When one buys or sells a firm, there are a number of key questions to consider. The art of a business is about building trust. The science of a business marriage relies on answering clear cut questions with quantifiable or, at least, unambiguous answers.
Last week we discussed the science of what a buy/sell agreement needs to cover along with questions to consider around firm profitability. We might think that if the firm is profitable everyone is happy.
But, what about the touchier subject of what to do with that profit?
As a first step, we need to be aware of what might be pushing or pulling us to recommend a certain course of action. If we begin by leveraging the wisdom of the latest neuroscientific research about financial decision, we’d start with an understanding of our own and our partner’s money types. Once we know what our type is (for example, Innocent or Warrior) and how it colors our decision-making, we can continue to explore the excellent questions Michael Kitces’ recent blog raises:
1. “Are Sales Terms Unreasonable Relative to Profits?”
In the financial planning world the commonly quoted value of two times revenue multiple assumes 25-30% profit margins. That’s why defining assumptions about profitability is foundational to determining the firm’s value.
If buyer and seller cannot agree on the value of the firm, a third party valuation is essential. (In future blogs, we’ll discuss how buyer and seller might come to an agreement in the “art” of M & A).
If the valuation gap is excessively large, it makes sense to walk away from the deal. That disagreement may be a signal of deeper mistrust issues that augur a bumpy partnership. Or, they may signal an opportunity for personal growth of both partners.
2. “Does Timing of Profit Distributions Match Loan Payments?”
Firms are free to decide on patterns of profit distribution: it may be monthly, quarterly or annually. For example, since financial firms collect fees for AUM (Assets Under Management) quarterly, they might make quarterly distributions to owners. But if the buyer has to service a bank loan that requires monthly payments, her distributions may not provide the cash flow to service that loan. Therefore, it’s important for owners to clarify any assumptions about the timing of profit distributions. Is your accounting responsive and timely? If not, why not?
3. “How Much Profit Should You Distribute vs. Reinvest?”
Depending on the owners’ stage of life, they may have very different needs and expectations. For example, younger owners who have a longer time horizon in the business may want to leave more of the profits in the business to reinvest for the future. On the other hand, older owners may want to start taking more profits out of the business and leave less money in the business. What are the relative ages of the parties? If this is not an issue yet, for whom will it be one in the future–and, if so, how far into the future?
Even if partners are the same age, their money types (http://www.jonhokama.net/when-money-makes-you-stupid/) could motivate different distribution patterns.
Most importantly, owners need to ask themselves this business marriage question:
Does our decision about using profits honor the life of the firm, the spirit of our partnership, and the needs of each partner?
The above three questions Kitces raises help us frame the science of establishing a great business marriage. They answer partner questions around
- perception of firm value
- matching distributions to meet needs of the firm’s loan agreements
- honoring the commitment of each partner to the firm and to the partnership itself.
If you’re in a partnership, here are a few more questions to consider:
- How do you feel about the current use of company profits?
- Do you have specific guidelines on how much profits should be retained? Distributed?
- If you don’t yet have such profit guidelines, what would you recommend they be?
The co-author of this and last week’s post, Kevin Condon, began his career in 1984, starting from technical due diligence and developing a full service financial planning practice through partnership, practice merger, acquisition, and diligent sales and marketing. He sold his mature Washington, DC-based practice in 2002 to return to Denver where he developed a first-ever commercial portal for financial advice provision online.
Active in leadership positions through the years as a CFP Practitioner, NAPFA Member and blogger, he provides a uniquely helpful perspective to new and mature business owners to buy, sell or enhance a professional practice. His thirty years of experience and honorably acquired scar tissue can help your firm think through and meet today’s challenges.