Resilient Companies Balance Continuity with Shock Absorption

Time can be an overlooked element in business.  Time can be an enemy, and time can be a friend.  Understanding the impact of time on your business separates the best business minds from the rest.  Time affects the pace of change for components of your business, your industry; and time affects our neighborhoods and cities, our economy, our government, and our environment.  These ideas struck me as I read Steward Brand’s book, Clock of the Long Now, and watched his recent presentation at an Evernote conference.

Source: Steward Brand,  Clock of the Long Now

Source: Steward Brand, Clock of the Long Now

Different paces of change

Brand uses this graphic to explain his idea that resilient systems (and resilient companies) have components with different paces of change.  The interaction among these components provides stability and the ability to incorporate shocks. His components from fast change to slow change are: fashion, commerce, infrastructure, governance, culture, nature.

Brand writes, “How do ecological systems absorb and incorporate shocks?  The answer appears to lie in the relationship between components in a system that have different change rates and different scales of size.  Instead of breaking under stress like something brittle these systems yield as if they were malleable.  Some parts respond quickly to the shock, allowing slower parts to ignore the shock and maintain their steady duties of system continuity.  The combination of fast and slow components make the system resilient, along with the way the differently paced parts affect each other.  Fast learns, slow remembers.  Fast proposes, slow disposes.  Fast is discontinuous, slow is continuous.  Fast and small instructs slow and big by accrued innovation and occasional revolution.  Slow and big controls small and fast by constraint and constancy.  Fast gets all our attention, slow has all the power.  All durable dynamic systems have this sort of structure; it is what makes them adaptable and robust.”

In business, it often takes a while to get alignment and coordination among the different layers in the stack of activities — such as the business model, customers, investors, employees, systems and processes.  The pace of change on some of these can be quick, and some will be slow.  Having the ability to absorb and incorporate shocks and new innovations while maintaining continuity with your most important values and competitive advantages helps make resilient companies.

Time (and its relation to the pace of change) is the friend of a great business, and the enemy of a poor business.  Time ticking past while a great business compounds in value is a wonderful thing.  Time ticking past as a company burns cash or a deadline looms is stressful.  It is worth thinking about how to construct your business so that time (and the pace of change in your business or industry) is your friend.

Resilient rates of change

I liked this quote, so I wanted to include it.  Brand includes this quote by mathematician and scientist, Freeman Dyson, with a similar idea on how different rates of change impact humanity.

“The destiny of our species is shaped by the imperatives of survival on six distinct time scales.  To survive means to compete successfully on all six time scales.  But the unit of survival is different at each of the six time scales.  On a time scale of years, the unit is the individual. On a time scale of decades, the unit is the family.  On a time scale of centuries, the unit is the tribe or nation.  On a time scale of millennnia, the unit is the culture. On a time scale of tens of millennia, the unit is the species.  On a time scale of eons, the unit is the whole web of life on our planet.  Every human being is the product of adaptation to the demands of all six time scales.  That is why conflicting loyalties are deep in our nature.  In order to survive, we have needed to be loyal to ourselves, to our families, to our tribes, to our cultures, to our species, to our planet.  If our psychological impulses are complicated, it is because they were shaped by complicated and conflicting demands.”

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Investment in Allied Health Education Company

I am excited to announce that my investment fund, Greybull Stewardship, has acquired an education company that helps health professionals maintainSummit Professional Education their licenses and certifications.  The company, Summit Professional Education (www.summit-education.com), offers seminars each year for over 75,000 physical therapists, occupational therapists, speech therapists, K-12 teachers, and others.  Greybull Stewardship partnered with  the company’s CEO, Scott Vogel, to make the acquisition.  Below are excerpts from the press release.

Greybull Stewardship Acquires Summit Professional Education

Leading Provider of Professional Continuing Education for 75,000 Allied Health Professionals Each Year Bought by Long-Term Oriented Owner

NASHVILLE, Tn. (December 15, 2014) – Summit Professional Education provides high-quality continuing education workshops and seminars to over 75,000 professionals each year.  The company has been acquired by Greybull Stewardship in partnership with its CEO, Scott Vogel, as Greybull’s most recent investment.

Summit provides workshops and seminars for physical therapists, occupational therapists, speech therapists, K-12 teachers, and others in all fifty states on a broad range of topics.  The workshops are approved by many different states, accreditation agencies, certification agencies, and others which enables these professionals to meet the continuing education requirements for their profession.

“Summit is a great organization that provides high-quality workshops that really help health professionals,” said Mason Myers of Greybull Stewardship.  “It is not easy to find great instructors, develop world-class content, and deliver these workshops in all fifty states. Scott Vogel is a dream CEO for this business and Summit has many competitive advantages that will allow it to do a great job for its customers for a long-time to come and make it a nice investment.”

“This is a very nice business and opportunity because of the growth in health care, the growth in continuing education requirements, and the satisfaction that comes from putting on great workshops for health professionals,” said Scott Vogel, CEO of Summit Professional Education. “We have an excellent group of instructors and team here that I love working with, and Greybull’s long-term oriented ownership will allow us to create value for our customers over a long time horizon.”

 

Wonderful Competitive Advantage Through A Unique Distribution Channel

Sustainable competitive advantage — a goal which will be always sought and ever elusive in business.  It is difficult to define. Yet, we often know it when we see it.

distribution channel competitive advantage

Less traveled distribution channels can become a large competitive advantage.

People attempt to draw-up lists in an effort to understand and remember the types of competitive advantage.  One common one is the competitive advantage of “network effects” — where a multi-constituent model becomes more entrenched the more users there are (Microsoft operating systems, Google search, Facebook, Visa/Mastercard).  Another common one is “economies of scale” — particularly in older industries such as matches, cigarettes, and steel. (Maybe even in the future market for batteries according to Elon Musk and Tesla).  Another one to add to the list, in my opinion, is competitive advantage which develops by owning or perfecting a unique distribution channel.

Competitive Advantage With Your Own Channel

A unique distribution channel can be a great way to differentiate your company and build a competitive advantage, often in industries where the product or service itself may be at risk of being undifferentiated (like some financial services products).  If your company can develop a more effective or less expensive channel to bring your product or service to the marketplace, you can develop a big advantage over companies that do not have your distribution channel.  It is even better if there is some reason why your competition cannot utilize your channel because of channel conflict (State Farm may have difficulty selling directly like Geico because their agents would get upset) or the expense of building out the distribution channel (Apple stores or Coca-Cola bottling plants).  Owning a distribution channel can also be very lucrative, such as the big three television networks or a city’s newspaper during the last century.  Or, Internet search is a lucrative channel thus far in this century.

The flip side is also true.  If you do not own your distribution channel, your business just became much more difficult.  I see this all the time as small product companies get eaten alive by retail chains who capture too much of the value for distributing product through their channel.  Constant price negotiation, slotting fees, terrible payment terms, all make selling your product through the retail channel very difficult.  Unless, of course, you are P&G and can negotiate with equal weight with the retail channel.  On the other hand, I have also seen some companies (particularly food companies) grow their revenues very quickly by utilizing the existing retail channels (club stores, etc.), so there is always a counter point to every business strategy.

Distribution as a Competitive Advantage

There are many examples of large businesses that were built where a unique distribution channel was a core piece of the puzzle and it made the company strong and effective for a long time.   Here are some examples:

  • Coca-Cola.  Most people list the brand as a primary reason for its success, but I believe it was the power of the coca-cola bottling network and distribution that placed Coke everywhere a customer could possibly want to buy.  A start-up today could never replicate Coke’s distribution network, making it a huge competitive advantage even in an era where the product itself may be waning in popularity.
  • GEICO.  A direct sales model to government employees (initially and now to everyone), cutting out the expensive insurance agent, has been and still is the competitive advantage of GEICO.  The company reinvests the cost savings from having a less expensive channel into lower car insurance premiums, which becomes a virtuous cycle for the company.
  • State Farm.  Before there was direct sales of car insurance, State Farm revolutionized the distribution channel for car insurance by utilizing existing networks (farmer associations) as explained in a nice book about the history of the company, The Man from Myrna.  USAA is doing this today by focusing on military personnel and their families.
  • Apple Stores.  Very unconventional when they made the investment, the Apple Stores have created a distribution channel that is a big advantage over other companies having to work through the retail network.  Apple can control the experience, create scarcity when they want, fix problems, and raise the level of service because they control the channel all the way to the customer.
  • Tesla.  Tesla decided to not work through car dealerships and to sell directly.  I love that it is different, because that is the first step to being better.  Time will tell if the dealership network is a necessary component to car sales or not.
  • Edward Jones.  A stock brokerage that has focused on building a broker network in small towns across America.  The other brokerage companies were not focused on small town America giving Edward Jones a wide open territory to approach and a safe base of profitable operations as a strong competitive advantage.
  • McDonald’s and the franchise network as a distribution channel.  Although this may stretch the idea a bit too far, I believe the franchise network of McDonald’s was an innovative (at the time) way to build out a network of stores with less capital from the parent company and a faster way to build a large network.  By perfecting the franchise model, it gave the company a unique advantage beyond just their food as the food is much more difficult to differentiate.
  • Peet’s Coffee.  On a smaller scale, I was able to observe how Peet’s Coffee went about expanding beyond their coffee stores because I live in the San Francisco Bay Area and my wife worked at Peet’s.  Freshly roasted coffee makes a big difference in coffee quality and was a key component of the Peet’s strategy.  However, to sell coffee through retail often meant that the coffee could sit in warehouses and store shelves for up to six months.  That was not good enough for Peet’s.  To take better control over their coffee’s freshness and quality, Peet’s chose to invest in their own direct-store-distribution (DSD) network of trucks and drivers.  This was an expensive and very unconventional decision that many companies are not willing to make.  It worked out beautifully for Peet’s.  The investment paid off as DSD became the profit-driver for the whole company and the coffee stores became a marketing mechanism.  It became a competitive advantage for Peet’s and part of what made the company unique — beyond just a chain of coffee stores.

If I were starting a business, I might first focus on having a unique distribution channel and then figure out what product or service could be sold through that channel.  In any case, I recommend that all business owners and entrepreneurs think hard about the distribution channel they are using, why they are using it, and how they can create sustainable competitive advantage through distribution channels.

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Lessons From Hyatt Family Decisions on Selling Businesses

For many business owners, selling a business is both about the money and about finding the right home for their life’s work.  This was very true for the Hyatt family as they worked to sell family businesses over the last decade after the patriarch’s death.  I was struck by several quotes from Thomas Pritzker, Chairman of Hyatt, about the process of selling businesses in a recent profile in the Financial Times.marmon

One of the companies that Mr. Pritzker was particularly proud of was Marmon, an industrial congomerate with interests from vehicle parts to railway carriages.  He ran the business before selling it to Warren Buffett’s Berkshire Hathaway.  “I wanted to find the right home for it,” he says.  “I considered an auction but auctions involve risk.  You may get a market clearing price but not a home that reflects us.”

Selling businesses gets personal

Business owners can often get a fair price from all sorts of buyers.  The difficult part is finding the right home for the business that works for the customers, the employees, and the owners of the business.  Here is a link to the full profile that appeared in the Financial Times on September 21, 2014.

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Warren Buffett’s Strategy, Selling Your Business, and Other Topics in Podcast Interview

I was interviewed recently by a very good business broker, Jim Cumbee of the Tennessee Valley Group.  I have gotten to know Jim this year as we worked on a transaction and we had a fun discussion about several topics including:

selling your business podcast

  • Lessons learned about selling your business
  • Warren Buffett’s strategy of being a different type of buyer than a strategic (meaning “competitor”), or a financial buyer (meaning “private equity”) and how my investment fund, Greybull Stewardship also is a different type of buyer
  • Importance of alignment among buyers and sellers on their objectives for the transaction
  • Discussion of a specific acquisition and how we crafted the transaction to meet everyone’s objectives

Selling your business podcast

The podcast can be found at this link: Entrepreneur’s M&A Journal Episode 17 with Mason Myers.  The 27-minute podcast explores my history with Greybull Stewardship as an investment partner through the seven deals I’ve put together so far.  It is also contains several stories about business sales and purchases. It tells about what’s been most difficult: understanding how to find the best fit for seller and buyer. If you like to hear stories about buying and selling businesses from two inquiring minds, take a listen.

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9 Lessons Learned About Selling A Business

When selling your business, it pays to learn lessons from others.  Most business owners will not get a second chance to do it well, and it is such an important process for your employees, your customers, and your own bank account that you want to maximize your chances of success.  I put together this list for my friends at Axial.net, a marketplace for buying and selling businesses who have also posted it on Axial.net.selling a business cartoon

I have been involved in over 30 business purchases – most with between $1 million and $5 million in profit —  and have earned scars from broken deals, learned many humbling lessons, and burned the midnight oil doing my best to craft the perfect win-win arrangement. Even now, I learn something new or experience something unpredictable in each transaction.

Here is the best of what I have learned about selling a business:

  1. Put Time on Your Side.  Most business endeavors are easier and better when time is your friend.  The opposite is also true — it is difficult to optimize the results of a business sale if you compress the time available to work all of the components.  This applies to both the time available each week and the time from the start to the finish of the overall process.  It is wise to begin thinking about selling your business well before you want to or need to.  Sometimes it takes years to craft the best trends in your business, get proper accounting processes in place, get the management team in place, and find the best investment banker.  I recommend that owners anticipate that the sale process could be a half- to full-time job by itself and they are well served by setting up an internal management structure that can keep the business on track during the months of a sale process and getting outside help (see below) to help manage the process.
  2. Get Expert Assistance.  You will come out ahead, both financially and psychologically, when you hire an adviser to help with the process.  The payoff will come on multiple fronts.  First, they save you tremendous time in talking with buyers, preparing documents, and providing a buffer to allow your business to stay on track during the sale process.  Second, they have experience navigating the sometimes confusing waters of a sale process.  Third, they can broaden the net of potential buyers, which is very important to maximizing the highest probability and highest valuation of a sale.  Networks like Axial.net will also help you widen your net.  Please see below for more commentary where success is often all about finding the right fit and the right timing.  Here is more information about how the experts can help you avoid six pitfalls between the letter of intent and closing the deal.
  3. Orderliness is Godliness.  Appearances matter in the sale of your business.  It is surprising how much the appearance of your records, reports, files and processes can impact how potential buyers view your business.  I think this is because every impression is important as buyers are operating with very little information so every little thing leaves an impression.  Being organized conveys to buyers that this is a well-managed business.  And, it will save you tremendous time to be orderly and organized when it comes time to produce documents and many other things for the buyer, particularly during due diligence.
  4. GAAP Accounting.  Make sure you speak the language of business, banks, and investment professionals.  For some business owners, selling a business is like entering a foreign land where the primary language is GAAP and EBITDA.  To operate effectively in this foreign land, you need to understand the basics of GAAP (Generally Accepted Accounting Principles).  I have had business owners tell me that “cash is all that matters”, or that “I have my own way of accounting that works for us”.  That is fine, but investors will not understand your particular language very well.  Therefore, you need to make sure that your financial statements are presented using GAAP and it is often worth it to hire a firm to do a review, an audit, or a Quality of Earnings analysis to get your company prepared and ready.  Here is more information about how strong accounting and reporting can pay off.  The number one pitfall can be situations where the business receives cash before delivering the product or service.  To business owners, they often consider that cash to be revenue.  In GAAP, that is not revenue until the product or service is delivered, and this can make the company’s revenue appear dramatically different.  There is nothing that hurts your credibility more than financial results that are significantly different when prepared via GAAP — it just makes you look unprofessional and naive.
  5. Getting Key Contracts and Leases Assigned to the Buyer.  A wise investment banker once told me, “no one is more arrogant than a landlord in a tight market.”  That is true, and unbelievably frustrating when a landlord is holding up the sale of your company. Most stopgaps occur because the landlord will not assign the lease to the new owner or he is using this point of leverage to extract some economic concessions from you or the buyer.  I recommend that you begin to review your key contracts and leases years in advance of the sale and attempt to get them “assignable” at your option to avoid being “held up” by a landlord or key customer.  This happens all the time.  Right now, I have one acquisition being held up by landlords trying to extract value for assigning the lease to the new buyer.  And, I have another acquisition that has been held up for 3 months while a few large Fortune 500 companies are reviewing some key customer contract assignments.  It is not good to have your big sale held up by these factors.
  6. Monogamy Happens at Different Points for the Buyer and the Seller.  In the balance of power, the seller is usually most attractive during the early part of the process since there are multiple buyers considering just one purchase.  However, once the seller selects a buyer and signs a Letter of Intent, the seller becomes monogamous and loses some of that advantage.  It is important for sellers to understand that there is still much that can distract or dissuade the buyer from that point forward.  The due diligence better check out.  And, the buyer could easily get distracted with other deals, or other companies in their portfolio, or their cousin Vinny who loses the family fortune.  The seller is wise to keep wooing the buyer all the way until the closing.   To ensure a successful close, business owners should keep the underlying business performing (frankly, it is really good if the business results keep getting better during the sale process), keep impressing the buyer with various elements of the business, and understand that the buyer is not married to the deal until the check clears the bank.  At some point, sellers need to transition from adversary to partner with the buyer, and they also need to keep reinforcing the attractiveness of the business until the deal is done.
  7. Selling a Business is All About Fit and Timing.   Along with everything else, selling a business is a numbers game.  Here is more information about finding the best fit and timing for a deal.  You need to find a way to maximize your chances that you will find several buyers for whom your business is a great fit and the timing is perfect.  For many buyers who may be great for your business, it may be bad timing as they are focused on raising money for their fund, or one of their portfolio companies just became distressed, or the partners are fighting.  There are so many things behind the scenes that affect how buyers behave that you will never know what is truly happening in their minds.  The best strategy is to cast a wide net, determine who is interested, and do not waste time with any other buyers (even when you think to yourself, “they would be perfect!”).
  8. Everyone Freaks Out Sometime During the Process.   In nearly every purchase and sale I have seen, there has been a moment when the business owner has freaked out.  This is quite normal and usually a good thing (better to have seller’s remorse before the deal happens) as it allows everyone to step back out of the details and make sure the deal is really a good thing for all involved.  It is such a grueling and emotionally charged process for many owners that there is quite often a moment when they question the transaction.  When you do freak out, please don’t call the buyer names.  Just this week, I had a seller call me all the names in the book because they misunderstood something only to realize it was their error.  It is no one person’s fault that the process is frustrating and time-consuming.  Most everyone is trying their very best to do the right thing.
  9. Control the Lawyers.  One business owner called the process the “tyranny of the experts”.  When you have not sold many businesses, it often feels safe to rely heavily on lawyers, bankers, accountants, and others from the expert universe.  This is important to a point.  It is also important to not let them drive the process too much.  You are the decision-maker.  You have good business judgment.  If you have questions, ask them.  Ultimately, however, you will need to make the business decisions about how to do the deal (is the lawyer trying to impress you or helping you get a deal?).  There always comes a moment where everyone must tell his or her attorneys to back down and get the deal done.

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Two Investments To be Announced as Soon as I Stop Slacking Off in Wyoming

We closed two more acquisitions on August 8 (will announce them soon) after having made two growth business investments earlier in the summer (Murphy business brokerage and one other unannounced).  When I began the Greybull investment fund, I expected to do 1-2 investments per year.  This year, I am on 4 with another likely to close this month.  It has been a crazy summer.drive to wyoming after business investment

Shortly after closing those acquisitions, I hit the road to spend a couple of weeks in Wyoming working remotely and recuperating.  Much of the road through Nevada, Utah, and Wyoming looked like the photo to the right with no cars in sight in front or in back.  My trunk was packed with my home office (monitors, scanner, printer, etc.).   My supply list was just a little different than the list by Hunter S. Thompson in Fear and Loathing in Las Vegas, but the opening paragraphs of that book were in my mind as I drove across Nevada.

“The trunk of the car looked like a mobile police narcotics lab.  We had two bags of grass, seventy-five pellets of mescaline, five sheets of high-powered blotter acid, a salt shaker half full of cocaine, and a whole galaxy of multi-colored uppers, downers, screamers, laughers . . . . . . and also a quart of tequila, a quart of rum, a case of Budweiser, a pint of raw eterh and two dozen amyls.”   From Fear and Loathing in Las Vegas

Along the way, I also drove over the Greybull River at the town of Meeteetse, Wyoming.Greybull River in Wyoming  I picked Greybull as the name of my investment fund because it was the small town in Wyoming where I was born and I wanted people to know that I am more of a Main Street guy than a Wall Street guy.  The Greybull River and the town of Greybull were named after an albino buffalo that the Native Americans said roamed the area.

Observations on Life and Investments

I am heading back to San Francisco this weekend, and the trip was great.  It made me very grateful and appreciative of all the people that I work with at the Greybull companies.  A few other observations:

  1. The CEO’s and management teams at the Greybull investments are doing a marvelous job.  Things are going well across the board.  The hard work is being done at the companies and I can’t claim any credit.  We are consistently creating value each month that passes, and the compound value of all that work is inspiring.  I love it and also feel guilty at the same time when I can go for a hike or fishing and know that value is being created at these companies.
  2. Working remotely is quite easy and effective.  Most of you know this already, but there really is not much difference, particularly because most of my day is on the phone and online anyway.  While it has been talked about for years, I can see more and more people able to work effectively from all sorts of locations.  This week, I spoke with a former leader of Automattic (company behind WordPress and others) who explained how their company is a 100% virtual company with people working all over the world.  He talked about how “the drama goes down, because everyone is literally in their own little world”.  The way it worked sounded quite nice.
  3. Ideas and thoughts spread quickly.  People in Wyoming are as savvy with modern tools and ideas as anyone.  It no longer takes a long time for ideas to spread.
  4. Wyoming is more beautiful than I remembered.  I was born in Greybull and lived in Cody through the 8th grade.  I thought it was fine when I lived here, but there are so many beautiful mountains and valleys that it was quite wonderful to be here for an extended period.
  5. Psyched to also get back to the great San Francisco Bay Area.

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My Co-Owners Are Best Part of Investing

The best part of Greybull Stewardship for me is working with the people at the portfolio companies once the investment is done.  The initial discovery process is fun — meeting the management for the first time, understanding what has made the company successful, and exploring the future possibilities.  Jim O'Hara has been great to work with at the National Holistic Institute.That is great.

Co-owners follow the investment

Then, there is the step of making the investment that is like crossing the desert to reach the promised land.

The investment process is just a means to an end — I am not a “deal guy” — not like some people who thrive on the intensity of the deal itself.  The deal is a lot of working with lawyers, thinking about worst case scenarios, “trusting but verifying” during the diligence process, spending silly money on things to just cover your bases that you know are not really big risks (but you don’t want to be the idiot who didn’t double-check something), and being on the opposite side of the table from the management I respect and can’t wait to work with.

These last few months have been heavy on the deal side for me.  One investment was made and announced (Murphy Business), one made and not yet announced, and three more to close in July and August.  Frankly, that is too many at one time for me.  However, I am doing it because they are all nice businesses with people who I enjoy.  This is the “investment” part of the job for me — putting in the time and money to get to the good part.

Co-owners — the good part

After the investment is made, working with our co-owners of these portfolio companies is the most fun of all.  The Greybull portfolio companies are excellent businesses which means there are many more positive surprises than negative surprises.  Don’t tell the management of these companies, but there is nothing better than seeing awesome financial results roll in (my only role was the easy one of cheering on these all-stars)!  Even the larger decisions are fun and interesting.  Smart people around the table bringing their life and business experience to the challenge at hand is enjoyable.

in the land of shiva james o'hara

When I bought the National Holistic Institute in 2003 with my good friend and business partner, Tim Veitzer, we quickly realized that the best part of that business is the people.  Many excellent, talented, and inspiring people work at NHI and have worked there over the years.  One person who has a large impact on NHI over the years is Jim O’Hara.  His personality and insights are stamped through the organization from his wisdom that has become part of the culture such as his “Tell the Truth with Compassion” and his phrase that “NHI is everybody’s dojo” space where we all learn life lessons.  His calm, grounded influence has played a very important role in NHI’s success and growth over the years.  The school and its graduates would not have fared as well without Jim’s presence.

That is why I read Jim’s memoir as soon as it was published last month.  In the Land of Shiva is about his seven years in India and Nepal setting up a new endeavor for an order of Catholic Brothers.  It is a wonderful book full of entertaining stories and large and wise observations about people and life.  It is rare to find someone who can observe life’s happenings, place them into a larger, thought-provoking context, and write well to convey them to others.   With Jim, we have all of the above.  If you are up for an opportunity to learn from a wise man, you cannot do better than reading Jim’s memoir.

Also, here is an awesome photo of Jim in India in 1980 with his mates that were part of the India adventure — he is the one on the left.jimohara in india

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Quality of Earnings in Due Diligence: What You Need to Know

As many sellers do not sell businesses frequently, I like to write about various parts of the transaction process that may be helpful for sellers to understand.  Due Diligence Quality of Earnings

One of the most important steps is when a buyer performs a “Quality of Earnings” review of the seller’s financial statements.  The idea is that the buyer is there to verify the earnings of the underlying business and any “add backs” that the seller added to the earnings as a representation of what a new owner could expect to receive in cash flow.

Quality of Earnings Due Diligence Before Legal

Below are the basics of a Quality of Earnings due diligence project.

Who:  For businesses larger than $500,000 or $1 million in earnings, the buyer will hire an accounting due diligence firm.  Their job is to get into the details, and prepare spreadsheets and reports of their findings for the buyer.  You can expect these firms to be extremely detail oriented and willing to double-check everything for their client.

What:  The diligence firm will provide a request list of documents with the goal of being able to verify the earnings the seller has represented.  Most likely, the firm will spend a few days to a week on site at the company to ask more questions, fine-tune requests, and ask follow-up questions as they get into the details.

When:  This usually happens after a Letter of Intent is signed between the buyers and the sellers and it is usually the first diligence project undertaken by the buyers.  The buyers want to verify the earnings power of the business before they spend money with the attorneys to draft the legal documents required.

Why:  It is just good practice.  Many times, sellers do not represent their earnings power properly not because of any ill intent — it is just that they are not accounting experts.  The financial statements need to be in proper accounting format so that it is in the language that the buyers and the lenders all understand.  For businesses whose accounting is very well done and they did not make any aggressive add-backs, this will be a “check the box” part of diligence and very easy.  If your accounting is not well done, however, this could be a major issue.

 What are some things that a Quality of Earnings diligence firm may find:

  1. Revenue or Expenses in incorrect periods.  It is sometimes easy for revenue or expenses to be accounted in an improper period.  Those are easy for diligence firms to spot.
  2. Improper accrual accounting.  This is related to the first point, in that accrual revenue or expenses may not be done properly which results in revenue or expenses being in the improper period.  In addition, many businesses that have deferred revenue (customers pay before the service is delivered) do not properly account for the revenue and take it too early causing their earnings to be higher than accounting rules would allow.
  3. Discontinued Operations.  If the seller closed a money-losing business, buyers will look at that as an nice gain for the future.  On the other hand, if you had a money-making business that you are no longer operating, the buyer will not want to include that in the earnings power of the business going forward.
  4. Open employee positions or missing expenses.  Are there open positions on your org chart?  If so, the buyer will assume you need those positions and reduce their earnings estimate to account for it.  Or, is there an obvious expense that you were able to avoid historically, but will be needed by the buyers going forward?
  5. Improper add-backs.  Many times sellers want to make their earnings look as strong as possible, for obvious reasons.  Some add-backs are logical and correct such as salaries for owners that are larger than what is needed to pay a professional manager.  On the other hand, other add-backs are not as defensible and I recommend not being too aggressive with add-backs as it inevitably causes issues.
  6. Pro forma adjustments (may not be anything you can influence).  While you may not be able to affect this, many buyers will add in other expenses that they assume they will need such as a budget to pay an audit firm to audit the financial statements if they had not been audited historically.  Or, maybe the buyer will want to expand the board of directors and include a budget to do that.

In my opinion, the more that sellers know about the process of selling their business, the more that everyone can be assured that the transaction will go smoothly and efficiently for everyone involved.  Due diligence is a very important step, and the most important part of due diligence is the Quality of Earnings verification.

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Owners’ Words Best When Reflect Both Noble Purpose & Bottom-Line

This revealing story was told by speaker Lisa McLeod at the recent Murphy Conference for their impressive network of business brokers across the country.  McLeod gave a very nice talk based on her book Selling with Noble Purpose.Selling with Noble Purpose

McLeod was facing a conundrum in her research.  As she spoke to sales people who loved the idea of selling with a noble purpose, they often said that their boss would never go for it as they were too focused on the bottom line.  And as she spoke to management who loved the idea of selling with a noble purpose, they also said that their sales people would never support it as they were too focused on their commissions and bottom line.  She could not figure out the disconnect.

One day as she was volunteering in an elementary school classroom, the students had an assignment to draw a picture of their mothers’ favorite things.  One by one, the children finished their pictures and there was an uncanny consistency among the pictures:  most of them showed ‘cleaning’ and ‘sleeping’ as their mothers’ favorite things.   McLeod knew the children and knew many of their mothers.  She knew that ‘cleaning’ and ‘sleeping’ were not their most favorite things.  She began asking the children why they drew those pictures.

The answers soon became obvious as the children said that their mothers talked most often about cleaning (‘We have got to clean up around here”) and sleeping (“I just can’t wait to get a good night’s sleep”), so those must be their favorite things.  It then became apparent to McLeod that both the sales people and the management may agree with the idea of selling with a noble purpose, but they were talking only about the bottom line with each other.

The words and emphasis of a business owner matters a great deal.  We must all be conscious about speaking to both the noble purpose of our organization AND the bottom line numbers and metrics.  Our organizations need to know that we care about both.

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