Cashing Out – 5 Steps to a Better Deal

Many of you know I sold my agency a few years ago and in June went into semi-retirement.  The most frequently asked questions I have received over the past few months are:

How do I get ready to sell my company?

What are the things I need to focus on to get the best deal possible?

Most of the tips offered below come from significant experience selling a few companies and participating in the due diligence for acquisitions or investments in numerous companies over the past fifteen years.

Why are companies acquired?
If we start our thinking by asking Why are companies acquired? This answer enables us to understand some of the key dynamics that must be in place before a company will be interested in acquiring it. Acquisitions are never out of the goodness of anyone\’s heart it is always to fulfill some larger business objective.  When we analyze the reasons for acquiring a company, the steps you must take to prepare make a lot of sense.

There are essentially two reasons companies are acquired:

Growth & Market Share

Now is about the time that search companies will be acquired to help the growth of larger digital companies or to move a well-funded mid-tier company into the top three.  Large holding companies are buying search companies for their revenue, client base, or most recently, dominance in an overseas market.

In most cases, it is hard sourcing talent and building a book of case studies it is easier to just buy a local player and empower them to grow to the next level.

Competitive Advantage or Skills

This was popular a few years ago where big ad groups were buying mid-sized shops in order to have a search capability that allowed them to keep business or gain business over a key competitor.

For example, WPP bought Catalyst Online for their experience with pharmaceutical companies. They were and are still the dominant pharma search agency and this fit in perfectly with Gray Healthcare and Ogilvy Healthworld since they have so much pharma & healthcare business that needed Search Marketing solutions. WPP bought GSI because we had the Fortune 100 clients and are the market leaders in enterprise and global search marketing.

Other acquisitions were around tools, Doubleclick bought Performics since they had great search tools that added that degree of technology and skills to Doubleclick’s portfolio.

Preparations & Due Diligence

To complete a deal, you must pass the painful due diligence process. While the deal is the sexy part, the devil is in the details.  You may have the best team, tools, and brand in the world, but you will not be bought if you don’t add value to the acquiring company.  You need to start thinking about the following before you even get an inkling of a deal. The better you are prepared before they reach out, the more leverage you have during and after the deal is done.

Step 1 – Improve your Balance Sheet

The goal is to maximize income and clearly demonstrate your future earnings potential.  The biggest surprise owners will experience in the process is the valuation process.  Except for a killer technology with a true competitive edge, company valuations are all done on the company’s future value based on performance today.  For example, you might be a two-person company that is on a roll ringing up sales and believes you can become a 100-million-dollar company, but you will not necessarily be paid for your potential.  You will be paid for today’s value with a multiple based on a glide path of potential.  If you are doing $1 million today and you can demonstrate that with the suitable investment and management team, you could do $5 million next year, you will only be paid for what is realistic growth today.  If you are really bullish about your performance, you will walk right into the earn-out trap, where you will then take the risk on your potential and not the investors.

As the owner, you need to understand the balance sheet, what it tells you, and, most importantly, what it tells others.

Maximize the income side of the Balance Sheet.

• Make sure current clients STAY current clients – hold on to them for dear life. If you have a bunch of short-term clients, they will dig into your turnover and be concerned that you will constantly be cranking for new business.
• Increase the diversity of your client base – if you are a one-trick pony, meaning one big client with 80% of your revenue, or only have Technology or Consumer Product companies, that will be a growth concern.  Try to get some diversification of the size and categories of clients.
• Increase size and duration of the relationship & sole source – Many small agencies don’t understand the actual value of an agency of record agreement. Being the AOR guarantees that you have the work as long as you maintain the status.  This is extremely valuable as any department or brand in the company that needs search work will have to use you.  Unraveling AORs is hard, and many companies don’t want to change vendors, so they often have poorly managed programs. Again, this is not quite money on the bank. Still, it is an excellent indicator to investors that you have a reasonable degree of potential to defend existing assets and get additional revenues from your clients.
• Increase Contractually Recurring Revenue – this is money in the bank. In most cases, you can get a loan against this revenue.  The client has agreed in the contract to an ongoing retainer or a fixed set of fees over time. Investors like this since it is believable revenue.  If you have a bunch of accounts not under contract, then that revenue can do away without anything you can do.
• Drop low-margin and/or low-prestige clients – are you crazy suggesting we fire a client?  Yes, if they are a drain on resources, not paying on time and do not add either revenue or brand prestige to your company – you may need to cut them loose.  I have never had a problem firing a client who was a resource drain.  However, even if they are small, pay their bills, and are easy to work with, keep and work with them to grow.

Reduce the expense and liabilities side of the Balance Sheet.

• Demonstrate fiscal controls & audits– if you manage your business from a shoe box or a desk drawer, you are in for a surprise.  Ensure you have a bookkeeper and/or an account keeping tabs on things.  With all the free and inexpensive accounting tools like Quickbooks online, it is silly not to have good, sound accounting practices – or at least in an editable format. One of the top 5 questions you will be asked is your receivables. If you don’t know that, the accounts will dig in and question your ability to manage a business. You can hire a fractional bookkeeper or CFO to help you get your reporting and process in order.
• Evaluate office space expense – This seems simple, but if you have expensive space because you want to look bigger or work on the beach, they will evaluate it. If you have excess space, consider subletting it or letting some part-timers pay a discounted rate to use it for meetings.
• Increase the Expense-to-Revenue ratio for key staff – this is a tough one as agency-holding companies mandate a 3.5 to 1 ratio of employee expense to revenue.  This is a big problem for search. Due to the lack of skilled talent, many agencies pay a premium for key talent.  For example, if you are paying that SEO Superstar $100k per year plus another 30% in overhead, they need to be billed out at a rate that generates $455k in revenue.  If you have 5 of those talented individuals, you need to pull in $2.7 million in revenue to have an EtoR ratio that will appeal to an agency group.
• Business Liabilities – If you funded your business with 20 credit cards or a personal line of credit, you must start cleaning that up.  While credit is tight now, you need to start getting business credit and look at all you have.  Since they are hard to manage, you will have to present any business liability and ensure you have a good handle on employee charge cards. We had a line of credit just in case someone was late in paying us that we never used but it was a potential for debt. We had to agree we would not use it, close it, and cancel company cards within five days of closing the deal.
• Evaluate overhead payments – review any expenses you want this area to be as clean as possible. Cancel unused tools and other subscriptions if they are not being used.
• Review payment terms – This is a big one. They will want to understand your contracted payment terms. Do you have them? Do you enforce them? A few F100 companies recently approached one of my investment companies, wanting 90-day payment terms.  You will be lucky to get anything less than a net 45 or 60 with most large companies, but monitor this. Funding a half million in labor costs can be risky and expensive if you don’t have the cash flow. That is why we had the line of credit before we needed it. Ensure you invoice at the first chance to start the clock ticking.

If you have an audited balance sheet, that will be very helpful. It will cut out a lot of the document gathering, as you will already have organized it to pass the audits. A good fractional CFO can help you prepare the documentation.

Step 2 Intellectual Property Protection

This is a big one, and it frustrates me that more companies don’t take the time to protect their intellectual property.  Two companies I invested in recently had key technology that was not protected.  Yes, it can be expensive, but it becomes an asset since you have rights to it. This is critical if you are being bought due to some competitive advantage you have with technology.  For Social Media companies, most of what you do is new to the marketplace and needs to be protected.

Document Intellectual Property

• Get Trademarks and/or Patents where applicable – these become assets that will come into play in the negotiations.  You cannot protect everything, but if you have a new tool, process, or terminology, get it protected.  The sooner you start, the quicker you have the date you put it into play. Ensure you have at least protected your brand name and logo.
• Publish articles, manuals, or books detailing methodology – you don’t have to give away the farm, but using your words or process in trade is a poor man’s way of some protection. If you can demonstrate you were doing something publicly, that will be in your favor.  This is not in any way a substitute for proper protection, but it is better than nothing. I have been able to point to things I wrote in Search Engine Marketing Inc and industry articles as proof of prior work.
• Detail typical engagement methodology – this is an internal document that an attorney can review to see if any attributes can be protected.  It also gives the acquiring company a lens into the process and that you have developed something tangible.

Demonstrate Technology Advantages

• Proprietary technology vs. me-to- so what – you’re a search agency, and you use Google’s Search Console face to mange client data.  At that point you are just a labor force.  However, if you have some uber-secret process, tool, or methodology that separates you from another company, you have an asset that has value beyond your revenue.
• Key Relationships with Vendors – any kind of relationship is an asset. Brand Ambassador Programs, Advisory Boards, and any organizations you have board seats.  All of these are assets to the company. They may not factor into the final deal, but they all help the acquiring company feel they are getting something that is a force to be reckoned with in the market.

Secure Current Employees & New Talent

• Employment contracts and non-competes – These are critical. If key talent doesn’t have them now, they will be in the deal.  Having contracts protects your ass and assets and is a great way to demonstrate you can manage your team.  Other than company principals, you will unlikely be able to do non-competes.  If you are given one, then please review it carefully and ensure that you are willing to give up your mode of income if it does not work out.
• Equity shares – Have a detailed list of who has equity, the type, and the terms. This is a great way to motivate employees. For some, it may make sense to vest upon the deal. Others may have to wait for a period of time post-deal. There should not be any surprises with expectations since this will come out in the process.  Any partner or employee that has them must be disclosed, and if you don’t have agreements today, you must get them in place before the deal.  Once the deal is done, they will be the shareholders or members of the LLC, and it is nearly impossible to get them out of the pool once the deal is done. Also, ask about their vesting or purchase. In every case, our minor shareholders were bought out by the acquirer just to minimize those in the earn-out phase.
• Line up key talent and tie them to the deal – if you need key talent before you can go to the next level, try to tie them into the deal.  Note them since you will be asked how the business can scale post-deal, and this helps keep them as many companies want to trim costs post-deal.

Step 3 Prepare for Due Diligence

This phase is all about proving your value and showing them the beef.  Prepare for many sleepless nights, lots of paper pushing, photocopying, and explaining the what and why of everything you do. When you are done, you will feel like you are running for office, or the investors will have zero trust in you.  They are doing this to protect their investment, just like you should if you acquire a company.  Do not lie during this process; if you find mistakes, be ready to explain them.  Now, if you told them you did $10 million in business, and that was all media dollars, and you only actually had a net revenue of $1 million, they will see that pretty easily.  I have seen this several times during initial conversations where the management will indicate a revenue or profit level they believe they have, but it turns out to be incorrect.

The good news is that if you have any problems with accounting or money management, they will be fixed after this. You will have a great set of financials and processes that, if the business is healthy, you should be able to take to nearly any bank and get a loan.

• Gather all pertinent documents – when I did this process with GSI, we ended up with ten large binders full of documents.  We had to show every current contract, every invoice, every purchase order, and every major expense and liability.  They will want rental and lease agreements, credit card statements, and any other document that shows the fiscal health of the organization.
• Check and recheck Financial Statements and other key documents – make sure they are correct.  If you have a contact you gave Net 30 terms and now they are on a verbal Net 60 that needs to be updated.  In one company we thought of buying they had nearly $2 million in receivables that had not been paid but showed them as being paid.  Collecting that money nearly nine months after they billed the client was a pain for them as it could not be counted as reliable revenue.
• Understand Financial Ratios— Hopefully, you manage your business with sound financial data. They will look at several financial ratios related to turnover, profitability, staff ratios, etc., and use these to help set the valuation and earn-out schedules.
• Update and Improve your business plan – Start with the question – is it believable? Yes, I know you have the next Pets.com or Google on your hands, but you also need to be realistic.  They want to know how you will grow the business once you are partners.
• Get your stories straight with the management team. Review the documents with your key team. Even if you cannot stand them and hope they leave post-deal, you need them to be a team now. It is critical to understand your financial controls, client relationships, market potential, and, most importantly, business direction.
• Detail all physical and intellectual assets – this is easy to understand. Simply put, the more you have, the more you can be valued.  You need detailed equipment lists as well as all of the IP and tools you have.
• Conduct a detailed SWOT Analysis – this would be helpful to prove your business plan and help them understand the market landscape and where you fit into it.  This is critical with social media companies since there have not been a lot of acquisitions in this area.

Step 4 What’s in it for Me?

Understand what you want out of the deal.

• Why do you want to sell? — if you are selling for money to grow, you will find that complicated. The money they give you is for your share of the company, and they will take the revenue from that share they bought. Also, don’t expect them to throw in other money to grow, nor will you get anything from reinvesting your payment into the business. While most won’t let you go bankrupt, there is typically no funding provision, so understand how you will fund growth and your pet projects if they allow them to continue.  If you want money to grow, get a capital infusion, not an acquisition.  If you are selling since you have problems with the business or want the advantages the new parent offers, then you must understand that when you do the deal.
• Retiring to the beach is not an option – most of the deals being done have earn-out conditions. You are there for the duration unless they bought a tool or other asset – at least two to five years, depending on the agreement. Sometimes, they may require you to move on and replace you with their management team. If you are the face of the company or the money maker, you are the asset, and you need to start thinking about how you rope in others into that role so you can depart.
• What is your Control Premium? What is the price for losing control? It would be best to consider whether the money you will get for the company will be worth the additional control and management structure you will have to accept. Do you have a board seat and any thresholds to spending or talent acquisitions?
• How long do you think you can work for the new owners? – this is the big one.  Like the prenup question, “Honey, if you love me, you won’t think about us ending.”  Everything is great if you find the right partner and have a long and prosperous life together. But if anything goes wrong, you need to understand your options and how long you will be tied up. Many have stayed after the earn-out but if you are not in sync you need to think about the pain point.

Seriously weigh cash vs. equity

• You can believe in the business and still take cash – that is my firm belief.  In my earlier accusations, I was only offered stock. When I challenged this form of payment, I was told that I must not believe in the company’s future since I wanted cash.  I don’t make that mistake anymore. There is real value in the business and there must at least be a stock and cash arrangement.
• Completely understand expectations – what are they expecting from you and your company regarding revenue, markets, or other opportunities?  The more this can be made clear, the fewer hassles you will have later. They are not a charity; they are underwriting future cash flow, not past success.

Get everything in writing.

• Document all agreements—If they don’t sign it now, they won’t sign it in two years. Mutual understandings and verbal agreements are worthless unless they are contracted on paper and signed by both parties. I typically list my wishes and wants and go through them to confirm they are all included.
• Don’t use friends and family for any of the paperwork unless they were investors and part of the deal keeps them separate. Even if Uncle Jimmy is a CPA, don’t use him. If there are problems with the deal, you need someone to blame, and that may not sit well at holiday time that he made a mistake or you lost money since he did not understand the ffiner points of M&A.
• Spend the money on experience – Get everything reviewed by experienced and competent Lawyers & CPAs.  The acquiring company with their teams bears much of the due diligence expense.  However, you need help with finances, especially legal matters.  You need someone with real experience.  The lawyer we used was brilliant and was a key part of the team.  In fact, to help reduce the costs of legal fees on contracts early in our business etc. early on we gave him an equity share of the business which made him fight even harder for us in the deal.  You will also need a personal attorney to review your non-compete and other legal documents. If your business attorney is a shareholder, you cannot have him review your employment agreements.

Step to Prepare for Change & New Rules

Management

Taking orders from others

• Receiving NO for an answer a lot! – you were the boss, and now you are an employee. In many cases, that is great, you get to execute and not worry about all the logistical details. Still, it hurts a bit when you need executive approval for a $50 printer cartridge when, a few weeks before, you were approving $50k server expansions.
• Falling into guidelines for their business – this is the one that hurts fast-moving companies. At GSI we paid well for the right talent. Promoting a person and that job warrants a $10k bump in pay may become a problem.  After the acquisition, raises were only possible twice a year and during specific months. Any raise could not be greater than 20% of their current salary and had to fall under their salary band no matter if they could suddenly walk on water.
• Understand ROI Goals and Timelines – this is another surprise you will encounter.  There is nothing like doubling revenue and profit and hunting or sacrificing revenue for another business unit that is floundering.  While taking one for the team is good, you need to understand the rules and how they will impact your numbers, especially toward an earnout.   Also, don’t expect a lot of exceptions for being a new acquisition. You will have to fight for revenue share like the rest.
• Client Conflicts – this is both an immediate and long-term problem. A couple of clients for the acquirer had strict non-competes in their AOR. This meant we could not work with that client post-acquisition. We had to resign from these projects. We could count the revenue to date and get a “credit” for the expected future revenue. We also signed their AOR clients soon after the acquisition so that worked out. Two years after the acquisition, the parent decided to roll all of the projects for a large CPG company into a separate company. The selling point was they would take the best people to serve them and only them. We lost 50 projects to this team and neither got credit for the revenue loss nor could our team work on those projects and had to share our process and our IP with a competing agency team in the group.

Integration & Compliance

• Equipment & Systems – this one will drive you insane.  As you think about acquisition, you need to factor that into any technology purchases.  It does not make sense to buy all new servers to find the acquiring company that will force you to use something else. In my case they actually wanted us to send them our new laptops since they were better, and they would replace them with their hand-me-downs.
• SOX & Accounting Compliance—Back to the accounting. You will need to develop reports that roll up into the parent. Twice, this has been a full-time headcount just to do the integration and translation of documents. Just wait until you have to become SOX compliant if a public company acquires you. You can expect to pay between $50k and $100k to get the needed systems and do the migrations and audits to pass the coming audits.
• Software Conflicts – If you have developed software, this can add complications and liability to the deal. With my first company, we developed an amazing email and retargeting solution. The acquiring company had just signed a deal with the largest player that required them to spend millions on licensing and revenue for clients. Initially, our software was not a problem, and we could continue to use it. However, as they failed to meet their commitments, they started to force us to migrate our clients over. Ultimately, they took all of our clients and our application was shut down. We got some Goodwill for our software during the acquisition but no credit for the revenue lost due to the cannibalization. Similarly, you may have revenue or performance deals with software that might be a problem post-acquisition if there is a conflict with the solution at the purchasing company.

While there is a lot to do, when done right, it is easier, and the rewards are more significant.  There is much more to this but this will get you started and thinking.  If your exit strategy is acquisition, then the sooner you have your ducks in a line, the better you will be when that time comes.

You may want to check out this article I wrote later when a few people ask how to value their agency.