Your company’s balance sheet is strong; it shows plenty of assets. Could this strength be causing you to leave money on the table both before and during a transaction?
When discussing the potential value of their companies in a transaction, entrepreneurs often lead with the strength of their balance sheet. Focusing on the company’s assets, including inventory, working capital, equipment, and the company’s lack of debt, often feels to owners like the right place to start a discussion. These are the places where the company has usually invested a lot of money, so it naturally seems like the best way to define the company’s value.
Unfortunately, this is a common and incorrect assumption.
Your company as a Black Box
Despite all of the energy and passion you have put into your company, it is, from a buyer’s perspective, a black box.
From BusinessDictionary.com, a black box is a
“Device, process, or system whose inputs and outputs (and the relationships between them) are known, but whose internal structure or working is (1) not well, or at all, understood, (2) not necessary to be understood for the job or purpose at hand, or (3) not supposed to be known because of its confidential nature.”
For the purposes of a transaction, a buyer is going to look at your company like it is a black box. Ultimately, the buyer cares about the inputs (investment) and the outputs (income) and the relationships between the two, but (preliminarily, at least) it is not necessary for the buyer to understand the company’s internal structure for evaluating the business.
Let’s look at two examples. Company A generates $10 million/year in EBITDA in an asset-light service business with customers that pay at the time of service. The company has $500,000 in assets and can operate on $0 working capital because of the timeliness of payments. In contrast, Company B, which also generates $10 million/year in EBITDA, is in a capital-intensive heavy industry. The company has $100 million in assets and requires an additional $15 million in working capital to finance its inventory and its slow-paying customers.
Which company is worth more?
For the most part, the companies have relatively equivalent values (although you could make a credible argument that the asset-light business is worth more because the capital-intensive business will require capital expenditures over time that will serve to reduce cash flow from the business). Looking at the companies as black boxes, we see that they are the same. A buyer will need to input a purchase price to generate $10 million in output income.
What about all of the assets in Company B? While this is greatly oversimplified, they don’t add value. Company A and Company B both derive their value from their income, not from their assets. The buyer doesn’t care what is in the black box that will generate the output.
Streamlining the Black Box
Once you understand that your company’s value doesn’t come from the assets inside it, the path forward becomes much clearer: Streamline the black box! Since a buyer will largely not pay for the assets inside the box, remove as many of them as you can.
There are a variety of ways that companies preparing for a transaction can whittle down their balance sheets:
1. Equipment: Companies can often simply maintain too much equipment on the books. If there is an opportunity to right-size the company’s equipment stock prior to a sale, this can be a good chance to generate additional value. Selling lightly used equipment can generate cash without significantly impacting the generation of revenue.
2. Inventory: Similarly, holding too much inventory can be a cash sink. There is a reason that many companies have gone to just in time (JIT) production strategies. Consider evaluating your company’s raw material and product inventory to determine if either can be reduced.
3. Accounts Receivable: While easier said than done, reviewing your accounts receivable and encouraging shorter pay periods can be helpful in reducing working capital needs.
4. Accounts Payable: Similarly, extending accounts payable can similarly reduce working capital needs.
5. Outsourcing: Finally, there are often activities within the company that require working capital and/or are capital-intensive that don’t necessarily drive a lot of profit to the bottom line. Consider whether outsourcing these sorts of activities can squeeze the balance sheet without significantly affecting the bottom line.
Streamlining your black box is a great way to both generate cash savings in the short term and increase the overall value to you of a transaction by allowing you to keep the value you generate in the streamlining.
However, like so many opportunities for improving the value of your company in advance of a sale, streamlining your company is something that you need to do over time. Because a buyer will rightfully want to know whether changes that have been made are sustainable, these sorts of operational and balance sheet changes need to be made well in advance of any transaction so that a period of steady operations can be shown downstream of the changes.
Michael Schwerdtfeger is a managing director at Chapman Associates. Michael and his team are focused on providing exceptional results through sell-side mergers and acquisitions advisement to entrepreneurs and business owners exclusively. Michael leverages his 20 years of diverse experience handling complex business transactions to help guide his middle-market clients to the best possible deal outcomes.