A few weeks ago, Google announced it had acquired Clever Sense, a small company that has developed a neat application called “Alfred” that helps you pick a restaurant (or hotel etc.) using your mobile phone. Google wants Android to beat Apple’s iPhone operating system and, having made 26 acquisitions last year, this was just the latest in a long line of Google takeovers designed to compete with Apple et al.

Getting bought by a big company like Google (or Coke, or Procter & Gamble, or Johnson & Johnson or Amazon…) is usually the entrepreneurial equivalent of winning the lottery. This is not like selling to a bean counting private equity firm.  With a strategic acquirer, the value is less about you and more about what you might be worth if they duct taped you onto their platform.

So how do you get bought by a strategic? One way is to talk to a guy named Steven Popell. Popell has been a management consultant for the last 40 years and has recently developed a process for positioning a business for a strategic (as opposed to financial) sale.

I asked Steve to share his philosophies and approach with you:

Warrillow: Can you give me an overview of your process?

Popell: The ExiTrak® process is based on the time-tested principal that, if you want to determine if a new product line or suite of services will sell, at what price, etc., talk with customers and prospective customers. This process asks key acquisition executives in prospective buying companies which strategic assets they find most valuable when acquiring a company in this industry today. When we have interviewed 15-25 of these key executives, and collated and analyzed the results, we have the profile of the valuable strategic acquisition candidate from the perspective of the buying marketplace. Then, the management of the company that wants to position itself to be sold makes decisions regarding which strategic assets to acquire and/or enhance in order to get the company’s strategic profile as close as possible to what the marketplace has said it finds valuable. That’s the process; and no one else does this.

Warrillow:  How would you describe the difference between a strategic sale and a financial sale?

Popell: In a financial sale, the entire return on investment (ROI) comes from the earnings and cash flow generated by the seller as an independent entity. Big Company A acquires Small Company B and sets it up as a wholly owned subsidiary. Company B then continues to operate essentially as it did before it was sold.
In a strategic sale, the ROI for the buyer also includes the increase in earnings and cash flow to seller and, especially, to buyer because they are together.  If, for example, the buyer is 10 times bigger than the seller, and the buyer increases its earnings by a mere 10% as a result of acquiring the seller, that figure represents the same dollars as if the seller had doubled its earnings. A 20% increase is the same as the seller tripling its earnings.

Warrillow: Can you illustrate an example of the math if Big Company A is a $100,000,000 company with 15% profit margins before acquiring Small Company B, a $10,000,000 company with 15% profit margins?

Popell: Big Company A has a pretax profit of $15 million. Small Company B has a pretax profit of $1.5 million. If Company A increases its earnings by 10%, that is $1.5 million – the same as if Company B had doubled its earnings. If Company A increases its earnings by 20% or 30%, that is $3 million or $4.5 million – the same as if Company B had tripled or quadrupled its earnings.

Warrillow: How do you see the difference between financial value and strategic value play out in the real world?

Popell: In 2011, we conducted the first and only statistically reliable survey on this topic. The results reflected deals under $5 million. Overall, about 2 out of 5 financial sales yielded prices at or above the owner’s target. In strategic sales, this figure was about 3 out of 5. In those deals in which the business broker had the greatest experience, the results were even more compelling. Strategic sale multiples exceeded those of financial sales by at least 25% about 53% of the time.

Warrillow: Operationally, how can business owners make their business more attractive to a strategic acquirer?

Popell: The best way is to learn what constitutes the valuable strategic acquisition candidate in this particular industry, and then undertake initiatives to bring the strategic profile as close as possible to what the prospective buyers have indicated they find valuable.

Interviews with key acquisition executives in prospective acquiring companies, utilizing a questionnaire customized for the client and the industry, will yield this information. However, irrespective of the strategic value of a prospective seller, it is critical to have an attractive P&L history and current financial condition. Positive numbers will enhance the price; negative numbers will, at a minimum, decrease the price and can cause the prospective buyer to walk because of concerns about management competence.

Warrillow: Can you give us an example of the questions you ask strategic buyers when interviewing them on behalf of a client:

Popell: While each questionnaire is customized for the client and industry, two questions are common to all:

1. If you were to acquire a company in this industry today, which strategic assets would be most valuable to you: location, key customers, market niche, technology, technology infrastructure, etc. – and for each choice can you give specific examples?
2. How are these preferences likely to change, if at all, over the next five years?

Warrillow: Can you provide a real life example of when you did this with a strategic buyer and something interesting they revealed?

Popell: For an electronic packaging company that does business in both military and commercial markets, interview responses indicated clearly that the three most critical technological characteristics were power, cubic area and temperature control – elements that are inherently in conflict with one another. In other words, if you increase the power of a component and reduce the size of its package, temperature control becomes very difficult. It’s very much like the aphorism: “I can give it to you good or fast or cheap. Pick two.” The details of the interview responses provided the basis for the company’s strategic product development program.

Warrillow: How can business owners get up on to the radar screen of a strategic acquirer without revealing to the market they are for sale?

Popell: Be the best in your industry. Take a leadership role in the trade or professional association. Write articles that demonstrate unique and valuable expertise. Have a first-rate website that reflects well on the company and on management. Find out what constitutes the valuable strategic acquisition candidate, and proceed to become that. When you are ready to sell, ensure that the broker’s first communication with prospective buyers is a non-confidential memorandum that describes your company well enough to smoke out interested parties, but not so well as to allow your company to be identified. After that, all communication with prospective buyers occurs after the signing of non-disclosure agreements.

The cockpit suddenly went quiet. The pilot called air traffic control to request an immediate emergency landing, but it was too late.

With no thrust and only a few hundred feet of altitude, Capt. Chesley (Sully) Sullenberger decided his only option was to ditch US Airways flight 1549 into the Hudson River.

As it turned out, he greased that landing back on Jan. 15, 2009, but there was no rulebook for landing an Airbus A320 on the Hudson River. Nor did he get to practice a few times with an empty plane to get the hang of it. He had 155 lives in his hands and one shot to get it right.

In a lot of ways, I think selling a business is a little like trying to land a passenger jet on a river:  you’ve probably never done it before, you don’t get to practice, and there’s a lot riding on the outcome.

To help give you a sense of what to expect from the process of selling your business, I asked Brad Bottoset, an eleven-year veteran of selling companies, to answer some common questions I get from readers….

Warrillow: Can you explain the role of seller financing in selling a business? How common is it? How exactly does it work in layman’s terms?

Bottoset: It is estimated that 80 to 85% of all business transactions carry seller financing.  Why?  Many potential buyers don’t have the capital or lender resources to pay cash.  Even if they do, they often want to leverage it into buying a larger business with greater cash flow.  Buyers interpret the seller’s insistence on all cash as a lack of confidence in the business, the buyer’s chance to succeed, or both.  Of course, every transaction is different, but typically a seller should expect somewhere around one year’s cash flow as the down payment.  Just like banks use formulas to determine what someone can afford as a mortgage on a home, knowledgeable business brokers use formulas too – which generally point to the Note being paid off in 5 to 7 years.

Warrillow: Isn’t the whole point of selling your business to get liquid? Why would you lend someone the money to buy your business? If you’re not getting the cash upfront, why not just hold on to the business?

Bottoset: For most sellers, getting all cash upfront is their preferred route.   However, it may not be possible.  And there are a number of positives with seller financing:

• Making the terms attractive and attainable increases the pool of qualified buyers;
• Offering terms will command a higher price (buyers paying cash often demand a discount);
• Tax consequences can be advantageous.  Instead of being taxed in the year that the sale occurs, the seller’s capital gain is taxed over the life of the Note;
• With interest rates currently at their lowest in years, sellers can get a much higher rate (6%) than they can get from any financial institution.

Warrillow: What is the typical interest rate of a seller-financed deal these days?

Bottoset: Six percent.

Warrillow: I know one of the steps in getting a business ready for sale involves dressing up the Profit & Loss statement to show as much profit as possible. Can you give me some examples of things business owners often overlook?

Bottoset: When determining the value of a business, one of the key steps is understanding what levels of discretionary, non-business expenses the current owner is expensing through the business.  There are many standard types of “add backs” such as the owner’s car expenses, personal health insurance, etc….  However, we also have seen a number of examples of creative bookkeeping, such as trips to Europe classified as a “market research” expense, owner divorces identified as “legal fees,” etc.    One common area that is often overlooked is when the business owner also owns the facility out of which the business operates. Depending on the situation, they may be charging themselves fair market value (FVM) rent, or they may not.  If they are charging the business more than FMV, a positive add back would be appropriate.  If they are charging themselves less, a negative add back must be accounted for.

Warrillow: You use “social desirability” as one of the factors that can drive up, or down, the value of a business. What do you mean by “social desirability,” and can you give some examples of either desirable or undesirable businesses? How big an impact is social desirability on the value of a business, and can you give an example?

Bottoset: I can’t say I’ve come across a lot of businesses that will generate a significant premium, but I do know of a few that have been adversely affected by a lack of social desirability.  For instance, in our portfolio, we have a national trucking company that transports live animals for medical research.  We’ve had a number of qualified buyers (both from within the transportation industry and from outside) look at the business but they have shied away because of perceived issues with animal rights organizations like PETA.

Warrillow: What other factors drive up, or down, the value of a business? Can you give a real life example?

Bottoset: The basic value drivers are management depth, proprietary product, customer diversity, etc….  Unfortunately, many clients don’t fully understand some of these principles. A few months ago, we had a manufacturing client approach us to find a buyer for his business.  He was particularly proud of two aspects of his business:  firstly, that all decisions go through his office as he is the point of contact with the clients; and secondly, in preparing the business for sale, he had whittled down the client base from 20 to two clients.  In his eyes, the new buyer was going to have 18 less headaches and personalities to deal with.  Yikes on two counts!  Unfortunately, this is a true story!

Warrillow: Can you explain the difference between an asset sale and a share sale? Why does it matter to business owners?

Bottoset: In an asset sale, the buyer essentially acquires selected company assets, consisting of the company’s equipment, inventory and “goodwill.”  In a stock purchase, when purchasing the company’s stock, they are acquiring all of the company’s assets, including its cash and accounts receivable, and are assuming responsibility to pay off the company’s debts (i.e., accounts payable) while assuming all “off the book” liabilities (i.e., pending or future lawsuits).  Buyers typically prefer to buy the assets of a company for two reasons.  Firstly, they are able to re-depreciate the value of the fixed assets and therefore acquire a larger depreciation tax shelter.  Secondly, they are not responsible for any “off the book” liabilities (i.e., lawsuits). Most business transactions are completed as asset sales.

I’ve asked Brad Bottoset to spend an hour with the 20 people coming to my Built to Sell workshop on January 16 & 17, 2012. There are three spots available – grab one here.

(photo Eric Thayer  /  Reuters)

The main character in my book owns a marketing agency. I picked a service business intentionally because, with so much of the value tied up in the owner’s relationships, service businesses are notoriously difficult to sell. The founders leave and so do the clients, making service businesses next to worthless unless you can figure out how to make the clients stay when the owner(s) want to go.

David C. Baker is one of four people in the United States that knows this better than anyone. In addition to being an author, David has made his living over the last few years selling agencies. He’s done 140 deals and along with two or three other M&A professionals, David is considered the guru of building and selling a successful agency.

I’ve been doing some research in preparation for my Creating a Sellable Service Business Workshop and I had a chance to interview David. I thought you might like to read our exchange:

John: What are the unique challenges of selling a marketing agency?

David: Mainly it’s the fact that there are no outside non-participating investors for smaller firms. I can’t think of one, actually. And that’s typically because the firm trying to find a buyer has grown up around the principal and his or her desires and hasn’t been viewed primarily as a business.

John: What attributes are buyers looking for in the agencies they are buying these days?

David: Specialized focus is always first. Second is financial performance. Third is client list that they will have access to. Gone are the days when someone buys a firm just to have a presence in some market. And very few transactions are initiated simply to add capacity instead of building it.

John: How are agencies being valued?

David: The more typical agency is being valued at 3-5 times EBITDA after normalizing principal compensation. Interactive firms are going at significantly higher multiples.

John: What proportion of the overall deal is “at risk” in some form of earn-out? (I’ve heard big agency holdcos are now paying 3 times upfront cash with up to 7 available in an earn-out; can you verify or refute?)

David: Usually one-third is paid upfront at closing; about one-third is paid in a longer-term note (not tied to any type of performance) over 3-5 years; and the remaining one-third is tied to earn-out goals.

John: What is the biggest mistake you see agency principals making when it comes to selling their firm?

David: Thinking it has value just because they’ve worked hard for many years, even though the financial performance has been meager; along with thinking that their company name has some sort of tangible value.

John: What proportion of the agency principals who sell last the full length of their earn-out? Why or why not? And do you have some survival tips?

David: The answer to that depends quite a lot on the terms of the sale. If most of the transaction value is in the earn-out, they are likely to stay. The typical scenario is that the principal DOES remain for the entire earn-out, especially since the typical earn-out has now dropped from 5 years to 2-3 years.

John: What other things do agency owners need to know about selling a service business?

David: They shouldn’t expect any money from it. I’ve participated in 140 deals, but the four of us who are active in that space for smaller marketing firms still find deals for a small percentage. The value of the firm is primarily in the cash it throws off to the owner on an ongoing basis, and not in a pot of gold at the end of the rainbow, unless all the stars align properly.

If you’d like to meet David in person, he runs a New Business Summit every January in Nashville.

Most service businesses never sell. They are started by someone with a specific skill. Maybe that person hires a few people, but the clients still want to deal with the most knowledgeable person in the company – and that’s probably you.

So when the time comes to get out, you’re left with nothing. If you’re one of the lucky ones, you get approached by another service firm who offers to “buy” your company — but you actually don’t get a check. Instead you get a little card with a magnetic swipe that grants you access to the building where you have a job as a Vice President at a big company. You then must toil for three to five years for someone else,  and if the stars align and the economy improves and if you can put up with the nonsense of big company life, you might get some money from an earn out.

I know your pain.

I’ve started four service businesses – a little marketing and design agency, a radio production company, an event business and a market research firm. Back in 2002 I got asked to lunch by a business development guy working for one of the big agencies. He wanted to “buy” my marketing agency if I was prepared to give them my clients and submit to a three year earn out with no cash up front. No thank you.

So how do you escape the service firm trap? The answer, in my experience, involves re-making your business and positioning it more like a product company. It involves “productizing” your services by naming and branding them so that they can be sold by salespeople instead of only you. It involves turning the project-to-project hamster wheel off and creating a recurring stream of revenue. It’s a hard process, but not impossible, and it is made easier by applying some basic techniques that I’ve chosen to teach at a workshop I’m hosting in Chicago and Toronto in a couple of weeks.

If you choose to come, you’ll learn how to:

1. Put your business on auto-pilot:

One of the keys to successfully selling your service business is to systematize and automate your processes, so you can walk away from the business after the sale and it can still run smoothly and generate a profit without you. Not only will you attract more buyers and be able to sell your business for more money if you have the right systems in place, you’ll also benefit now by dramatically increasing your efficiency and results as the business owner. At the workshop, you’ll find out how to:

• Create a reliable stream of recurring revenue so you can stop charging by the hour or project and be able to see how your revenue is looking months into the future – a key factor in creating a sellable business
• Reduce your reliance on a few big clients so you can stop grovelling for work and worrying they might leave one day
• “Productize” your service so you can hire salespeople to do some of the selling for you
• Eliminate the need to respond to a Request For Proposal (RFP) and get clients to start giving you work without tendering
• Increase the number and quality of your referrals so you can grow more quickly and profitably through word of mouth
• Reward and retain key employees without making them a partner – that way you retain all of the equity

2.  Maximize the value of your business

Whether you want to sell your business now or in ten years, it’s nice to know you’re building a valuable asset as opposed to just walking on a tread mill. At the workshop, you’ll learn what drives up the value of your business and specific techniques to:

• Calculate the value of your company using the same methodology acquirers use so you’ll know if you’re getting low-balled
• Avoid the biggest mistake service firm owners make when getting their business ready to sell
• Structure your customer agreements to include the one sentence you need to sell your business for a premium

3. Negotiate with leverage

To get the best price (and deal terms) when you go to sell your business, you need to understand how to negotiate from a position of strength. Part of having a powerful negotiating position is being knowledgeable about the process, and it also means understanding the strategies you can use to:

• Shorten the length and importance of an “earn out” so you need not work for someone else
• Spot and interpret the second most important sentence on an offer to buy your company so you can clear more after tax cash from the sale of your business
• Get multiple competing offers for your business to drive up the price through competitive tension

The Agenda

About twenty of us will meet for dinner and get to know one another over a glass of wine and a good meal. The next day, I’ll lead the workshop. I’ll explain a concept and give you some exercises to help you apply each technique to your business. I’ll wander around and work directly with anyone who has a question or just wants a partner to brainstorm with. You’ll be given a booklet to write your answers in so you’ll have all of your key ideas and action items in one place at the end of the day.  With just a handful of people in the room, we’ll get plenty of one-on-one time together.

This is a one time thing

So why am I sharing these strategies now? And can you wait until the timing is better to attend one of my workshops? The short answer is no, this is a one time thing. The long answer is that, since my last business was acquired in 2008, I’ve been doing some writing and teaching. I like it all right but I’ve recently started to focus on a new software company I’m launching. A while ago I made a commitment to be in Chicago at the end of September. I live in France so I decided to make the trip a little more worthwhile and tack on a couple of days to teach this workshop. I have family up in Toronto so it made sense to tack on a day there too. I have no plans to repeat these sessions so if you’re keen you should come.

Turn $1,000 into $100,000

Another question you might have is, “will it be worth the $1,000 plus travel and a day out of the office?” Fair question. My response is that your business could be your most valuable asset if you set things up right so investing a little to make it more sellable could pay off many times over.

Let’s look at some numbers: according to my reader poll, most service business owners never get an offer to buy their company. Of the lucky ones I surveyed who did get an offer, the average bid was around three times earnings. I’m confident you can increase your multiple by following the techniques I’ll teach at the workshop. Four times earnings is very do-able. Five times is not out of the question. Six, seven —  even eight times earnings or more are all possible. But I’m getting ahead of myself. Let’s be conservative and say you have a business generating $100,000 in profit before tax. At three times earnings, it’s worth $300,000. If, by applying the techniques you learn at the workshop, you can make your business worth four times earnings, then all of a sudden it’s worth $400,000. You can do the math on your own financials. Either way, I’m pretty sure the workshop will be an investment that will pay for itself many times over. And if it doesn’t, flip me an email after the session and I’ll refund your ticket price, no questions asked.

The unmistakable, glorious feeling of control

It’s a special feeling going from grovelling for clients to owning a sellable company. My fellow Inc contributor, and 37signals co-founder Jason Fried went through a similar process. He started 37signals as a custom web development shop and made the switch to a “productize” his service business. He described the feeling of turning a service firm into a sellable company as follows,  “When you’re a consulting business, you have to say yes to big clients, who end up telling you what to do. You become beholden to the giant corporation who is paying you $60,000 for a project. I love the feeling of control I have now”.

Save $250 by registering today

If you register today using the Discount Code “reader”, you’ll save 25%. Just follow one of these links to register:

Chicago: September 29&30

Toronto: October 2&3

I think a lot of service business owners get fleeced when they sell their businesses.

I’m going to make a huge generalization, but my guess is that service company owners are  somewhat less financially skilled than their peers who run technology and product companies.

Part of the reason is that the barrier for us to enter a service business is lower, so there is no need to get educated about finance. When you own 100% of the shares and you don’t need to raise start-up money, you can skip the whole learning curve associated with valuing a business, return on equity, discounted cash flow, etc.

I, for one, was blissfully ignorant about business valuation until I actually sold one.

And I don’t think I’m alone. The service business owners I know tend to be a little more right-brained. We can think conceptually, imagine the future and empathize, but perhaps we lack some of the math and science of the left-brain types who run technology businesses.

More emotion, less knowledge

So when it comes to selling our companies, I think service firm owners approach the sale with more emotion and less financial knowledge than other company owners – which is a recipe for getting taken advantage of by the left brain analytics who work in the finance department of acquiring companies or as partners in private equity firms.

And I don’t think our naïveté is lost on buyers. In a recent survey of readers of this blog, fully half of all service firm owners had received an offer to buy their business in the last twenty-four months while only one in ten product-based companies had been approached:

That statistic may look encouraging for service firm owners, but the problem is, those offers were well below the offers received by product-based businesses: two-thirds of the bids service firm owners received were for three or less times earnings; and only one out of all of the service firms surveyed got an offer for more than five times earnings.

Easy prey

My conclusion is that buyers are seeing service firms as easy targets. If they can scoop up a service business for two or three times earnings, and retain the clients by locking the owner(s) into an earn-out, they can’t really lose. Even if there is some client attrition, most buyers make off like bandits in the long run.

Which is why, if you own a service firm, it is critical to go into a negotiation armed with the knowledge you’ll need to defend yourself against these predators.

Arm yourself

To understand how buyers calculate the value of your service business, read this article.  To know when strategic acquirers pay better-than-average multiples, read this article. I’m also going to host a couple of workshops (one in Chicago and another in Toronto) just for people who run service businesses.  You’ll learn how to:

• Calculate the value of your company using the same methodology acquirers use;
• Bump up your multiple;
• Create a reliable stream of recurring revenue;
• Reduce your reliance on a few key clients;
• “Productize” your service;
• Reward and retain key employees without making them a partner;
• Eliminate the need to respond to a Request for Proposal (RFP);
• Increase the number and quality of your referrals;
• Spot and interpret the second most important sentence in an offer to buy your company;
• Shorten the length and importance of an “earn-out”;
• Avoid the biggest mistake service firm owners make when getting their business ready to sell;
• Structure agreements to include the one sentence you need in order to sell your business for a premium.

If you want to come to one of the workshops, register before September 9 using the discount code “Blog” and you’ll save 25%.

Register for the Chicago event on September 29&30.

Register for the Toronto event on October 2&3.