Posts made in November 2018

Gary Miller: Benchmarking: a tool for small-and medium- sized businesses

The Denver Post | BUSINESS

 BUSINESS

Gary Miller: Benchmarking: A management tool for small – and medium – sized businesses

Gary Miller, staff photo

By GARY MILLER | gmiller@gemstrategymanagement.com | GEM Strategy Management

PUBLISHED: November 25, 2018 at 6:00 am | UPDATED: November 26, 2018 at 3:18 pm

Gary Miller writes a monthly column for The Denver Post.

 

If you don’t know where you’re going you might not get there. – Yogi Berra

 

Now that the mid-term elections are behind us and businesses are closing out the year, it’s time before lunging into 2019 for business owners to take a serious look at how their companies stack up against the competition. One management tool that large businesses have used for years is called “Benchmarking.” However, in the last few years, small- and medium-sized businesses are engaging in this management tool, as well.

Benchmarking is a process for obtaining a measure –- a benchmark. It is a process designed to discover the best performance being achieved –- whether in a particular company, by a competitor or by an entirely different industry. This information can then be used to identify gaps in an organization’s processes, operations and financials in order to achieve a competitive advantage.

Some of the more useful financial benchmarks involve: (1) gross operating and net profit margins; (2) sales and profitability trends; (3) inventory, accounts receivable, and accounts payable turnover; (4) salary and compensation data; (5) revenue and cost per employee; (6) marketing expense as a percent of revenue; and (7) revenue to fixed assets ratio.

Suppose you learned from your benchmarking study that your gross profit margin is 3 percent lower than your competition. For every $1 million in annual revenue, that’s $30,000 a year that they’re making that you’re not. Is it because their prices are higher or their costs are lower? Does their sales mix include higher margin items that you don’t carry, but could? Do they have some sweetheart deal from their suppliers that you should know about? Do they spend that extra gross profit or does it fall to the bottom line? Finding answers to these questions, among others, could change your business strategies going forward.

Another example of benchmarking is considering the metric of “wait time.” It does not matter whether waiting for a car repair at a dealership or making a deposit in a bank lobby, customers do not like waiting in long lines. Similarly, whether waiting on a telephone help line of a cable company or a favorite online retailer, customers do not want to remain on hold. They want their concerns addressed quickly and efficiently.

The bottom line: Important information can be learned by going outside one’s own industry because many customer concerns are the same.

Benchmarking is a difficult, time-consuming process. Most business owners engage a consulting firm that subscribes to various business databases of diverse industries and asks them to evaluate the problems found, recommend solutions, and measure results. However, some small-business owners prefer to take the time and learn for themselves.

For best results:

  1. Use data from similar size companies and, where possible, within your own geographic area.
  2. Use a source that represents a large universe of inputs so that numbers are not skewed.
  3. Choose the industry group that best represents your business North American Industry Classification System.

Below are 10 of the best sources for free or low cost financial data covering a wide range of industries.

  1. Your Industry Association may be the best source for consolidated industry data and financial benchmarks.
  2. The Internal Revenue Service Corporate Sourcebook offers summary balance sheets and income statement numbers for all industries by size of company.
  3. Annual Reports of Public Companies in your industry as well as the 10K and 10Qs provide rich information and often compares their performance with their industry’s overall performance. Also, very important information is often buried in the foot notes, so read them carefully. Though these companies may be larger than yours, their numbers can offer significant insights.
  4. The Bureau of Labor Statistics Labor Productivity and Costs shows output per hour and unit labor costs by industry.
  5. The Bureau of Labor Statistics Labor Pay and Benefits provides information on wages, earning, and benefits by geography, occupation, and industry.
  6. Bureau of Labor Statistics Labor Producer Price Index offers production costs trend data by industry.
  7. Department of Labor reports hours, wages and earnings reports by industry.
  8. Census Bureau Economic Census provides annual and trend data on sales, payroll, and number of employees by industry, product, and geography.
  9. Census Business Expense Survey reports sales, inventories, operating expenses, and gross margin by industry.
  10. Census Annual Survey of Manufacturers covers employment, plant hours, payroll, fringe benefits, capital expenditures, cost of materials, inventories and energy consumption.

In addition, three other inexpensive sources of industry data that are useful for many business owners include:

  • Dun and Bradstreet offers individual company data on sales, employees, net worth, nature of financing, credit worthiness, balance sheet/income statement/ratio data, law suites, public filings, liens, and judgments.
  • The Risk Management Association offers benchmarking data on a business’s performance. This is one source that your bank probably uses to benchmark your business’s performance, so it’s well worth the cost.
  • Morningstar.com offers easy access to financial information about public companies. It also provides the same research information as financial professionals use.

 

No better evidence for the value of benchmarking exists than the Winter Olympic Games. When watching the games we repeatedly hear “the time to beat” as downhill skiers race for the finish line. That information drives skiers to shatter new records set just minutes before.

In business, benchmarking your performance against that of your competitors can propel you to greatness, too. It can help you establish internal goals, pinpoint market opportunities, exploit competitors’ weaknesses, and create the kind of esprit de corps to unify and motivate your team.

Gary Miller is CEO of GEM Strategy Management Inc., which advises business owners on how to sell their businesses or how to buy companies and raise capital. He can be reached at 970-390-4441 or gmiller@gemstrategymanagement.com.

 

Should you consider a “structured earnout” when selling your business?

The Denver Post | BUSINESS

 | gmiller@gemstrategymanagement.com | GEM Strategy Management

PUBLISHED:  | UPDATED: 

A structured earnout is a portion of the purchase price of a business that is paid overtime at a later date contingent upon the acquired business achieving certain agreed to performance targets. Basically, the buyer agrees to pay at closing a certain percentage of the agreed to purchase price with the commitment to pay additional amounts (the earnout) to the seller if the acquired business achieves certain future revenues and profits.

Photo provided by Mark T. Osler

Gary Miller writes a monthly column for The Denver Post.

Structured earnouts increase or decrease sharply depending on economic conditions. During the Great Recession, economic volatility made it more difficult to accurately project revenues and profits and tight borrowing conditions made it difficult to finance transactions. As a result, buyers and sellers increasingly relied on earnouts to consummate transactions.

However, today buyers have regained confidence in the economy. Competition for quality investment opportunities has increased, creating a seller’s market for quality companies.

Therefore, sellers of high-quality companies have become less willing to enter into earnout agreements. But, for those companies for sale whose financial performance is inconsistent, who have a concentrated customer base, or are operating in poor market environments, a structured earnout could be the best option for selling your company.

Introduction to earnouts

The purchase price of a business is determined by many factors including future cash flow, earnings, growth rates, among others –- topics that are major subjects of disagreements between sellers and buyers. These disagreements often reach an impasse during negotiations because of a gap in their expectations about the future performance of the business.

The seller expects the price to reflect his/her projections on the potential future revenues and earnings. The buyer is reluctant to agree when the projections do not seem realistic. An earnout can help the parties bridge this gap and therefore complete the transaction.

The parties need to agree on what those performance targets are –- financial and/or commercial.

If they are financial, they can be set at the top of the P&L statements (e.g. gross revenues or net revenues), or at the bottom of the P&L statements (e.g. EBIT or EBITDA). If they are commercial (e.g. diversification of the customer base, or the launch of new products) milestones can be set to measure those commercial achievements during the earnout period. Most earnouts are a combination of both.

Although earnouts are an excellent tool for bridging the gap between the parties’ expectations, they have become controversial due to the potential for future disputes. Many M&A practitioners (including this writer) question whether they are ultimately good for either party. There have been various court cases in connection with earnouts. Vice Chancellor Travis Laster of the Delaware Chancery Court famously observed in the Airborne Health case: “An earnout often converts today’s disagreement over price into tomorrow’s litigation over outcome.”

Advantages of earnouts

For a buyer, the advantages of using earnouts are hard to challenge. By deferring payment(s) of a portion of the purchase price and making it conditional on the achievement of certain performance targets, the buyer is actually transferring the risk of the uncertainty of future revenues to the seller. For a buyer, this is the most valuable benefit of an earnout, as it will only pay for those potential revenues/earnings when they are achieved. The frequency of payments and the earnout period are determined by the purchase agreement — usually paid on a quarterly or semiannual or annual basis over a one to three year time period.

Another advantage for the buyer is to use the earnout as a tool to protect itself against misrepresentations or a breach of covenants by the seller. If at some point during the earnout period, the buyer makes a claim against the seller for misrepresentations, breach of covenants or other terms and conditions, the buyer may decide (depending on the purchase and sale agreement) to deduct the amount of its indemnity claim from any earnout payments due to the seller.

Finally, earnouts can help a buyer retain key employees. For example, when the seller is also the CEO of the business, having an earnout would encourage him/her to remain with the company after the transaction closes. For the seller, remaining with the company would give more control and a strong personal incentive to do his/her best to meet the performance targets.

Disadvantages of earnouts

The biggest disadvantage of earnouts is the risk of post-transaction disputes. Typically, the disputes center the seller’s ability to achieve the earnout performance targets. More often than not, disputes arise when performance targets are not met because the buyer (at the shareholder level) makes certain management decisions that prevent the acquired business from achieving its performance targets.

Structuring the earnout can be a serious challenge too. If the earnout is not tailored to or in alignment with the uniqueness of the business’s operations, complications followed by disputes can arise. Since each business operates differently, even when operating in the same space, special attention to operating details is required for a successful earnout structure.

Although the risk of earnout disputes is difficult to eliminate, earnouts work best when a seller-CEO stays with the acquired company after the transaction closes because (1) a continuity of management practices will be in place; (2) the risk of disputes based on the seller’s lack of control over the company’s operations is reduced and, (3) the seller will be rewarded for his/her own performance rather than for the performance of a new management team brought in by the buyer.

Most importantly then, one should think of an earnout as creating a partnership between seller and buyer. If an earnout is structured properly, the buyer and seller become partners, sharing in the upside and downside risk of a deal.

Gary Miller is CEO of GEM Strategy Management Inc., which advises middle-market private business owners how to prepare to raise capital, sell their businesses or buy companies. He can be reached at 970-390-4441 or gemstrategymanagement.com