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Dealing with risks in a company sale

The passing last week of Harvard Business School professor Clayton Christensen – famous for his theory of business disruption - is a good time to consider business risk. Specifically, what are the risks faced by your business during a transition in ownership.

For background, A visit to the Christensen Institute website finds this definition of the business school professor’s theory: “Disruptive Innovation describes a process by which a product or service initially takes root in simple applications at the bottom of a market—typically by being less expensive and more accessible—and then relentlessly moves upmarket, eventually displacing established competitors.”

Fear of disruption often is ignored. A business thinks it is well established, has strong customer relationships, unique products, special services. It is insulated from disruption. Right?

There are plenty of examples to the contrary: newspapers; video rental stores; land line phone companies. Every owner needs to be sensitive to the danger. When it is time to a business sale, every buyer will focus on areas of risk to decide whether to go forward or not.

Let’s look at a couple.

Revenue generation. Can the business perpetuate the revenue it currently generates? Are there ways to grow it in the future. These two points are fundamental to getting a successful transaction.

Owners who have given this question thought can share what they have done through the years to make revenue reliable, and what they believe is possible to preserve in years ahead. Many small companies developed in an age where there was little if any shopping. But the internet has opened up opportunities for buyers to look around.

If you have time to prepare, look for ways to make your business “sticky” with the customers. Offer services that are hard to replace. Turn orders around more quickly, or provide a level of customization that bigger outfits can’t provide. You get the idea.

Customer concentration. It is not uncommon for a business to cater to needs of reliable customers. But it is not a good idea to become too reliant on one customer. This refers to a customer producing over 20% of a company’s revenue.

Distribution of customer business gets close scrutiny by prospective buyers. In general, a broad blend of customers is better than a handful of major ones. If there is a concentration issue, there are methods to address it.

First, disclose it. Second, identify real reasons why it is an opportunity, not just a risk. Third, be agreeable to efforts by a buyer to address it in the Letter of Intent and the final agreement.

A buyer may ask to review contracts to see if they can be transferred. It is a given that in diligence you will need to provide detailed records on the customer’s activities. It is also almost certain that an introduction to major customer(s) will be requested before the closing of a sale.  Although scary and risky, this introduction is where the rubber meets the road.

If you have time to prepare, look for ways to ease the concentration by broadening the customer base.

Ongoing management. It is very common in small companies for the owner to be the key decision maker and the top salesperson. However, this represents a risk to a buyer. And it sometimes is a deal killer.

A management team, or second in command, is very desirable. It enhances value. One private equity group told us they will not even consider an acquisition that lacks a management team or successor manager in place. This is not universal, but it is a key indicator of the value of having management in place.

A company with an operations manager or team will get a higher multiple in a transaction. This individual or group can carry on the operation without the owner’s direct involvement, making an acquisition less risky for the buyer. Plus, if the team has a vision for growth, it is even better.

A strategic buyer in the same industry may have “people” to deploy, but they will still want someone steeped in the current business who can carry on through a transition.

If you have time to prepare, consider putting a second in command or management team in place to help with day to day decisions. Good places to start are operations and sales. This way the owner is not directly responsible for everything that will be critical for a buyer.

Risk is part of every business acquisition, and there are many ways to address it. In the end, it will be reflected in deal terms expressed in the definitive agreement. Two significant ways are for an “owner earnout” based on retention of critical customers or a performance bonus paid to the owner over several years based on sales.

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