In our previous articles, we’ve been discussing the changing landscape of Fashion M&A — in particular, how private equity has been shaking up the established patterns of mergers and acquisitions. We’ve looked at how companies that have strong brand equity are most in demand, and we’ve gone through probable scenarios an owner might encounter in the process of selling a business. In this installment, we’ll talk about what a seller needs to do to get a company in shape — not only for sale, but also as good practice for running a profitable and desirable business over the long term.
Generally speaking, company owners sell a business only once. That is, they have one chance to select the right buyer and to maximize the value of the business, which typically represents the vast majority of the individual or family’s income and net worth. As such, the sale of the business is the nest egg, the chance to retire in comfort and maybe leave something behind. For these owners, getting the most out of the sale is very important. Preparing a business for sale will help to achieve maximum value and a smooth transition. Getting into the mindset of preparing a business for sale is something that can be done right now. Regardless of whether a sale is imminent or not, it will help the company’s profitability and create a stronger, more resilient business.
So how do you prepare your business for sale?
The top priority when contemplating a sale should be maximizing profitability. In most transactions, the business valuation is based on a multiple of profitability. The most common value metric is EBITDA (earnings before interest, taxes, depreciation and amortization). As most businesses are valued at a “multiple” of EBITDA, every dollar of EBITDA is multiplied for the purpose of determining the purchase price. Business owners looking to exit need to be driven by earnings, rather than sales, in the years leading up to a sale — most importantly in the year in which the company is sold.
This means that owners should do a thorough evaluation of the business. It’s time to close down unprofitable divisions, improve sourcing and gross profit margins, if possible, and analyze and remove all unnecessary operating expenses. Since privately held businesses generally exist for the benefit of the owner(s), it is not unusual for expenses to exist in the business that would otherwise not be there if the company was owned by a third party — family members who are employed in the business and the like. In addition, companies have non-recurring expenses that arise from time to time, such as extraordinary legal fees, employee severance packages, and other one-time items. These types of expenses should be segregated and clearly identifiable, but do not need to be eliminated — they will be treated as adjustments to EBITDA in a transaction.
While profitability is the number one consideration in preparing a business for sale, several other factors matter in determining valuation — in particular, company size, recent trends and growth prospects. Bigger businesses typically warrant higher multiples — so if the opportunity presents itself, growing the business to the next level, organically or through strategic acquisitions, will ultimately pay off. Additionally, it is critical to understand and manage year-over-year financials to demonstrate a trend of consistent growth — movement in the right direction. While the transaction valuation will be based on the most recent or current year’s financials, historical trends and clear and identifiable future growth prospects are key to enhancing value. Selling a business at a point when growth potential is maximized will result in a lower multiple. Additionally, buyers will pay more for sustainable business models — this includes companies with brand equity (owned or licensed) versus private label, low customer concentration and/or diversified distribution (wholesale, owned retail, ecommerce), and strong customer relationships.
Moreover, businesses that operate professionally tend to enjoy higher multiples — so it’s important to professionalize the business before a sale. This can be done in several ways. First, ensure the recordkeeping and reporting systems are organized and current, and can withstand the scrutiny of a buyer’s due diligence team. Financials should be GAAP-compliant, and a certified financial statement will be required for at least the current and/or most recent year. In the same vein, the business should be managed against a carefully conceived financial plan that’s reconciled by senior management on a monthly basis. Since most acquirors do not have management teams that can immediately parachute into an acquired company, the selling company needs to demonstrate that there is a strong management team already in place, plus a strong second bench. If the owner or key operator is planning to leave the company soon after the transaction is complete, it is critical to know who the torch is being passed to. Having a plan in place for this in advance of the transaction will enhance value for the business.
Other considerations that speak to value
In the years leading up to a transaction, a company needs to be prudent with capital expenditures, new business ventures, long-term lease commitments, and transferability restrictions and transfer fees in license agreements. Some capital expenditures, like investments in information technology, will not be valued in a transaction — when a strategic acquiror buys a company, it already has its own IT structure in place, so any investments in IT by the selling company will likely go down the drain upon a sale.
Also, new business ventures often log in years of losses before profitability is achieved. These losses will be a drain on the company’s EBITDA, and thus on its valuation. There should be a strong strategic rationale, and midterm visibility into the success of any new venture — so while losses in the first year or two are expected, unless there’s a clear path to profitability, the investment may not be warranted. Another value consideration we often see in transactions is that office space will be consolidated, making long-term lease commitments an obstacle to transactions. Similarly, license agreements with large transfer fees will detract from value — and those with transferability restrictions may kill a deal. The overarching advice is to think critically about all long-term commitments and capital investments taking into account the impact on a transaction.
Organize your information
We can’t stress enough the importance of having a clear and transparent view into the healthy workings of the business. Make sure all of the business documentation is in order, current and organized — including contracts, trademark registrations, financial information, records by account, employees, and outstanding lawsuits. If there are lawsuits in progress, it’s best to get them settled before the sale process begins — it’s much easier to explain a concluded event than an ongoing one.
As early in the game as possible, internal and external teams should be identified to run the process. Even if you are not yet ready to hire an investment banking firm, conversations can and should begin anyway — getting “free” advice and building relationships will go a long way toward getting you comfortable with the process and getting the business ready, and it will make things easier when you are ready to dive in.
Timing is everything
This piece of advice is crucial. We’ve alluded to the fact that there’s a rhythm to a transaction process. We’ve seen it hundreds of times, through billions of dollars’ worth of deals over 25 years. To connect with this rhythm, first think about who you want to sell to — whether it’s a strategic buyer or a more financial-based buyer, like a private equity firm. If there is a clear “right” buyer, or two, have a trusted advisor initiate conversations with those principals without divulging the seller’s name — even years before you’re ready to sell. Building those relationships, in a measured way through an intermediary, protects the prospective seller’s confidentiality while allowing the advisor to get “under the hood” of the prospective acquiror which in turn allows for the advisor to best position the selling company and to do so at the most opportune time.
You don’t want to break the transaction rhythm, whatever you do — there is often just one chance to get this right — so don’t start a process until you are ready to bring it to its full and fruitful conclusion. This involves, paradoxically, thinking backwards. Generally speaking, companies in our industry are structured such that the principal is incentivized to stay on with the business for a number of years, to ensure a smooth transition to the new owners. It may take three to five years from the start of the sale process to full payout, so in determining when to sell, count backwards. If you want to retire in five years, you should be thinking about selling today.
Remember, it is never too soon to start preparing your business for sale.
About the Author
Allan Ellinger is MMG’s co-founder and senior managing partner. In addition to his involvement in M&A, restructuring and crisis management, he serves as a strategic advisor to many fashion and consumer product CEOs. He can be reached at A.Ellinger@mmgus.com.
Now in its 25th anniversary year, MMG provides investment banking, strategic and financial advisory services to clients in the retail, fashion, textile, home, and jewelry and beauty sectors. The firm guides owners of both privately and publicly owned businesses through mergers and acquisitions, management buyouts, divestitures, strategic alliances, operational restructurings, valuations and business model analysis.