How to optimise your exit plan for the best results
Need to ready your business for sale? Or show equity growth to your investors? Maybe you’ve been running your business for ten, even twenty years, and you’re itching to do something new. Certainly, the seismic shifts of the pandemic have made business leaders re-evaluate where they’re at and what they want.
Even if you’re not looking at selling in the immediate future, there’s value in having a ‘sale-ready business’. So, whatever your business faces, you have the flexibility to pivot or weather the storm. By setting out your stall and knowing the things that are true for your business, you can plan for the future, making the decision to push yourself harder to maximise your rewards.
Exit planning is one of the big reasons our clients hire us. Our Scaling Up methodology fits so well with the need to optimise businesses for sale. In the past, I’ve worked alongside Arrowpoint Advisory, the UK’s leading M&A advisors to mid-market companies. I’ve also tackled the subject of ‘Getting the most when you sell your life’s work’ in my podcast interview with Daniel Havercroft, partner at Oakley Advisory – one of Europe’s leading independent corporate finance firms.
It’s an area of real personal interest. I’ve been there. In January 2013, I was Managing Director of Peer 1, which sold for C$635 million. At the time, it realised the highest multiple for a hosting company ever achieved. My experience scaling this business showed me the levers that drive valuation in tech businesses. And now I share these with the businesses we coach.
The valuation formula
What do you think of first when you’re looking at valuation? Profitability? You’re not alone in that. We use EBITDA here (meaning Earnings Before Interest, Taxes, Depreciation and Amortisation) because it gives a measure of profit excluding costs to grow. But there’s something else at play in valuation that’s often overlooked. Why is it that some businesses in your sector are worth 2x EBITDA and some are worth 100x? What is it about these businesses that make them more valuable? Simple answer – a good multiple.
I came across this valuation formula when I worked for Shirlaws back in the day. Valuation is actually a function of your profit (EBITDA) and a multiple. And if you aim to manage the valuation of your business, you have to work on both. Not many people have a clear idea of how to do this.
When we sold Peer 1, we were a C$200 million company that sold for 16.5x EBITDA. So our enterprise value was C$635 million. Achieving the highest multiple in our sector had massively increased the value of our business. We were happy! Job well done. Some of our clients operate in different industries where the average EBITDA is 10% to 30%. So as long as you’re as profitable as your industry average, then you won’t get dinged. What were the things that influenced Peer 1’s multiple? High margin recurring revenue and a scalable platform that people could invest in and grow.
Tell a story
So what are the things we work on as part of the Scaling Up methodology that increase your multiple as well as your profitability? For a start, you need to tell a story. How you got to where you are now and what your plans are for the future. A clear line of sight backwards is important, like the wake behind a boat. You don’t know how far you’ve come or whether you’re travelling in a straight line until you look behind you. And you need to know where the boat’s heading.
At Peer 1, we ran the business on a quarter by quarter basis and you could see evidence of the plan that we’d rolled out very clearly. We were a publically listed company with outside shareholders so this level of planning was essential. But most SMEs don’t have a quarterly cadence and plan. Therefore, it’s much harder for them to tell a convincing story about historic investment decisions and their impact. As well as set out a three-year plan that makes them investable.
The rule of 40 and growth rate
In an IT services business, there are three big levers you can pull in the final valuation. The first is the growth rate. The second, percentage of recurring revenue. And the third is the profit rate measured as EBITDA. If you’re a SaaS company, you may have heard of the rule of 40 – a simple financial framework that balances revenue growth against profit margins. This rule of thumb will quickly determine the health and attractiveness of your SaaS company.
The rule states that your EBITDA and growth rate should exceed 40. So you simply add your growth in percentage terms plus your profit margin. For example, if your revenue growth is 15% and your profit margin is 20%, your rule of 40 number is 35% (15 + 20) which is below the 40% target. To be attractive, you must increase either growth or profit to reach a total of 40% or greater.
Increasing recurring revenue
At Peer 1, the percentage of our revenue that recurred was around 80% – pretty high. Long term contracts were the norm and our customers bought into our vision of the future and our five-star service. This also meant churn rates were low, further stabilising our revenue. As a result, even if things didn’t change, any downside risk was mitigated by contracted customers whose revenues were growing.
Building recurring revenue is a key focus in our coaching. We work with our clients to move their business from project-based to service-based revenue. This might involve bundling or packaging products for the best return.
An investable leadership team
Take a long, hard look at your Executive team. Are they really investable? We’ve known some great deals on paper that fell through as soon as the vendors met the team. This can really drag you below your industry benchmark if your team’s not up to the job. Remember, if you’re buying a business, it’s not worth what you’re paying today. Its value is what it’s worth to you in the future (which is why the Scaling Up methodology works so well).
It’s vital that the business is led by a high performing team of A-Players. So, we focus on culture and talent acquisition. This requires a solid behavioural framework that attracts and retains A-Players. And we decide whether it’s possible to double the business without it falling apart.
Sometimes, a member of the management team tells us they don’t want to go with the acquirer at exit. If that’s the case, we plan it early. Then we’re able to tell the story about how we replaced them so that it doesn’t impact the value of the business. It’s important to get the timing of this narrative right.
Total transparency around investments
A well-run business should return at or above the EBITDA margins of its competitors. And yet, people run their accounts without thinking about investments. During my conversation with Mike Michalowicz for our Melting Pot podcast, we discussed his book ‘Profit First’. He said that running your business should involve thinking about where you physically put the money. It should be really clear to any future buyer where you’ve invested. So often, we talk to business owners who tell us they are re-investing for growth. But it’s not transparent what this actually means. It just looks like they’re running their business badly.
If you’re generating a profit surplus on a monthly basis and then deliberately investing it, make it clear how you’re testing your assumptions and showing a return on the investment. Again, it’s about telling a good story. Vendors need to see the outcomes of any decisions you’ve made and the actions you’ve taken. Be careful that these don’t just exist in your head. You might know that you’ve hired five salespeople and it’s an experiment. But unless you’ve ring-fenced that money and shown where the costs are, you won’t know at what point the experiment broke even. And whether you should stop or invest more.
Get really specific and track important metrics to back up your decisions. What is your CAC to LTV ratio? Do you know your customer acquisition cost? Make sure you’ve got solid evidence behind you.
New product development capability
Ah yes. New products and your ability to develop them. Another thing that impacts valuation. I realised early in my career at Peer 1 that, whilst we could engineer a new product, we couldn’t bring it to market. What would the pricing be? How should we train sales? How would we transition the new product into support? These were all important questions that needed answering. So, we set up Project Challenger to address them.
A typical UK business is started by a middle-aged person with, on average, 12 years of experience in their industry. They’re often selling a service that’s related to their industry knowledge and find it easy to create the first product or service offering. But often there’s no methodology for further products or line extensions. Product marketing can be a big hole. This needs to be sorted. We use Alex Osterwalder’s tools ‘Business Model Canvas’ and ‘Value Proposition Development’ to help clients with product development.
And could you add a new distribution channel? This will accelerate growth in your business like nothing else. You might be selling through the channel or face to face, or digitally. But are there other routes you could use to increase your valuation?
Brand and positioning
Then there’s a whole thing around brand. It has to fit with your expectations. If you’re a £10 million turnover business and want to be £100 million, you need a brand that will work for that. It needs to pull through a sufficient level of revenue and customers as well as communicate your ambitions to the marketplace.
Your brand can make a big difference to your ability to attract and retain A-Players, not to mention customers, so it needs to be right. We use tools like the attribution framework to look at market positioning. The 3HAG methodology can be so useful at this point. It’s important to work out how scale-ready you are. We look at the functional health of the organisation in the shape of key function flow maps and scorecards. They give us a good understanding of whether the building blocks for growth are in place.
Ultimately, our Scaling Up process can be summed up really simply. Do you have the right people in the right seats doing the right things? Along the way, we’ll get into culture using measurements for staff and customer engagement. We’ll design a simple strategic framework that lives on a One Page Plan. We’ll communicate this so that everyone knows the direction of travel and their OKR commitments. We’ll establish a rhythm of daily huddles and weekly Level 10s to keep the momentum moving. All of which will increase the multiple of our client businesses. And that can only be a good thing for exit-planning.