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Helping clients build businesses that sell: It's time for a little due diligence

by Meredith Erlewine

June 2002

A couple of years ago, entrepreneurs planning to tap into their companies' equity may have had exit strategies that included securing venture capital or making an initial public offering (IPO). But in the wake of the dot-com bust and facing a dearth of venture capital, many up-and-coming entrepreneurs will look to sell up or sell out. Many will get rich in the process. But what will buyers look for? Merger and acquisition (M&A) expert Bruce Milne has a good idea.

Milne is president of Corum Group Ltd., which provides M&A services to software and technology companies worldwide. With more than 30 years of experience in the software industry (including owning three software companies), Milne has executed nearly $4 billion in mergers and alliances for small technology companies. In the process, he's seen firsthand what can make or break the sale of a company.

Selling up into a strategic alliance, majority investment or business partnership, or selling out through a merger, asset sale or stock purchase can be the most important transaction of an entrepreneur's life, according to Milne. It requires extensive knowledge, experience, planning and preparation. Milne says entrepreneurs preparing to sell up or out should start with due diligence of the internal variety. "What would your clients find if they performed due diligence on their own companies?" he asks. The answers may be surprising.

Milne suggests that entrepreneurs pay close attention to the following aspects of their businesses before even thinking about selling their firms. And even if your clients intend to remain lifestyle companies or are bound and determined to make an IPO, they will be well served to keep these basic business components in check.

Ownership. For a deal to be successful, all owners must be satisfied with the outcome of the sale. Issues of company ownership and individual owners' wants and needs must be clear long before dealmaking begins. For instance, if a small company has issued a mixture of common and preferred stock, do those holding the preferred stock have the right to nix a deal? Are there minority owners who could oppose a transaction and make a sale difficult? "Don't find out after six months of hard work that one shareholder doesn't want to sell," Milne says.

Vision. Depending on the entrepreneur, vision can range from being certain that major growth and worldwide dominance lie ahead to near passivity. "Buyers will pay more for people with strong vision," Milne says. "Vision is important when [buyers] don't have the staff to be successful [in the proposed] market." An entrepreneur must have a convincing and compelling story to tell about his company's bright future.

Management. Does the company have a good management team in place? "A lot of small firms don't," Milne says. Buyers want to see that the company has put resources into developing its people, because they'll then have fewer problems growing the business. Buyers also want to see a track record of good management decisions with measurable results. Managers should be able to show prospective buyers the effective tools they have put in place for hiring, product development, tracking sales, and so on.

Planning. Buyers want to see planning on the part of management, both strategically and operationally. Through business and strategic planning, an entrepreneur should know where his company is headed for the next several years, what its strengths and weaknesses are, and who its market and competitors are. Strategic planning also encompasses soliciting and incorporating customer feedback to learn how the company is perceived and if it is achieving its objectives. Operationally, principals need to figure out what to do in terms of sales, support, management and administration in order to achieve the strategic plan. For instance, if a firm thinks it will need a telemarketing operation in place in 12 months, it better be ready to do some hiring in six months.

Research and Development (R&D). If a potential buyer asks an entrepreneur what his firm is doing in R&D, the entrepreneur must be able to provide an articulate response. "[That entrepreneur] should be able to say, 'Here are the trends, and here is how we're responding,'" Milne says. That doesn't mean that the entrepreneur needs to have all of the answers, but he or she needs to be able to show what the company is doing to stay ahead of the game.

R&D process. Whereas R&D encompasses the areas in which a company is exploring, R&D process refers to formal methods of getting that work done. Does the firm have a way of thinking through ideas? Does the firm have a board of advisors, product or service users, or dealers to provide feedback? Does it have an effective method of performing alpha and beta testing? And finally, does it have a process to get new ideas to market?

Record keeping. Keeping impeccable records is crucial. "When you go to sell, there are certain people who will listen to your words and believe your vision," Milne says. "However, the people who must approve a sale are accountants, lawyers, CFOs and others who will look at your revenues and expenses and how you've broken them down." Good record keeping applies to nonfinancial matters, too. For instance, if an entrepreneur has alliances with other companies, are they verbal or formal? If a Web presence is an important component of the client's firm, is the entrepreneur tracking and documenting Web traffic? Are sales teams tracking leads and customer service?

Documentation. Documentation refers to putting a firm's processes and procedures in writing. For instance, in the software industry programmers had better take care to document their code. It may be brilliant stuff, but if a buyer has to spend a month cracking it, it's probably not very appealing. "It's true of anything," Milne says. "If you build a product or service, you have to document how you do it so someone else can come in and start doing it." A lack of training manuals, for instance, could slow employee training, increase product or service support costs, result in poor customer service, and ultimately decrease revenue.

Marketing. If a buyer asks, "How do you market your product or service?" or "Where does your product or service fit strategically in your customers' needs?" he or she wants a definitive answer backed up by research. A product or service may be fabulous, but is there a demonstrated need for it? Another pitfall for entrepreneurs, Milne says, is underpricing products or services due to insufficient research or marketing. "They're going so fast that they shoot from the hip," he says. "[Immediately after an acquisition], most buyers raise prices, because [the product or service is] really worth it to the customer." If a seller performs the proper level of market research, she may find that she can raise prices by justifying new technologies and features to customers. That extra margin could translate into a more profitable company that will sell for more.

Staff. "You have to get the best people you can, particularly in high-tech businesses," Milne says. "It's a brain game." Although hiring a brother-in-law or ex-girlfriend might be quick and easy, they're not necessarily (or likely) the people who can grow a company. Entrepreneurs need to demonstrate to potential buyers that they have a formal process for hiring people, perform extensive candidate searches, interview thoroughly, perform background checks, conduct exit interviews and track turnover rates. "It's [a matter of] doing it right vs. cheaply and expediently," Milne says. "When looking at a company, buyers know if the staff are fools. And they won't pay much for them."

Competition. Entrepreneurs should know their competition better than they know themselves. "A lot of companies make the mistake of getting lazy or arrogant," Milne says. Entrepreneurs should thoroughly research their competition, make a list of comparative strengths and weaknesses, and be prepared to explain to a potential buyer what the company is doing to address those weaknesses.

Sales Process. Entrepreneurs must be able to demonstrate to potential buyers that they have a way of getting leads, turning them into qualified prospects, and then making them customers. "I see so many companies that exhibit at conventions and don't even follow up on leads made at booths," Milne says. "They might send a brochure, but people don't buy based on one brochure. You need to make follow-up calls. Those leads are worth a fortune." When considering a target company, buyers want to know if that firm has videotapes or CD-ROMs that describe its product or service; Web-based product demonstrations; customer referral programs; and tools, techniques and processes that can turn a prospect into a customer.

Accounting Policies. "Just look at what's happening with Enron," Milne says. "Don't get yourself caught with questions like, 'Where did these expenses come from?'" He suggests that small companies account and report (or be able to recast) their financials the way that publicly held firms in the same industry do. And entrepreneurs shouldn't accept everything their accountants suggest – their accountants may be too lax. "Do it right in the first place instead of being in a position to defend [yourself to a potential buyer]," Milne says. Even if an accounting error is minor, it can become a much bigger problem during the sale of a company because it can create distrust on the part of the buyer. "Lack of trust can destroy," Milne says.

What are the most significant challenges you face?

Entrepreneurs sell companies every day. Likewise, other entrepreneurs snap up firms that will create opportunities for their own established companies. Of course, everyone is looking to make a buck, but there are many other reasons why buyers buy and sellers sell.

Buyers may want to …

  • Diversify product or service offerings
  • Gain management experience or expertise
  • Establish a foothold in a new market
  • Acquire patents
  • Get up to speed on R&D in a particular market
  • Improve cash flow or increase profits
  • Increase sales volume
  • Broaden customer base
  • Move into international markets
  • Gain knowledge and expertise in specific industry niches
  • Access distribution networks

Sellers may …

  • Be having difficulty raising funds
  • Have conflicts with partners, employees, board members or investors
  • Be experiencing fatigue or health problems
  • Find that management challenges aren't as satisfying as developing ideas
  • Realize that a firm may be pushed out of the market by bigger companies if it doesn't sell
  • Know that selling the company will ultimately provide the best shot at large-scale growth or success
  • See an opportunity for investors to receive a hefty return

Keywords: benchmarking clients, business planning -- client, company valuation, human resources -- client

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