byfiq.com/terms-and-privacy-policy for additional important information. 

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Transcript

When it comes to buying or selling a business, you can really screw yourself by either overpaying as the buyer or leaving a ton of money on the table as a seller. So today I'm gonna provide you with a CFO's perspective from someone who spent his entire career buying, building, and selling businesses and generating over a billion dollars in value in the process. I'm also gonna reveal the four things that add value to a company and the eight things that detract from it. So regardless on which side you sit, you know how to maximize value. So let's go ahead and jump in.

When I look at a company to determine whether I wanna buy it, there are two things that I first look at. That is revenue, it's top line revenue, and then number two is it's EBITDA. EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. Of course, I wanna look at its free cash flow and I'll build out a discounted cash flow model and make it much more sophisticated than what I'm gonna explain today, but I just wanna keep things really high level so you know how valuation works, which leads me into this.

Let me just talk about the three approaches to valuation first, and then I'm gonna get into things that add value and detract value from a company. So the three main approaches to valuation include number one, the income approach, and that's when you build out a discounted cash flow model because you're trying to determine how much cash is the business gonna generate over a forecasted period, normally five to ten years. So literally, you'll build out a forecast from revenue all the way down to cash flow for the next, let's say, five years, and then after year five, the business isn't planning on going away, I'm sure. There is a mathematical formula that you can use to figure out the continuing value of the business. That is for a whole nother conversation, but that's a discounted cash flow model and that's widely used in the world of valuation under the income approach.

The next approach is a multiples-based approach, and that's where you take some type of item, financial item like revenue, profit, or free cash flow, and you multiply it by some type of factor. So most commonly in valuation, it's EBITDA times a multiple or free cash flow times a multiple, or maybe the business doesn't have any profit or cash flow. You may use a revenue multiple. I've purchased a lot of companies like that back in the day when I was working in tech. But nonetheless, you look at profit, let's just say it's a million bucks. You apply a multiple that's standard to the industry and what's being sold in the market, and let's just say it's five. So you take a million times five X and you come up with a valuation of five million dollars. Just know that the multiples-based approach is shorthand for building out the discounted cash flow model.

And then number three is the asset-based approach, and that's essentially where you look at the assets of the business. You subtract out the liabilities or the debt on those assets, and you come up with some type of value or a fair market value. So think about it. Maybe your business doesn't have a lot of profit, but you have a ton of assets. Therefore, you may take the asset-based approach as another check figure. And oftentimes, I'll use the asset-based approach as like a ground floor number in my valuations because no business is gonna sell less than the fair market value of its assets, right? Okay, so those are the three common approaches when it comes to valuation.

Now, one last thing before we get into adders and detractors. Ultimately, the value of an asset comes down to this: how much cash it's gonna spin off in the future, the expectations for that cash. So think about it. It's like a vending machine. You buy a vending machine, you put a dollar in. You're gonna want at least your dollar back or two dollars back or even better yet, ten or twenty dollars back, but there's also a time element to it as well because I don't wanna put a dollar into a cash machine and get two dollars out in twenty years, right? If I put a dollar in right now and I get two dollars out in ten minutes, that's a great machine. I'll keep doing that all day long.

So there is a time element to it, but just remember that when it comes to valuation, the most basic definition of intrinsic value is the present value of all the future cash that a business will generate over its remaining useful life. And that's what we're trying to do ultimately is figure out how much cash is this business gonna generate and how much are we willing to pay for that? Because if a business is gonna spend off, let's say one hundred dollars and I'm uncertain about those hundred dollars that are gonna come out of the machine later on, I may only be willing to pay eighty or seventy dollars to take on that risk. But if I know that the cashflow is certain because I've seen it and there's a track record, then I may be willing to pay a little bit more, especially if I could go into the business and I can maximize its value and then sell it for more in the future. Okay, so that's how it all works, but it all comes back to cashflow.

All right, let's talk about some shorthand though. So when I'm looking at a business, like I said, starting off, it's revenue and it's EBITDA, right? Earnings before interest, taxes, depreciation and amortization. I want to understand essentially how much revenue does the business generate because it will help me to understand its scale. Because if a company is doing a million dollars in revenue, that's gonna require a lot of my time and attention. In fact, I'll probably be a very active operator in that type of business.

And beyond that, there's a death zone between one and three million dollars in revenue. And let me explain. Once the business surpasses a million bucks in revenue, and I'm generalizing here, okay? There are tons of exceptions, but just follow along with me. For the majority of companies, this is how it goes down. Over a million dollars, you can no longer run the business by yourself. So therefore, you need to hire on more technical people, more expensive people. But at the same time, the business also isn't generating a lot of profit because you're pouring a lot of profit back into the business to help it grow.

So therefore, you're faced with this conundrum. Let's say you're doing a million dollars in revenue. You have a ten percent bottom line. That means you have a hundred grand in profit. Do you take that hundred grand and do you bet it on an experienced hire that's gonna cost more money? Because if you do and they don't work out, your profit's gonna go nearly to zero. But if you do invest that money and they do work out, that's how you scale.

But a lot of business owners between one and three million, they're so small and they're so worried about making these big bets, rightfully so sometimes, that they refuse to invest in the right types of things. And therefore, they stay small and stuck forever. And you can't stay small and stuck forever because like I said, you're wearing too many hats. You're trying to take on all of this work when it comes to running the operations of the business. Nobody's focused on growth like they should be. And then next thing you know, the business implodes.

So I like to avoid the one to three million dollar death zone. And instead, for me personally and at Coltivar, we look for businesses with at least five million dollars in revenue. Now, maybe you're not in that position and you need to start out smaller. That's fine. You may wanna buy a business that's five hundred thousand dollars in revenue or a million or a million and a half or two, whatever it may be. But just know that that's gonna require heavy operations on your part. You're gonna have to be an owner operator, in other words. So that's why I look at revenue.

And then EBITDA, I look at that as a dollar amount. And then I'll look at that as a margin, as a percentage of revenue. From a dollar perspective, I like to buy businesses with at least a million dollars in EBITDA because that will give me wiggle room, number one, to service the debt. If I put debt on the business as part of the acquisition. And number two, it will give me money to reinvest in the business.

Now, I've spent my career turning around and growing businesses, so I'm comfortable with doing turnarounds, but it requires an entirely different skillset. So if you're just starting out, I would try to avoid doing a turnaround situation if at all possible, okay? Now, you could do it and you could be very successful, but just know that there are greater risks.

So those are the two things that I look at first. If they don't check those boxes, I typically move on, okay? But now I wanna get into, what are the four things that add value to the business? Because if I do take it to the next level and I buy it, I'm gonna wanna build it up and then eventually sell it. Or I'm gonna hold the business and reap the benefit of consistent cashflow.

All right, so let's get into the four things.

Number one, I'll look at revenue growth. And these are just general rules of thumb. There are a lot of factors that I look at when it comes to buying a business. I just wanna share with you a few things. And then just know that if you're on the sell side, these are things you should be preparing in your business. So you make sure you hit these boxes or check these boxes. So when it comes time to selling your business, you can maximize the value that you get.

Okay, revenue growth, I like to see plus 10% growth year over year consistently for the last three years. Now it depends on the industry. If the business is in an industry that's growing at a 30% rate, then obviously I'm gonna want it to grow at the same rate as the industry. But 10% is the minimum. More likely, I like businesses that are growing at a 20% or greater rate. That means every three and a half years, they will double in size, okay? That's number one.

Number two is I like to look at the annual revenue retention. This is how much revenue is retained by either the products and services that the company offers or the customers it does business with. In other words, revenue retention is really important because if I just go out and buy a construction company and they're just bidding on work and then they do the work and then they have to go find more customers to do work for, this was my landscape business back in the day. I started a company when I was 16 years old. And at first, we were just doing design build work. So we'd find high-end clients, design their landscapes, go build them. And then we wouldn't hear from them for years until they either moved or they needed upgrade work done at their property.

So we are very much finding work, building the work, and then it wasn't recurring. So we didn't have a lot of revenue retention, which meant we constantly had to spend money on business development and marketing. So I like to look for businesses with annual revenue retention of 80% or more. Recurring revenue, sticky revenue will make a business very valuable. So once again, if you're on the sell side and you're operating a business and you're looking at exiting, it's a good idea to grow product lines or service lines that are gonna allow you to have recurring revenue because that will make your business more attractive and more valuable.

Next, you know I talked about EBITDA as a dollar amount in my initial criteria. I also wanna look at EBITDA as a percentage of revenue. And I want that number to be greater than 10%. Because like I said, if you have a margin that's less than that, sure, sometimes I'll go in and buy a company that's struggling and I'll turn them around. But typically I want a business with a healthy track record so I could take that EBITDA and reinvest it in the business to accelerate its scale.

Right, number four is its sales in marketing efficiency ratio, which is measured by LTGP to CAC, lifetime gross profit of a customer to its customer acquisition cost. This is a really important ratio because it will tell you how effective is the company at generating returns on the money it spends on sales and marketing.

In other words, I like to see a three to one ratio, LTGP to CAC, because if I put $1 into sales and marketing, I wanna get $3 back in lifetime gross profit for that customer. And if not, that means I'm constantly spending money to acquire customers and it's gonna erode my profit.

When I talk with businesses, oftentimes they're like, Steve, help us set a marketing budget. And I'm like, you shouldn't have a marketing budget if your LTGP to CAC ratio is working, because if it is working well, and let's say it's five to one, that means every dollar I give you, you're gonna generate five more dollars in lifetime gross profit. And in that situation, why would you wanna constrain the amount of money you're spending on sales and marketing unless you're trying to cap growth for other reasons, right? So that's a really important ratio that I look at, three to one is the minimum.

Okay, those are the four things that add value to a business and makes it more attractive. But there are eight things, all right, double the number of things that make it unattractive or detract from a company's value. Let's go ahead and get into those.

Right, number one is key man risk, key person risk, whatever, right? It's the person running the business. And essentially, if they go away, they leave the business, they sell the business, they get hit by a bus, whatever, the company's revenue and profit are gonna slide. They're gonna deteriorate, they're gonna go down, right? So you don't want that.

So business with key man risk is a company where one person or a group of people are running the company and the business is highly dependent on them being there or on their skillset or on their network, whatever it is. So let's say you have an owner operator and they do all the sales because they have this great network and all the builders like to work with them. And if they leave, maybe those contacts go with them or maybe that loyalty no longer is there or maybe the owner used to answer all the questions because there are no written processes or systems and therefore it's a major risk to the business.

Sometimes it can lower the valuation of the business by 20, 30 or even 40% or even greater sometimes, just depending on how extreme it is. So that's the first thing I'll look at. Can the business run without the owner? If you wanna test this, tell the owner to go on a vacation for a month and they can't email, text, call or whatever with their team. And if they could do this and the business doesn't fall flat and it can continue to operate and even grow, then you don't have key man risk.

If the person goes away and the business falls apart, you got a problem there. Okay, so that's something to be aware of. So like I said, if you're on the sell side, just think the opposite. This is where you need to put in place processes, systems, SOPs, right, in your business so it can run without you.

Number two is key client risk. What I like to do here is look at revenue by customer and then I'll take the top 20% of customers and they should not make up more than 70% of the total revenue, okay? Because if they do, that's a major problem. Because think about it, I don't want any customer to leave the business and to have a negative impact or a major negative impact, I should say, on the company.

So how do you eliminate this? You diversify your offerings and if a client's starting to get too big, you may have to scale down their scope or even fire them, which sounds crazy, right? But if you're a million dollar business and $700,000 is coming from one customer, if they leave, you're screwed. So you never wanna build your business around a key client like that.

Number three is single channel risk. And what I look for here is if the business generates leads from any channel like YouTube, LinkedIn, paid ads, conferences, etc., and it's accounting for more than 40% of their revenue, that's a major risk to the business. Because what if conferences go away, like COVID happens again? Or YouTube changes its algorithm? Or paid ads are no longer effective? That will have a major impact on revenue and hence profit and cash flow.

Next, number four is capital intensity in a business. In other words, if a business requires a lot of capital expenditures — like trucks, trailers, equipment, tractors, etc. — and let's just say it spends more than 10% of its revenue on capital expenditures, that's going to require a lot of cash going forward. So I prefer investing in businesses that are capital light. So that's something to look out for.

Or you could also look at working capital as a percentage of revenue, which is essentially the difference between current assets and current liabilities expressed over revenue. And if that number is above 20%, that could be a major red flag for the business, because a lot of money is just going to be trapped on the balance sheet. And it's going to require constant cash as the business grows.

The fifth factor is market risk. So if you're in an industry that's dying, or that's shrinking — think about like the media business or the printed media business. If you're in the newspaper industry, essentially — that can pose a lot of market risk to the business. So you just want to make sure that the market's strong, it's going to continue to be strong, and it's not going to be disrupted in the foreseeable future. Otherwise, that's going to require discounting to account for this type of risk that a buyer will be taking on by buying this type of company.

Number seven is data risk. This is huge. I see this a lot with small to mid-sized businesses. If your financials are a mess, if you don’t have KPIs — key performance indicators — if you don’t have success measures for your employees, if you don’t have a financial forecast, if somebody asks you, “What is your LTGP to CAC ratio?” and you don’t know what it is, that means you have data risk.

Or if I say, “Hey, can you pull a report and show me our revenue by our top customers?” and you can’t pull that because your system is a mess, that means you have data risk. So you want to make sure you have clean financials, you have clean numbers, you’re running the business based on KPIs, and you have all that in place. Because when it comes time to selling your business, most often, you’re going to have to have audited financials, or at least reviewed financials, and it all starts with clean data.

And number eight, lastly, we have performance consistency. So when it comes to buying a business, I want to ensure that it has performed well consistently, period over period. Because I don’t want to take risk when it comes to cash flow. If I’m buying a business, and one year cash flow is high, the next year it’s negative, and then it’s medium, and then it’s high, then it’s negative — that’s too risky for me.

So I want consistency in the business. I want to know that the business can generate gross margin year after year at the same rate, or show improvement year after year — and then same thing with profitability. So three years of profitability is the minimum that I like to look at.

So if you’re in a situation where you haven’t been profitable but you wanna sell your business, now’s the time to start getting your financial house in order. And it starts with having the right strategy, knowing your numbers, and putting in place a system.

And this is what I like to do in companies. Number one, I go in there and put in place a strategy so there’s strategic focus and clarity among the team. Number two, put in place a system for sales and marketing so the company can have a profitable, predictable pipeline. All right, that’s really important.

Number three, I like to create financial health through financial clarity, which requires tools like a forecast, KPIs, clean financials, a monthly financial strategy review meeting — which I call the FSR. And then finally, strong leadership and culture to drive high-performing teams and to just drive performance overall.

That’s what I call a system. And so if you’re looking at selling a business, it takes time. But if you invest in the system and you can add to the adders and minimize the detractors, you’re gonna maximize value.

And if you’re buying a business, maybe you’re seeing some of these issues in the company. Maybe they don’t have adders. Maybe they have a lot of detractors. And you’re wondering, huh, should I buy this business?

If you’re confident in yourself and your leadership abilities and your financial acumen and just your strategic thinking, you can go in and buy a business and you can improve any of these levers and you can have a massive impact on the company’s valuation.

Think about it. You buy a business, a million dollars in EBITDA, and they’re trading at a 3X multiple. You go in there and you improve the EBITDA by pulling the right levers. And then you fix the valuation multiple by adding to the adders and minimizing the detractors.

And maybe it sells for 5X one day. You could take $1 million in EBITDA, grow it to 2 million, and then take that 5X multiple. You could grow your business to a $10 million valuation when you bought it for three, and you could do that in just a matter of years.

But you need to know how to do that. And the same thing is true on the sell side. You can sell your business and leave a ton of money on the table, but if you know where to focus, you’re gonna have a successful exit and you’re gonna get the money that you truly deserve by running your business and pouring in all the blood, sweat, and tears over the years.

All right, that’s what I wanna leave you with here. If you wanna deepen your understanding on how valuation works, you could go to byfiq.com. That stands for Boosting Your Financial IQ. On the homepage, you’ll get access to the lesson of the week. And every two weeks, we swap this out.

I’ll walk you through real case studies of companies where I’m either buying, building, or selling the businesses, and I’ll show you the templates that I use and how it all works, and I’ll help you to grow your skills in these areas.

So if you’re interested in doing the same type of thing, either buying, building, or selling a business, you’ll be fully equipped. You’ll have the confidence you need to be successful, and all of this will come together to improve your financial life.

All right, so be sure to check that out — byfiq.com. It’s free, and it’s ready and waiting for you.

That’s what I have for you. I hope you have a great week, and until next episode, take care.

Cheers.