Cutting costs to smarten up the figures of a business for sale can be counterproductive. Smart buyers will spot the window dressing for what it is.
The dangers of window dressing
Most business owners put off preparing their businesses for sale far too late to do any serious changes. Generally they decide that they wish to sell out and it becomes an imperative that they do it as quickly as possible.
If you think about this a little, you can readily understand why selling quickly is foremost in their minds. For many years they have been working diligently in the business and their efforts has been focused on the future of the business, now, all of a sudden, their focus is on life after the business and their willingness to put the same energy into the business reduces – thus the quicker the sale the better.
Suddenly faced with the prospect of selling, they realise that they really should have spent some time increasing the profits so that the valuation on sale would be higher.
This is almost certainly based on their expectation that their business will be sold for some multiple of earnings and that the earnings number will be, most likely, the most recent full-year result or some variation on it.
With this in mind, they seek to improve the bottom line by cutting costs – it is generally not possible to increase revenues rapidly. As they search around for costs to reduce, they imagine they can cut some infrastructure costs, which won’t have an immediate effect on revenue generation.
This often leads to cutting back on advertising, marketing expenses, research and development, delaying equipment replacement, deferring maintenance of plant, and so on. This window-dressing takes costs out of the business and immediately improves the bottom line. They now feel ready to put the business on the market and confident the increased profits will gain them an extra kick up in the valuation.
This could not be further from the truth. In fact, what they are doing is rolling the dice on whether a smart or a dumb buyer comes through the door. If they are really unlucky, only the smart ones will be interested.
However, smart buyers know these tricks as well and they will diligently go about looking for such adjustments. Smart buyers are looking for sustainable profits.
As soon as they see that window dressing has been cut back they will simply add back the expenses to get a better view of the long-term profitability. They will also probably increase their assessment of the risk in the business, on the assumption that they may not have found everything and that the business may need additional investment or time to bring it up to the estimated profits.
The increase in risk reduces the earnings multiple, thus further reducing the value of the business. The window dressing, which the seller had undertaken to improve valuation, has now actually reduced the valuation. The business is likely to sell for less that it might have before the cost-cutting.
If you want to protect the value of your business on sale, make sure the buyer only sees changes in the business that improve the long term profit potential.
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Professor Tom McKaskill is a global authority on exit strategies and the Richard Pratt Professor of Entrepreneurship and Academic Director of the Master of Entrepreneurship and Innovation, Australian Graduate School of Entrepreneurship, Swinburne University of Technology, Melbourne.