I had dinner last night with a guy who trains dogs. He used to train dogs for an hourly fee but decided to shift his model from selling time to selling a product. Now he markets a set of pre-recorded dog training videos through his web site and earns more than a million dollars a year selling something people buy while he sleeps.

Selling a product, rather than your time, offers a fantastic leap in lifestyle benefits and makes your company more sellable. When I recently surveyed merger and acquisition (M&A) professionals about what makes a business attractive to a strategic acquirer, virtually all of them agreed that a company’s potential growth is second only to profitability among the factors that make the company a must-buy in the eyes of an acquirer.

But the term “growth potential” is a little nebulous, so I asked the M&A guys to go a layer deeper and explain how buyers assess a company’s scalability. The most important question they ask themselves is: “Could your business be five times bigger without adding five times the cost or complexity?”

Customization is the five times killer

If you customize what you sell, it means people are involved, which makes it impossible to scale quickly.

In my research business, we started out offering to customize the reports we sold, but it robbed our business of its leverage. Once we standardized and stopped offering to tailor reports, we were able to scale up.

Yes, we lost a few customers who were used to the custom reports, but we added many more new subscribers because we weren’t wasting our time and money customizing and could invest those resources in hiring sales people.

Often the need to customize comes from ten percent of your pickiest clients. If it is time for you to say goodbye to the customers who want their Big Mac without the pickles, follow these three steps:

1. Narrow your target market. Part of the reason you have to customize may be that your audience is too wide. Decrease the diameter of your bull’s eye until you can identify a group of people who like what you sell off-the-shelf and develop a discrete offer for your ideal customer.

2. Productize. When customers buy services or time, they are accustomed to being able to provide input. At the same time, everyone is used to buying products off-the-shelf. The trick is to brand your stuff consistently so customers start to see it as a tangible product instead of a squishy service.

3. Say no. When customers ask for special tweaks, explain that your offering has been time-tested for X number of years to render the best results. Explain that you’ve honed your formula and – just like the twelve herbs and spices or the secret for getting the caramel inside the chocolaty pockets – you’re not willing to change something that has been proven to work. I have found that most people respect your intellectual integrity and go along with your standard offering. The one or two who insist on special favours are not worth the hit your valuation will take when you’re ready to sell.

PS. One available spot at my “Sellability” workshop

One of the 16 attendees at my upcoming Sellability Workshop in Chicago on September 28 & 29 just cancelled. This session is not for everyone (attendees must have between $500,000 — $7,000,000 in annual sales), but if you want his spot, this is your opportunity. First come, first serve, and I have no plans to repeat the session. What you’ll learn is the “inside baseball” on selling your company for a premium from people who have actually done it. Apply here.

(photo courtesy of Flickr/pamhule)

I’m starting a new business and have decided to build it from the start to be attractive to a strategic acquirer. My most important operating metrics will be Net Promoter Score, cost per account acquired and number of users, and my financial statement of choice will be a cash flow statement, not my P&L.

If I get it wrong, I’ll most likely walk away with nothing.

One of the most important decisions we all need to make is whether to position our business for a financial acquisition or a strategic one. It’s a high-stakes call that can end in disaster.

The safe route

The safer – but potentially less rewarding – route is to build your business for a financial acquisition. Financial buyers will base their offer on all of the core operating metrics taught in grade nine economics: How much profit do you make? How fast are you growing? How much recurring revenue do you have? How dependent is your business on you? The basics.

Swinging for the fences

A strategic acquirer will look past your financial metrics and dream about what your business could be worth in their hands. They’ll model the impact on their business if a small percentage of their customers buy your product – or if your customers buy their product. They might see your little business as a Trojan horse that will allow them to enter a brand-new world of buyers. That’s why, for example, Herman Miller announced plans to buy Hong Kong-based POSH Office Systems. It bought the company not for its $50 million in revenue but for POSH’s relationships with Chinese furniture dealers and the corresponding billion-dollar opportunity of selling office furniture to Chinese companies.

Because strategic acquirers have much more to gain, they also pay a higher price. Nowhere was that more evident than Microsoft’s recent acquisition of money-losing Skype for $8.5 billion. My guess is that Ballmer wants to convince more Windows users to upgrade to a new version (half are still running XP) – and a slick Skype integration could be the killer app. If Skype was valued by a financial buyer, it’d be worthless. But if Microsoft can use Skype to get a good chunk of a billion Windows users to upgrade, it might be well worth $8.5 billion to Microsoft shareholders.

The curse of the high school dropout

A strategic acquisition sounds great, right? So why wouldn’t everyone prepare their business to be attractive to a strategic?

For the same reason most right-thinking people don’t buy lottery tickets. If you pour all of your money into building a company for a strategic acquisition, you’re playing high-stakes poker. If it works, you get rich. If it doesn’t – and you end up with an unprofitable company – your business might just be worthless in the eyes of a financial buyer (fives times zero is still zero).

It’s like the promising high school athlete who forgoes education to focus on making the big leagues. If he is more talented and determined than a million other kids with the same dream, he is set for life. If he misses, he will probably end up pumping gas.

So why can’t you position yourself for both a strategic and a financial?

Well, you can, but you’ll probably end up with a business that is sucking and blowing at the same time. Just like Newton taught us, every action is accompanied by a reaction of equal magnitude but in the opposite direction.

When you’re optimizing for a financial, you’re not optimizing for a strategic and vice versa. For example, the company positioning itself for a strategic acquirer will pour all of its cash into product development. If the same company was positioning for a financial exit, it would limit its R&D spending to the bare minimum to protect its market position and maximize its EBITDA.

If POSH had been looking for a financial exit, it might have focused on directly serving a small number of very profitable Hong Kong-based investment banks instead of undertaking the cumbersome job of building a mainland dealer network that an acquirer like Herman Miller could leverage to enter China.

How to decide

Imagine who would want to buy your business and try to quantify the impact acquiring you would have on their business. If the financial upside for an acquirer is substantial (1,000% + return on their investment in the near term), then perhaps it makes sense to roll the dice and build for a strategic acquirer, assuming your lifestyle needs do not require you to draw much cash out of your business while you build it.

If, in your most sober analysis, a buyer’s upside will be more modest (less than 100% in the near term), it may be better to hedge your bets and build a good business with real profits any financial buyer would love to acquire. A profitable business will still be attractive to a strategic, but a financial will rarely be interested in an unprofitable business.

One final note on the subject of strategic acquisitions: I still have three spots left for The Sellability Workshop. I’m not planning to repeat it, so please fill out the application here if you want to join us.

You’ll get the most for your business if you sell it to a “strategic acquirer”.  A strategic may think it can sell your product to its customers, thereby tripling the size of your business in a few months. Or maybe it sees your company as the perfect complement to one of its existing business units. Or it wants to enter the city where you dominate, and acquiring you is easier than battling you for every new customer. Or perhaps you’re snapping up its customers, and rather than compete, it figures it’ll buy you.  Microsoft made a strategic acquisition when it paid $8.5 billion for Skype even though the free calling service was losing money.

16 people climb inside the black box of selling to a strategic

If you’d like to position your company to be acquired by a strategic, I’m hosting a 16-person workshop on September 28 and 29 at the Four Seasons Hotel in Chicago.

The Sellability Workshop is an intensive, two-day program designed for business owners running profitable companies with between $500,000 and $7 million in annual revenue who want to make their business attractive to a strategic acquirer. I’m accepting just 16 people into this workshop.

Selling your business to a strategic acquirer is hard work, and only a small fraction of business owners who want to be acquired ever get an offer from a big fish. But just because something is hard, doesn’t mean you shouldn’t try. Like climbing Everest, selling your business represents the top rung of your entrepreneurial adventure. There is no magic formula or recipe book on how to do it. But, based on my experience, there are some things you can do to improve your odds.

If you’re one of the 16, you’ll learn how to:

• Prepare your business to be an attractive acquisition candidate:
  • Create a recurring/subscription revenue model (how to implement, mistakes to avoid)
  • Increase your valuation multiple
  • Create a positive cash flow model
  • “Productize” a service
  • Tell your employees you’re selling and get them to help you in the process
• Negotiate a deal to sell your business:
  • Reduce or eliminate an earn-out
  • Get multiple, competitive offers for your business
  • Handle management presentations to potential buyers
  • Evaluate a letter of intent (things to look for, mistakes to avoid)
  • Shorten the due diligence period
  • Increase the likelihood that your offer will survive from letter of intent to closing day

Being part of a small group is a luxury. You’ll have the opportunity to address your specific situation, questions and challenges. I’ll lead the conversation in a workshop format, but there will be lots of Q&A, time to reflect on your own business, and plan your takeaways from the session.

Confidentiality

Your identity will be kept in strict confidence. The attendee list will not be published before or after the event, and attendees will be introduced by first name only in the session.  The decision to reveal your full name or your company name to your fellow attendees will be left at your discretion.

Who is the Sellability Workshop for?

The workshop is for business owners running profitable companies with between $500,000 and $7 million in gross annual revenue and interested in positioning themselves for a strategic acquisition in the next five years.

Who is the Sellability Workshop not intended for?

This is not an exit-planning event.

I assume you have evaluated your exit options and made the decision that you want to position your company to be acquired. Therefore, if you’re considering passing your business on to your kids, this session is not for you. If you’re considering selling your business to your managers, this session is not for you. If you’re hoping to attend to pitch your services to the business owners in the room, please do not apply.

Please note, I’m not a mergers and acquisitions professional, lawyer, exit planner or insurance salesman. There will be no sales pitch or veiled agenda. You won’t be asked to buy a time share, either. My only goal is that the 16 participants walk out with confidence, inside knowledge and an action plan to position their business for a strategic acquisition.

Grab one of the 16 spots now

To apply, scroll down to the bottom of this page and complete the application form.

Drive your first shot into the woods and most friendly golfers will give you a “Mulligan” which allows you a second chance to start out right. Lately I feel like I’ve been handed The Entrepreneur’s Mulligan.

Don’t get me wrong, my last business wasn’t a disaster, but there were things I would have changed:

• Over the years, I had painted myself into a corner by having employees on a hodgepodge of bonus plans which reflected my latest thinking on incentives at the time of hiring them. Hire enough people over a long enough period and you have a labyrinth of employee agreements to juggle.
• I had longstanding suppliers we stuck with out of inertia, not because they offered the best of what we needed.
• I had given one-time favours to some customers, only to have them taken for granted as long term elements of our relationship.

And because all of those things involved people and emotions and drama, they weren’t as easy to change as it was to write them just now. Over time, my business began to feel like how I imagine an artist feels mid-way through a painting when she realizes she selected the wrong-sized canvass: it’s too late to turn back, but it will forever be a flawed piece of work in the artist’s mind.

Starting fresh

And that’s one of the things you can look forward to after selling your business: you will get a blank sheet of paper and some time to design your next company. I think we entrepreneurs are creative souls and every artist is striving to create their masterpiece.  Can you name a song writer who wrote only one tune? How about a legendary architect who designed just one building or a photographer who took just one picture?

So why would an entrepreneur want one business as their legacy?

Scribbling on my blank sheet

I for one have started to jot down some ideas about my next business. My first few baby steps have been to:

• Develop a long terms vision and a set of values for my company which I personally find motivating and I think will resonate with people who come to work with me.
• Write an analogy for my new business which will quickly communicate the business idea to people who want to get involved.
• Quantify a 10-year goal and a basic strategy.

I’m sure I won’t get this business completely right either. And nor does the golfer who gets a second chance at their tee shot hit a hole-in-one. But that’s not the point. I’m just savouring that sense of excitement you get when someone gives you another chance to do it all over again.

So, have you taken your Mulligan?

About a year before I sold my last business, I started working with a friend — let’s call him Rick — to help me prepare my company for sale. Rick had sold his own business and had gone on to lead M&A for a public company.  He had seen the guts of a lot of deals.

Our first few conversations were frustrating because I wanted to focus on how to maximize the multiple someone would pay for my business and Rick always responded in the same way:

“Multiple of what?”

“Multiple of earnings of course” would be my response, annoyed because I knew he was acting dumb.

Over time, I came to appreciate what Rick was talking about. It took me about a year — call me a slow learner — but I finally got it. So in this post, I’ll try to pass on Rick’s wisdom to you.

A multiple of course is M&A parlance for the multiple of your Earnings Before Interest Taxes, Depreciation and Amortization (EBITDA) that you’ll fetch for your business when you go to sell it. Smaller businesses use something called Sellers Discretionary Income (SDI). Like fishing stories, cashed-out entrepreneurs often brag about the multiple they got for their business leading owners to a distorted view of what their business is worth.

Like a golf handicap or a marathon time, it’s tempting to fixate on getting a certain multiple for your business. It’s natural to want an objective measure for the value of your business and your multiple looks clean and simple to calculate.

But just like any other number on a spreadsheet, multiples can be manipulated.

Let’s say you’re having lunch with a potential acquirer and you ask her how much she thinks your business is worth. To answer your question accurately, she would likely do a discounted cash flow analysis.  Instead of making your eyes roll with complex financial equations, she responds by saying  “four times”. That sounds like a straightforward offer but, as the example below illustrates, there is a lot of room for interpretation:

Time

Let’s say you expect your business is going to generate $500,000 of EBITDA for the year ending December 31, 2011. Therefore, you might assume her offer of “four times” would equate to $2,000,000.

However, most buyers would argue that they’re going to peg their offer on your most recent completed financials.  If you only did $300,000 in EBITDA last year, then her “four times” offer now amounts to $1,200,000 – almost half of what you thought.

What’s more, some buyers will take a blended approach and average the last three year’s EBITDA. Assuming you just broke even in 2009, and you can get them to include your current year forecast, your average would be $266,000 and their “four times” offer is half of what you were expecting.

“Normalized expenses” – the market rate effect

Not only can an offer of four times vary on when you calculate EBITDA,  the price you get for your business will also go up or down depending on how you keep your books.  A buyer will want to “normalize” your earnings which means they will want to figure out how your business would perform if you stopped using it as a tax shelter.

For example, you might pay yourself a below market salary to minimize your personal tax bill. An acquirer will argue that, if they buy your business, they will have to install a manager with a market rate salary and will therefore recast your Profit and Loss statement with a fatter salary for the manager and corresponding lower EBITDA.  Therefore, if you’re paying yourself $100,000 a year but it would cost $200,000 a year to replace you, then your “normalized” EBITDA is going to be $400,000, not the $500,000 you told the buyer. Their “four times” offers will go down from $2,000,000 to $1,600,000 (4 x $400,000).

“Normalized expenses” – the piggybank effect

Normalization can work the other way too. Let’s say you’ve been running your business like a personal piggy bank (don’t worry, I won’t tell). Your spouse is on the payroll and the kitchen renovation you did at the house last year found its way on to your list of business expenses as an “office renovation”. You can argue to an acquirer that these costs should be deducted from your expenses when calculating EBITDA. So maybe, once you eliminate the piggy bank effect, you actually make more like $600,000 of EBITDA which means an offer of “four times” should garner more like $2,400,000.

Hard assets

When you’re talking about multiples you also have to take into consideration any hard assets. If your motel is generating $500,000 a year and you get offered “four times”, $2,000,000 may sound like a fair price until you take into consideration the land your motel is sitting on (that you own) is worth $1,000,000.

Working capital

Sometimes buyers will offer you an abnormally large multiple only to take it all away with an overly stingy working capital calculation. Working capital is the money you need to leave in your business at closing. If you’re able to pull out $200,000 in excess cash based on the working capital calculation a buyer proposes in their offer, you’re putting an extra $200,000 in your jeans even though the multiple the buyer is offering has not changed.

Fully loaded

Some buyers casually refer to a multiple they would pay including an earn out. For example, let’s say for a business generating $500,000 in EBITDA an acquirer offers $2,000,000 at closing with another $1,000,000 in consideration available if certain performance targets are met in the future. Most would agree that the acquirer is offering “four times” based on the cash changing hands at closing. But a sly buyer, looking to optically inflate their generosity, may choose to characterize their offer as “six times” basing the multiple on the full price paid if the earn out is achieved. That’s a big if.

Savvy buyers know that we entrepreneurs get fixated on getting a certain multiple for our business and the smart buyers use our obsession to their advantage.

Before you agree to discuss a potential acquisition based on a certain “multiple”,  peel back the layers of the offer to understand the details.

Just curious, how else have you seen multiples manipulated?