A buyer was interested in a building products manufacturer that did $70 million a year in sales.  Although the business was profitable, it seemed that their margins were lower than they should have been for this industry. The buyer asked the seller how they priced their products.  As the seller was explaining his pricing strategies, he happened to mention that a price increase of 1.5 percent would not really impact sales. He failed to see that the price increase of 1.5 percent on $70 million in sales would bring $1 million in profit. A smart buyer would realize how to get an additional $1 million in bottom-line profit simply by increasing prices by 1.5 percent.

A recent book titled The Art of Pricing by Rafi Mohammed went immediately to the business best-seller list, and no wonder. The author stated: “One of the biggest fallacies in business is that a product’s price should be based on its costs.”

Here are some of the author’s suggestions:

• Restaurants: Keep the entrees priced attractively, but expect to make up the profit shortfall on drinks, desserts and extras.  McDonald’s profit on hamburgers is marginal, but it has substantial profits on French fries and soft drinks.

• Television Advertising: Sell 75-85% guaranteed slots six months in advance, then sell the balance of advertising to the spot-market with little advance notice at premiums of 50%.

• Financial Printing: Price the printing of IPO prospectuses at near break-even, and then charge exorbitant fees for last minute changes.

• Investment Banks: Quote a relatively modest accomplishment fee as a percentage of total consideration, but insert a rather substantial minimum fee.

Another notable quote from Rafi Mohammed is: “Companies should develop a culture of producing profits. Through better pricing, companies can increase profits and generate growth.  In many ways, smart pricing is like hidden profits.”

This takes us back to our first premise: Small pricing increases can greatly increase profits.

There once was a family-owned bakery that had sales in the millions. The bakery sold bread to restaurants, supermarkets and some retail outlets. The founder gave each of his 5 children 20 percent ownership of the business.  The kids really didn’t want to work in the business, so they turned the operation and management over to 2 members of the third generation.  For some years the business had been operating on a break-even basis, and sales were not increasing.

The founder’s children decided that they wanted to sell the business since they were close to retirement age. A professional business intermediary was retained to do this.  He contacted as many of the larger bakeries as possible, hoping to find a suitable acquirer, but there was very little interest. The intermediary continued his search, willing to do the hard work required to find a good buyer. He finally found a successful businessman who offered a price equal to 50 percent of sales – a generous offer.

The intermediary presented the offer to the five children – all equal partners.  Little did he know that he had walked into the proverbial hornet’s nest. A huge family argument ensued, and finally the intermediary was asked to leave the room so that the siblings could decide what to do.

The offer was turned down flat. There was no counter-proposal or even any negotiation on price, terms or conditions. The offer was dead. The intermediary had worked on trying to find the right buyer, figured he had – all to no avail, six months wasted.

It turns out that the major obstacle was thrown up by those two members of the third generation who had been operating the business. They feared that they might lose their jobs even though the prospective buyer assured the sellers that he would retain them.  Were they being unreasonable? The reality is that the operators were “family” – related in one way or another to the five owners, and blood is usually thicker than water.

Flash forward some 20 years.  The bakery is still in business with very little growth and still operating on a breakeven basis.  The five owners are now in their 70s, they have never received anything for their equity, and there is very little hope that they ever will.

The above is a true story.  It shows how a family can own a business and not be prepared or in agreement when it comes time to sell it. Although the bakery is still in business, it is barely hanging on. The story is sad as well as true. The proposed deal could have satisfied all of the owners’ goals and made their retirement years a lot more comfortable.

Family-owned businesses make up a lot of the non-public companies in the U.S., and according to industry reports, many of them will be up for sale in the near future.  In situations where the family owned business is owned by more than one person, it is crucial that a meeting be held with all of the family owners prior to electing to sell, unless a strong buy-sell agreement has already been agreed to.  This agreement should establish, among other things, specific guidelines about what happens if one family member wants out of the business.

At this meeting, the company attorney and accountant should be in attendance along with a business intermediary.  The reason to include the intermediary at this early stage is that he or she knows what the pitfalls are, what buyer concerns will be, and what should be done prior to going to market.

One of the major problems when there is more than one owner is communications. For example, one owner who is active in the business decides that he needs a new, expensive car and that the company should pay for it. This is the kind of issue a decision-forming meeting should bring to light and address. Strict guidelines should also be in writing concerning salaries, benefits, etc.  When one family member wants to cash out or another one spends a lot of money furnishing their office – it is too late to have an agreement drawn up to cover these possible roadblocks. The time is now!

Much has been written about “fairness opinions” due to the financial manipulations among companies such as Enron, Tyco and others.  The conflict in the use of fairness opinions  was (and is) that an investment banking firm not only handled the sale of a company,  but also got paid for doing a fairness opinion.  For example, when the Bank of America decided to buy Boston’s Fleet bank, B of A paid the investment banking firm of Goldman Sachs $3 million as a retainer, $5 million for a fairness opinion, and was prepared to pay a success fee of $17 million if the deal actually was completed.

Keep in mind that a fairness opinion is prepared by one or more financial experts, or by a firm, to protect the shareholders; in other words, to assess whether or not the deal is fair to the real owners of the business.  It also protects the officers and board of directors from shareholders who feel that their company is paying too much for the business being acquired.  It is also apparent, from the example above, that the investment banking firm makes money, and a lot of money, through the entire purchase from beginning to end.  They don’t have much of an incentive to really come in with a “fair” fairness opinion.  However, regulators are looking at this obvious conflict of interest very seriously, and changes in the current regulations are almost sure to happen with full disclosure being only the first step.

So, how does all of this impact the privately held company?  It is vital that an owner of a privately held company who has minority or family shareholders should also seek a fairness opinion.  It may not have to be done by an investment banking firm and probably shouldn’t be prepared by the owner’s accounting firm, for the same reasons outlined above.  A third party evaluation should be done to insure that a minority owner doesn’t come out of the woodwork and claim that the business was sold for much less than it is worth – at least according to the dissident shareholder.

A professional intermediary can be an excellent resource in the preparation of a fairness opinion for the privately held company.  They can provide several valuation professionals and/or firms and also assist in the gathering of the necessary financial records.  Generally speaking, a fairness opinion is prepared after the selling price is agreed upon.  In the sale of a privately held company, the price may fluctuate throughout the negotiations, but a third party valuation can set the bar.  And, it’s very possible that using a business intermediary to market the business will bring a price above the valuation, pleasing everyone.

This is just a partial list: Church’s Chicken, Uno Chicago Grill, Charlie Brown’s, Domino’s Pizza, Burger King, Cinnabon, Sizzler.  The first response would be that they are all in the food business, and that’s correct.  Now name the second thing that they all have in common?  Give up?  Well, they (and many others) have been purchased by private equity firms.  And, apparently, this is just the beginning.  The huge Dunkin Donuts chain is being sought after by two or three private equity firms.

Why the interest in restaurants from groups that most people associate with high tech?  Many firms got burned during the dot com and high tech meltdown.  Now these same private equity firms are looking at businesses that are stable, with more predictable earnings, and that are also very familiar businesses, time-tested and still have a lot of growth ahead.

One industry expert said in Nation’s Restaurant News, “What’s really driving this is the success of these deals, the numbers that the private equity companies are getting when they sell…”  For example, he noted, “Restaurant Associates bought Charlie Brown in 1975 for $3 million and sold it to Castle Harlan seven years later for $50 million.  Castle Harlan got almost three times that price – an appreciation of $90 million with the sale to Trimaran.”

If private equity and similar firms are now buying restaurants, what businesses are next?  If you are the owner of a small growing company or chain of businesses – is a private equity firm in your future?  A professional intermediary may be able to answer that question for you and if you are considering selling – they can also help.

If Starbucks raised the price of a cappuccino, sales most likely would not be affected. If your attorney raised his or her hourly rate, would you switch law firms?  If a company or service firm does not have pricing power, then its value is less than it should be. Here are a few ways to develop or increase pricing power:

• producing a discernible branded product or service
• innovating with patent production such as Apple’s i-Pod
• providing such exceptional service that competitors are not able to replicate it

An interesting question for company management is – how should they set their prices?  Sometimes the answer is that management figures out at what price the item can be sold and then works their costs backward.  The more traditional way is to add up the cost of labor, material, and overhead plus an acceptable profit.  But times have changed, and in many cases, the power of pricing has moved from the producer to the customer.  Today, Wal-Mart tells most of their vendors what they will pay for certain items, and Ford tells their suppliers the same.  On that basis, many companies are beholden to the Wal-Marts and the Fords of the world and do not have the benefit of pricing power.

A recent article in INC magazine titled”Street Smarts,” by Norm Brodsky (his column is worth the price of the magazine) addressed the subject of the title above.  However, in the very first paragraph of the article, Mr. Brodsky stated, “Unfortunately, most of them [business owners] have grossly inflated notions of what their companies are worth.” Mr. Brodsky is not one to mince words.  Some of his examples were: “One company had lost money on sales of about $60 million, and yet its owners thought it was worth between $50 million and $100 million … Another company had a net profit of less than $335,000 on sales of about $6.5 million – and still the owners somehow came to believe it was worth between $100 million and $200 million.”

Mr. Brodsky feels that the reason for this is “… our egos can get us in trouble when it comes to putting a dollar value on something we’ve created.  We generally take the highest valuation we’ve heard for a company somewhat like ours – and multiply it.”

He goes on to point out that prospective acquirers are more concerned about profits, especially Free Cash Flow, than sales.  Too many company owners use some rule of thumb based on sales.  He also points out that company owners tend to use a comparison of a similar business across town that sold for some multiple of sales and then apply it to their company.  There are so many variables of how sales (and subsequently earnings) are generated that no two companies are ever alike.

Business owners tend to forget the negatives of their business; e.g., sales from just a few customers, lack of contracts with customers and suppliers, lack of product diversity, out-dated equipment, etc.  Also, as Mr. Brodsky points out, “Before you try to sell, make sure you know what buyers want.”

Turning to another expert voice, here is some good advice from Allen Hahn, Senior Vice President of Valuation Research Corporation: “The level of EBIT or EBITDA used for negotiating a purchase price is the ‘normalized’ level that will be available to the new owners from the assets acquired.  Often times this requires elimination of unusual, inappropriate or non-recurring expenses.  Buyers will typically consider a company’s last twelve months of financial performance.  However, projected results may be more relevant if a structural change has recently occurred in the business (loss of a key customer, acquisition, etc.) that renders historical results less meaningful.”

What does all of this mean?  It means that owners should disregard rules of thumb based on what the company across town sold for; it means that owners should not use a multiple based on what the business did four or five years ago, or what they think the business will do next year.

Business owners should first put their egos aside, then look long and hard at the company’s cash flow, realistically assess the negatives (and positives) of their business and “make sure you know what buyers want.”

Does your business have an orphan product or service that is doing okay, but doesn’t seem to fit into your core business?  Many companies, private equity groups and even some individual buyers are seeking product lines to augment existing ones, or even to build a business around.  Here are just a few of the reasons why a company might want to divest itself of a product line or even a particular service:

• It may not be a good fit for the parent company, thus diffusing efforts that could be placed into the core business.
• Because it is an orphan, it is a distraction.
• It man be a break-even side business that with a full-time effort could be profitable, but resources are better devoted to the core business or service.
• The money received could be used to expand the core business or fund some improvements that are not currently budgeted.

Certainly, there can be some disadvantages in allowing the adoption of an orphan – on both sides.  There is the all-important people issue.  Some valuable employees may be attached to the product line – and may go with the sale or decide to leave and move on.  This can negatively impact both sides of the transaction.  It can also have a negative impact on the selling company’s employees when the selling or purchasing company releases employees. There are cultural issues to consider.  The product may be a more important part of the selling company than management thought.  It may have played a role in selling other products or services.  The distribution channels may play a role in other product lines.  It is important for management to consider whether the orphan is really an orphan before selling it off.

On the plus-side for the acquiring company, the addition of the product line may be a perfect fit for their existing distribution chain.  The brand name acquired may provide name recognition to some existing products.  The new product line may be able to be manufactured with only a minimum increase in employees and plant capacity.

The purchasing company may have a difficult time establishing a price.  It may seem easy to look at the sales and the cost of sales, but the cost of sales may not include an allocation for rent, and for support services such as legal, accounting, corporate oversight, etc. Some part of the product may be manufactured on equipment used for other products, warehousing may be shared, and parts used in other products.  Many acquisitions are sold with a form of licensing agreement so the selling company receives a royalty or license fee representing a small portion of the sales of the acquired product line.

Company management is prone to think of only selling the entire business, a division or subsidiary of the company, when a sale of a product line may be an excellent solution.  The decision to sell a product line or service may solve a host of problems and perhaps even eliminate the need for sale of the entire business.  As Fortune magazine has written, “Companies once obsessed with cutting costs are now urgently trying to boost sales – with new products, new services and new markets.  The surest – and ultimately cheapest – way to increase your total sales is to persuade your existing customers to buy more products.”

Companies can be in trouble or headed for it for many reasons.  However, most of them can be linked to one or more of the following:

• Lack of proper focus
• Poor management
• Poor financial controls
• Loss of key employee(s)
• Loss of important customer(s)/client(s)
• Not keeping up with technology
• Quality control or other operating issues
• Legal or governmental issues
• Target market change or shift
• Competition

Unfortunately, by the time a business owner realizes that the business is in trouble and recognizes why, it may already be too late. The obvious solutions are to either fix it or sell it.  The decision should be made quickly, since time may be of the essence.

Unfortunately, too many owners of privately held businesses wait too long.  A decision to sell should be made when the business is doing well, not when it is in trouble.

Now may be the time to check with a professional intermediary to see what you can do to prepare your business for sale.

Valuation of private companies is much more subjective than public companies because there is no free trading marketplace for the private companies’ stock.  Just like a champion Olympic figure skater, the performance has to be flawless.  Take a look at the following check list – see if the target company rates near perfect (on a scale of 1 to 10 – 10 being best):

• Stable Market
• Stability of Earnings Historically
• Realized Cost Savings After Purchase
• No Significant Capital Expenditures Herewith
• No Significant Competitive Threats
• No Significant Alternative Technologies
• Large Market Potential
• Reasonable Market Position
• Broad-based Distribution Channels
• Synergy Between Buyer and Seller
• Sound Management Willing To Remain
• Product Diversity
• Wide Customer Base
• Non-dependency on Few Supplier

• They neglect to run their business during the sales process. – The owner of a business with sales under the $20 million range can get so involved in the selling process that they neglect the day-to-day operation of the business.

• They don’t understand the “real” value of their business. – A business may actually command a higher price than the value determined by an appraiser.  The business may be worth more than the sum of its parts.  A professional intermediary, along with other advisors, can answer the question of real value and help determine a “go-to-market” price.

• They aren’t flexible in structuring the transaction. – In many cases, how the deal is structured is more important than the price or terms.

• They are not looking at the business from a buyer’s perspective. – Buyers may look for different aspects of a business than those the seller looks for.  For example: growth potential, management depth, customer base, etc.

• They start with too high a price. – Sellers obviously want to maximize the price they receive for their business, but today’s marketplace is difficult to fool.  A good buyer may just elect to pass because of an overly aggressive starting point.

• They are impatient. – Sellers have to understand that it can take 6 to 18 months to find a buyer and proceed through the sales process, which includes due diligence, the legal and accounting issues that must be handled, and ultimately the closing.  However, on the flip side, the longer the deal drags, the more likely it is to fall apart.  As the saying goes: Time is of the essence!

• They have insufficient or inadequate documentation. – Sellers should have current real estate and equipment appraisals at the ready along with any documentation a buyer might want, such as projections, business forecasts and plans, and environmental studies.  Having all the documentation and financial records readily available will not only speed things along, but might also provide for a higher price or, even more important, save the deal.