Armando (0:00 – 0:44)
Hi, I’m Armand Roman, host of the Founder’s Guidepost. You’ve built your business over decades, and now it’s time to think about that once-in-a-lifetime exit. You’ve come to the right place.
Here, you will hear business exit professionals talk about what you should know before exit. Besides hosting the Founder’s Guidepost, I’m CEO and founder of Axiom Founder’s Family Office, working with founders to help preserve their American success story. And it all begins with a founder stress test.
We also host the Scottsdale Founder’s Forum for the founder considering exiting in the next 36 months. Here’s to your hard work and to your American success story. Enjoy.
This is Armand Roman with the Founder’s Guidepost today with Gerhard Kratzer. Gerhard, how are you?
Gerhard (0:45 – 0:49)
Good, very well. Happy to be here and thank you for having me.
Armando (0:49 – 1:28)
Oh, certainly. Gerhard, I’m really anxious to share the information that you provide to your clients because I’ve spoken with a handful of your clients, and they are really, really thankful that you are helping them. And what’s been interesting in the conversations I’ve had with them is that they can see a path going forward that you’re digging in as a fractional CFO and that, and just helping them look at what they have, mapping out a plan going forward, and helping them execute on that plan.
So Gerhard, maybe you can talk just a little bit about your background and how that helps you do what you do for the clients that you’re working with today.
Gerhard (1:30 – 4:17)
Absolutely. So I was born and raised in Germany, moved to Arizona in 2008 for a Fortune 500 German corporation that used to have a facility in Chandler, Arizona. So I came here for that company in 2008 and worked for that company here until 2015.
Then I left and started my own business, not really knowing what I was getting into. So it was a little bit scary, but I think it needs to be a little bit scary in order to be successful. So I started networking, building relationships in all of greater Phoenix, and even down to Tucson and up north to Flagstaff and Sedona.
And since then, I’ve been helping small businesses to use their financials, basically, to make more informed business decisions. That’s it in a nutshell, but I’m going to explain what that means. A lot of small businesses use their financial statements exclusively to prepare the tax return, right?
Because that’s what everybody has to do. However, there is so much information in that financial data that is so useful to literally run your business with that data and make informed business decision based decisions based on that data. And that’s what I help small business owners to see.
I translate that information for them into data that is more digestible. Let me put it that way. Nobody likes to read a balance sheet, right?
Maybe an income statement. But balance sheets, no, that’s boring, right? I guess most business owners would agree with me on that.
Probably. So I take that data and I translate it into information that it’s easily digestible, that it’s easier to understand, that shows key performance indicators that the business owner then can use to make more informed business decisions and improve both the performance and the cash flow of their business.
Armando (4:18 – 4:25)
Okay. The starting point, it sounds like, really is the financial data that they have when you first meet them.
Gerhard (4:25 – 4:42)
Yes. So in most cases, when we come in, the first thing we need to do is review the financial statements and the accounting system that the client uses. And in most cases, it requires a cleanup.
[Speaker 4] (4:43 – 4:44)
Okay.
Gerhard (4:44 – 5:18)
Because when we come in and provide fractional CFO services, we need to be certain that the financial data that’s in the accounting system is both accurate and up to date. Because everything what we do is based on that financial data. And if that financial data is not accurate and up to date, it’s garbage in, garbage out.
So everything what we do would be a waste of time. So we help with that cleanup.
[Speaker 4] (5:19 – 5:19)
Okay.
Gerhard (5:20 – 5:34)
If that is required, we collaborate with local accounting firms here in Phoenix that we subcontract that cleanup to. And then once that is done, then we come in and do our fractional CFO work.
Armando (5:34 – 5:59)
Okay. So once you have good data, once the cleanup is done, maybe the financials are reorganized a bit, but once those are now clean and providing good data, that’s when you can begin to help them really, I guess for you, now you know what’s really happening because you can see the real data. Exactly.
Begin, maybe that becomes the baseline. And from there, you’re building the performance and cash flow.
Gerhard (6:00 – 6:14)
Yes. So most of our work is very analytical. So it’s what, what’s commonly known as FPNA financial planning and analysis.
That’s a lot of the work that we do.
[Speaker 3] (6:15 – 6:15)
Okay.
Gerhard (6:16 – 7:45)
And obviously the data needs to be accurate to be analyzed. So that’s what do, that’s what we do once the, the cleanup of the accounting data is done. And the analysis results can go into a variety of different directions.
So once the analysis is done, we help our clients to take on the action items that are required to eventually improve their performance and ultimately improve their cash flow, because that’s the ultimate goal of everything we do. Optimize the client’s cash flow. So we actually use the acronym CFO, which is obviously known as chief financial officers or chief financial officer, right?
For us, it’s actually cash flow optimizer, because that’s what it’s all about at the end of the day, especially for small businesses. Cash flow is the ultimate, optimization of cash flow is the ultimate goal for basically every business, but the smaller the business gets, the more important it becomes.
Armando (7:48 – 7:56)
Yeah. I like that point, the distinction that you made that financials are often done for a small business, really for the tax returns.
[Speaker 3] (7:56 – 7:57)
Yes.
Armando (7:57 – 7:59)
It’s the necessary evil to get that tax return filed.
[Speaker 3] (8:00 – 8:00)
Exactly.
Armando (8:00 – 8:27)
And some tax practitioners are a little more, they pound the pavement a bit more about getting the financials in a shape that allows for that tax return. Some are a lot more with that. And sometimes the business owners provide financials that are honestly just terrible.
[Speaker 3] (8:27 – 8:28)
Yes.
Armando (8:28 – 9:11)
And some practitioners, tax practitioners will take that, do the best they can and file it. Others will say, let’s get some cleanup done. Not a lot, but let’s get some done and then we’ll file it.
But you’re going well beyond that to make sure that from, it sounds like the data entry standpoint and the chart of account standpoint and the nice, neat, clean functioning financial statements, that that’s your starting point. So I guess a question for you Gerhard, when you typically meet a new business and begin working with them, do they have a bookkeeper on board, a controller on board? What do they have?
What’s that look like for them when you come on board?
Gerhard (9:12 – 12:09)
In most cases, they either have a bookkeeper or an accountant. Sometimes they have a controller or even a CFO. That totally depends on the size of the business.
Most small business have usually one person in finance that does all the bookkeeping and all the accounting. The difference between how we look at an income statement and a balance sheet and how a CPA who is supposed to prepare the tax return looks at an income statement is that we really look at it from a managerial perspective. And that can actually result in changing the chart of accounts, or let’s say restructuring the chart of accounts.
For example, we make sure that all bookkeeping entries land in the right, let’s call it category. For example, we work with a lot of manufacturing companies and one of the most important categories is cost of goods sold, right? So the tax CPA, for the tax CPA, it doesn’t matter if something is categorized under cost of goods sold or under SG&A.
I’m exaggerating a little bit. It’s an expense either way, right? It’s an expense either way, it doesn’t make any change to the tax liability, to the net income of the business.
However, if you want to use that data to run your business, it’s actually very important that all expenses are categorized correctly. Because the cost of goods sold determines your gross profit or your gross margin, which in turn is important for your pricing strategy, right? So you want to know exactly what the manufacturing of your products costs you.
It’s very important. So we need to make sure that every employee who works on the product is categorized under direct labor, that all the material that goes into the product is categorized as material cost, that all the infrastructure that is required to make manufacturing possible is categorized as manufacturing overhead, and then that all your research and development is categorized as R&D, and all your sales and marketing expenses are categorized under sales and marketing, and everything else is categorized under G&A, general and administrative, right? So from a tax perspective, for the tax CPA, he doesn’t look at that.
Armando (12:09 – 12:31)
Right, right. Yeah, but you’re looking at cost accounting and making sure that that particular product that gets sold, that all of the costs are captured correctly. So you know, the owner knows what their real cost is to get that out, then they can see the real margin, and see if they’re actually underpriced for losing money or making money and then make improvements from there.
Gerhard (12:31 – 13:54)
Exactly. So thank you for mentioning that because you hit the nail on the head. That’s the difference between financial accounting and managerial accounting.
The majority of managerial accounting is, as you said, cost accounting, right? Making sure that a manufacturing organization has the right standard costing in place for their products. It’s also important, for example, when you want to apply for, let’s say, an R&D tax credit, you need to make sure that the R&D expenses that are reported in your income statement accurately reflect what your R&D expenses are.
So you cannot just book some raw material that you use for production under R&D, or a sales event that you organize, you cannot book that under R&D either. Those are extreme examples, right? But it’s very important to make that distinction when it comes to using your financials to run your business.
Armando (13:54 – 14:37)
Are you wondering if you’ve missed anything in your planning? We hear that a lot from very smart, very successful people. And that’s why you may want to know more about our Founder Stress Test.
If so, go to axiomcorp.com. You know, so Gerhard, once all the cleanup is done in the financials, and now from this point going forward, all the expenses are captured in the right categories, and now you’ve done your analysis, and now you’re having that first conversation with the owner of that business. What are some of the common things that you’re sharing with them that they didn’t know, or they’re, they’re maybe in disbelief or surprised as to what you’re telling them?
Gerhard (14:37 – 17:10)
Yeah. So we usually start with a financial assessment. We also call it a financial health check.
So we analyze on a high level, the financial statements of the last three years. And then what I meant earlier with translating that data into information that is easier, more easily digestible for the business owner or the CEO, that basically means that we transfer the financial data into KPIs, key performance indicators. And those key performance indicators reveal to the business owner where the opportunities for improvement are.
Okay. So here are a couple of examples. So when it comes to the income statement, one of the most important KPIs is gross margin, right?
Is the gross margin sufficient to not only cover your operating expenses, but to result in a profit of your business? So profitability is the number one financial number that we look at. And as I mentioned earlier, in a manufacturing organization that starts with gross profit and gross margin, but that’s not where it stops.
That’s where it stops for a lot of business owners, because the income statement is usually the financial data that they look at regularly. Another important piece in addition to profitability is networking capital, specifically when we talk about cash flow, right? So another KPI that is regularly analyzed is inventory churns.
For example, a lot of business owners look at their income statement, they see a profit at the bottom, right? And then they wonder why they don’t have enough money in the bank account. So what I usually do, I go to their warehouse with them.
And then I show them, look, this is where all your money is.
Armando (17:10 – 17:11)
Yeah, all the inventory.
Gerhard (17:11 – 17:13)
Sitting on the shelf and not working for you.
Armando (17:13 – 17:13)
Yeah.
Gerhard (17:14 – 19:05)
Another beautiful example is accounts receivables. You have those sales on your income statement. But that doesn’t mean that that money is in your bank account, right?
That’s why, for example, collections is so important for small businesses. I always tell salespeople, who, in my opinion, should be heavily involved in the collection process, because they have the relationship to the customer, right? I always tell salespeople, the sales process does not end with the sales order coming in.
It also doesn’t end with shipping the product to the customer. It ends with collecting the payment from the customer. That’s when it ends.
If I had to decide, I would make all small businesses do the accounting on cash basis, because accrual basis can be misinterpreted. Right, exactly. Right.
You know what I mean, right? It shows a profit, but there’s so much capital employed in inventory and in accounts receivables that the cash flow shortage that some small businesses have to deal with is not transparent. That’s why it’s so important that in addition to the income statement, you regularly look at your balance sheet.
And again, that’s exactly what we help business owners with, to see that. And that financial assessment is really eye-opening. Literally in over 90% of the cases we do this, it’s eye-opening for the business owners.
They’re like, oh my God, I have no idea.
Armando (19:05 – 19:20)
Yeah, yeah. I guess to the point, if they don’t have good numbers, they wouldn’t have any idea. They might have a gut feeling, and maybe that’s why they hire you, because they just feel something needs attention and they don’t see it.
They don’t know where it is. Yes.
Gerhard (19:21 – 22:52)
So the thing is that to have the awareness that help is required, that’s the most important first step. And it’s a challenging first step for a lot of business owners because it requires some vulnerability, right? I need to admit that I need help.
Usually business owners are awesome at what they do. They are usually creative minds that have great product or great service ideas, and they start their business and it gets off the ground and it’s successful. And then they hit a ceiling after a while, and then they get stuck.
And they don’t know how to get out of it. And then to admit to themselves, hey, you know what, I need help with finding out where the root causes of my issues or my challenges are. And then when they reach out and we do the financial health check, it’s an eye opener for them in really most cases.
And I think what differentiates us from other financial consultants is that we do not stop once the financial analysis is done. That’s actually when the work starts. And that’s actually when the fun starts, right?
You do the financial analysis, you come up with all those KPIs, you have industry benchmarks for those KPIs, you know where the business underperforms, that opens up these opportunities for improvement. And then to discuss with the owner, who is still the business expert, right? We are not the business expert.
We are just a piece to the puzzle that was missing in the past. And then discussing with the business owner, okay, how can we improve gross margin? How can we reduce day sales outstanding, which is an accounts receivables KPI, right?
How can we increase inventory turns? That’s where the fun starts. And then we even help implementing, then we even help implement those action items that eventually result in improved performance and optimized cash flow.
So that can go in all that can go in a variety of different directions. We help our customers with process improvements on the shop floor. We help with system implementation, for example, an ERP, right?
Because at some point, QuickBooks is not good enough. Right, right. As it has its limitations.
We help with organizational restructuring. We help with sales growth initiatives, we help with cost reduction initiatives, turnaround management. So that’s why we call ourselves not just finance consultants, but we are literally finance and management consultants.
Because all the analysis that you do doesn’t help if it does not result in action items.
Armando (22:53 – 22:55)
Yeah, some kind of a change. Yeah.
Gerhard (22:55 – 22:56)
Does that make sense?
Armando (22:56 – 23:24)
Yeah, no, it does. It does. And it sounds like from what you’re describing, that you’ve got a core team, you also realize when you need to bring in other team members who are not part of your company, you mentioned the accounting firm, for example, to come and clean up.
And you probably have others as well you bring in if it’s an HR expert, a human resources expert, then so you’ve got folks who you draw on, depending on what the needs are of that business.
Gerhard (23:24 – 24:01)
Absolutely. So we have an extensive network that goes in all different directions. As you already mentioned, HR consultants, we work with lean manufacturing experts, we work with organizational experts.
By that I don’t mean HR people, I mean, really people who come in and put the optimized organizational structure in place. So the org chart…
Armando (24:04 – 24:50)
Sorry about that. I’ll be right back. Certainly.
So the org chart, it sounds like what Gerhard is talking about is the organizational chart. HR, of course, is managing the people and that. But the organizational chart is the overall structure of the functions and the people that do.
So I’m just explaining the organization chart, what it really means, the impact. And we talked about bringing in people to look at the whole organizational chart, the structure of the business, if that’s what you’re referring to.
Gerhard (24:50 – 25:31)
Yes. We worked with ERP companies that we referred to the client for ERP implementations, and then we actively support the finance module of that ERP system. We help with the implementation of that.
We bring in fractional VPs of sales. So it’s really important with the ultimate goal that we have, that we have a sufficient support network that we can use to help the client with whatever is needed.
Armando (25:34 – 26:12)
Okay. And you mentioned, you know, before you began that part of the conversation, you mentioned that a business owner gets to a certain plateau and gets stuck and says, hey, I need help. And that can be a difficult thing to say, I need help.
And that makes sense from just a human nature standpoint. At the same time, if you look at the world’s most successful companies, the companies that we see and hear about all the time, they’ve had tons of help along the way. They’ve brought in all kinds of experts for their people, for the organizations, strategic planning, growth.
They’ve had so many experts on board that helped them get to the top of the food chain.
Gerhard (26:12 – 27:44)
Right? Yes. Yes.
It’s so important to realize that you cannot be an expert in everything. And let’s face it, finance is not the most exciting. It’s not the most exciting thing, right?
Especially when it comes to accounting. So I understand business owners that avoid that topic and then minimize their finance resources to what we talked about earlier, the necessary minimum, which is the tax return, because that’s a must do, right? However, it’s an important step to realize, okay, that’s not my area of expertise.
That’s not the area that I enjoy being in. However, I need someone who does. And it’s not like that we come in, and we think that we know all the truth.
No. As I said earlier, we are just a piece to the puzzle. An important piece.
I always tell business owners, whatever advice we are going to give you, that’s just one piece. And I always advise them, for example, not to stop listening to their gut feeling. It’s important.
It is.
Armando (27:44 – 27:44)
Right?
Gerhard (27:44 – 28:53)
Yes. Because they have the experience, they’ve been growing their business for the last 10, 15, 20 years. They need to keep listening to their gut.
They really have to. What we provide is an additional piece that substantiates whatever they feel with data. And that’s the beauty of data.
Data has no emotions attached to it, which doesn’t mean that we are non emotional people. But the data, as long as it’s accurate, as we said in the beginning, right? Those are facts, and they don’t lie.
So those KPIs that we calculate and analyze for our clients, that’s an additional piece to the puzzle. It’s very important. Something that the business owners needs to consider when they make important business decisions.
Armando (28:54 – 29:33)
You mentioned manufacturing, Gerhard, and that makes me think about heavy equipment, which can be very, very expensive, which can be leased, it can be purchased, different ways to get it. And I imagine as you’re having some of those conversations, and they’re looking at that big price tag of that manufacturing equipment, plus the installation time, the ramp up time, etc. There’s got to be a payback on that.
So I imagine as you’re going through those conversations with your owners, you’re also looking at, you know, if we do this, it’ll cost x. And we should expect the following results in year one, year two, year three, year four, you’re doing those kind of projections as well with them.
Gerhard (29:34 – 30:41)
Oh, absolutely. We do a lot of financial modeling. Purchasing a piece of equipment is just one of them.
That’s what’s commonly known as an ROI calculation, which we usually do with discounted cash flow methodology. So we basically predict future profits out of buying that piece of equipment, and discount them to today’s day. And then we make sure that there’s the appropriate amount of cash flow out of that investment.
And we make sure that the payback period, that’s a term that’s commonly used, is not too long. So if you invest into a piece of equipment, and it takes you 10 years to get that investment back, that’s way too long. It’s usually somewhere between a year and a half and four years.
Armando (30:42 – 30:42)
Okay.
Gerhard (30:45 – 31:45)
Without getting into too much detail, but yes, we do a lot of financial modeling. And that is part of FP&A financial planning and analysis. The planning part is specifically important for startup companies, obviously.
So we have helped a lot of startup companies develop a financial model that they use. And they actually need that financial model for fundraising purposes. Because when they talk to investors, yeah, so they’re raising capital, let’s just want to see, okay, what’s your outlook for the next three to five years.
And to build that financial model is actually one of our most requested services. And it’s very detailed. It’s obviously since it’s planning, it’s based on a lot of assumptions.
[Speaker 3] (31:46 – 31:46)
Yeah.
Gerhard (31:47 – 32:04)
However, the model that we built, has the advantage that once it’s built, all you need to do is because you know, in a startup, changes happen literally daily. Right?
Armando (32:04 – 32:08)
You have a plan, right? That might get modified very quickly.
Gerhard (32:08 – 33:58)
Yes, maybe daily is a little is an exaggeration. But the beauty of the financial model is, because it’s based on assumptions. And it results into a three to five year income statement, balance sheet, cash flow statement, use of funds, capitalization table, all these numbers that potential investors want to see.
And the beauty is, if you change an assumption, every outcome of that model updates automatically. And that’s what the startup owner wants to play around with, literally. Yeah, what if I do?
Okay, so what? Yeah. So what if I change this?
What if I assume that my average customer payment terms are 30 days instead of 45? Or my inventory terms are six instead of three. So they change these variables.
And then all the key metrics that come out of that financial model update automatically. That’s what we’ve been doing increasingly. And the reason for that it’s not only used for startup companies, it’s also used for companies that are preparing for exit.
Because that’s what a potential buyer wants to see too. You know, it’s a lot obviously, when it comes to exit planning. It’s a lot about EBITDA multiples and historic data, but potential buyers, they also want to see an outlook over the next at least three years.
Armando (33:59 – 34:06)
Yeah, you’re telling them what they should reasonably expect based on this. Yes, exactly. Potentially going to buy.
Gerhard (34:07 – 34:09)
Oh, thank you for saying reasonably.
Armando (34:11 – 34:13)
You’re not guaranteeing results.
Gerhard (34:13 – 35:06)
Well, an exit process is very, very emotional for a business owner. Yeah. Right.
I mean, you know that I’m preaching to the choir when you and I talk about that. It’s a very emotional process. Usually the expectations are higher than what the business is actually worth.
And it’s a lot of business owners are just shocked when they realize that gap between what they think the business is worth and what it’s actually worth. And that’s a very emotional process. That’s why it’s so important to get all the support that you can get when you prepare for exit.
[Speaker 3] (35:07 – 35:07)
Yeah.
Gerhard (35:07 – 35:46)
Because business owners are usually most business owners do that once. That’s a once in a lifetime event, right? Exactly, exactly.
And it’s a lot of times it’s so sad to see that business owners leave so much money on the table after putting all their sweat and blood and tears into that business for 30 years. And then when they sell the business, they leave so much money on the table because they think they can do it all on their own.
Armando (35:47 – 36:55)
Right, right. And that is one of the biggest shames out there. Because as you said, they’ve spent so much of their life building this company.
And if they don’t get at least the market value of the company, they’ve left money on the table, but they’ve also impacted the future of their family going forward, which could be substantial if they’ve left big chunks of money or did it in a way that just hit them really heavily with tax. Well, maybe that could have been minimized, mitigated quite a bit. But having that team of experts at that time is just critical.
And I imagine you talked about the financial modeling. I imagine as the potential buyer is looking at a company and looking at your financial modeling, they’re probably picking that apart, looking at the assumptions and making sure that they feel comfortable with those assumptions. And maybe not double checking, but second guessing your assumptions so they can feel comfortable that those numbers look like they should.
Gerhard (36:56 – 37:22)
Yes, yes. We usually advise the business owner to rather take a confident but conservative approach. Because if future cash flows are part of the deal, it usually results in an earn out, right?
And in this case, you want to make sure that that earn out is actually paid out.
[Speaker 4] (37:22 – 37:22)
Yeah.
Gerhard (37:23 – 37:40)
I remember that in one of your founder forum events, I cannot remember his name, but there was a former business owner who kind of sarcastically said, if you have an earn out in your deal, just write it off.
Armando (37:42 – 37:57)
Right. Unfortunately, yes. But that is…
Unfortunately, yes. Exactly. M&A merger and acquisition attorneys tell me that on the cash you get, assume that’s the only thing you’re getting from the sale.
The earn out may or may not happen.
Gerhard (37:58 – 38:09)
Exactly, exactly. And usually it doesn’t because it’s based on too optimistic, yet to say unrealistic assumptions.
Armando (38:10 – 38:16)
Right. And for those who are not familiar with the term earn out, maybe you can just touch on what that really means to the seller of the business.
Gerhard (38:17 – 38:34)
Yeah. So that means that a portion of the sale is paid out in later periods based on the performance of the business.
Armando (38:34 – 39:00)
Yeah. So just use some numbers. Let’s say that the company sells for $100 million today and the owner, the seller, the person, your client who you’ve been working with to help build the value of the company, they got say 60% cash today, that would be $60 million.
Yes. But there’s $40 million in an earn out that they may get over the next two, three, four years or so. May.
That’s the earn out, correct?
Gerhard (39:01 – 39:49)
Yes, that’s the earn out. And that earn out depends on the future performance of the business. So if you tell your buyer, hey, I’m gonna, my EBITDA is currently 10.
And I sell you the business for a multiple of 10. So that’s 100 million. Right.
However, you’re telling me that the business is actually going to grow over the next three years to 12, 14, 16 million in EBITDA. And then those remaining 40 million really depends on that you achieve these numbers. Because if you don’t, then it’s not paid out or only partially paid out.
Yeah.
Armando (39:49 – 40:11)
Yeah. And then if the seller, your client who you’ve helped do all the work that you’re doing, if your client has no control over any of those future operations, they don’t have any control that they cannot influence if expenses are too high, or if they hired the wrong people, there’s no, there’s no control whatsoever.
Gerhard (40:12 – 40:50)
If that’s the case, I mean, in some cases, the former owner stays on board. Right? Because that’s what usually a buyer requests that the owner or the CEO or at least the key executive staff stays on board for at least a year or two or three.
If this is the case, then you have more influence to achieve those numbers. However, I would never ever advise to make earn out a part of a deal. If you have no influence on achieving those numbers.
Right.
Armando (40:50 – 41:22)
Right. Right. I spoke with a business owner recently who is selling now.
And she was happy to say that her earn out was based on the top line revenues, not on EBITDA, not on profits, not on cash flow, but based on top line revenues. And she felt much more comfortable that those were achievable numbers and felt much better that her earn out, she was going to actually collect it.
Gerhard (41:23 – 42:43)
Yes, that makes sense. I mean, that depends on how the buyer is going to consolidate that business. And I mean, if they consolidate it, and all the fixed costs are basically shared with the acquiring company, because they integrate that new business into their operations, right?
It’s hard to determine what the EBITDA of that specific business would actually be. Right. So if an earn out is basically, or exclusively based on top line revenue, that’s that makes it easier, right?
Because there’s also, I mean, an earn out is literally constructed to create conflict, especially when you don’t have any influence anymore, on how the business is being managed, right? Right. I mean, the buyer, they can just change things in the accounting, how costs and expenses are allocated.
There are so many areas where you can manipulate. Right. And I don’t mean in an illegal way or anything like that.
[Speaker 4] (42:44 – 42:44)
Right.
Gerhard (42:45 – 42:52)
Yeah, if you can avoid an earn out, then you should definitely avoid it. Right.
Armando (42:52 – 43:38)
Right. And I’ll just mention one thing about that as well, that, you know, when the seller, we say, well, your client now sells his or her company, and now the buyer is now in control, they’re concerned about themselves, their shareholders, and themselves going forward. That seller, your client who you’ve worked with for years, doesn’t really matter to them nearly as much as their own people and their own future and their own direction.
So if they’re making an accounting move or accounting change, or make some strategic changes to the business, and it ends up making the seller’s earn out zero or drastically less, it’s not necessarily skin off their back.
Gerhard (43:39 – 43:57)
Yes. And there are always ways to manipulate financial data. And again, by manipulate, I don’t mean doing illegal things, right?
But manipulate financial data in a way that makes the earn out go away.
[Speaker 4] (43:57 – 43:58)
Yeah.
Gerhard (43:58 – 44:06)
And then there’s the conflict all of a sudden, and then it results in legal action. And it’s just not worth it. Right.
In a lot of cases.
Armando (44:06 – 45:01)
Right. And, you know, it’s interesting, you would mention that I just, we had a client a few years ago who went through a sale. And they, the owner accepted quite a bit less than the value of the company, because they just wanted to be done.
It was a very stressful thing. And even though the owner said very clearly to me that from a legal standpoint, they had every basis, every foundation from a legal standpoint where they could have gone to court and they could have won. But the the other side had so much more money and cash and big lawyers, that it would have been a very expensive battle.
And they could have drug it out for a very long time. And this owner, the seller didn’t have those kind of resources.
[Speaker 3] (45:02 – 45:02)
Yes.
Armando (45:02 – 45:09)
And realized it was better to cut bait, take a lesser amount and be done and move on than to try to fight something like that.
Gerhard (45:10 – 45:15)
Yeah, especially when when a small business is acquired by a big player.
[Speaker 4] (45:16 – 45:17)
Yeah.
Gerhard (45:17 – 45:23)
Yeah, you don’t you, you definitely want to avoid any legal conflict. Yeah.
Armando (45:23 – 45:37)
And I guess to you earlier about having, you know, having the right team, the right professionals during that time when you’re exiting. So yes, they can spot things that maybe you don’t see that the owner, the seller just doesn’t see.
Gerhard (45:38 – 47:21)
Yeah. That’s why you need that team of an investment banker, or at least an M&A advisor. You need the right legal support, an M&A attorney, and then you need the finance support to prepare appropriately for exit on the finance side.
Right. And then so that’s usually a team of five people that’s required. And a lot of business owners shy away because obviously those people are not for free.
Right. However, the return on that invest of the return on investing in these people is usually a multiple of five, six at least. Because if you spend just as an example, let’s say for those five people over a period of six months, if you spend $200,000 on those five people, an M&A advisor alone can actually get you at least a multiple of five in additional money out of the deal.
I mean, you have experienced that multiple times, right? Right. With your clients that it’s really worth it.
I understand that business owners are careful when it comes to that support, but it’s definitely advisable to get it.
Armando (47:21 – 47:58)
Yeah, definitely. And if this is the biggest transaction of your life, your biggest asset you will ever have, then you want to make sure it gets done correctly and leaves you in the best position possible, certainly. So, Gerhard, when you’re going through your work and now you’re working with the company, I’d like you to describe on day one, when you first start working with a new client, what does that company typically look like?
You know, number of employees, revenues, you know, life cycle, where are they, when it’s a good situation for them to engage you?
Gerhard (47:59 – 48:11)
Okay, so our typical clients are up to 50 million in top line revenue. Beyond that, they usually have a full time CFO.
[Speaker 3] (48:12 – 48:12)
Okay.
Gerhard (48:13 – 49:16)
So our biggest clients, but our biggest client right now is right there at 50 million. The most fun, however, is companies that hire us when they’re in growth mode, or they’re a startup company, or they’re preparing for exit. Those are the three scenarios that we enjoy most.
However, I’ve been in this business, I started my company nine years ago. And it’s been such an amazing ride. So much diversity and so many different situations.
And it’s so rewarding to see after working with a client for six, nine or 12 months, how they have actually improved. That’s the most rewarding piece of that job.
Armando (49:17 – 49:48)
So let me ask you, you mentioned exit. And, you know, exit, they’ve got to get this right, obviously. How does that conversation typically go?
Are they looking to exit in two years, five years? Are they looking for a certain number in a sales price? Are they looking for a certain after tax sales price?
What are they really looking for, as you talk with them, and they’re thinking about exit and bringing you on board to help them have a better exit?
Gerhard (49:49 – 50:06)
Yeah. So that also ranges. Ideally, when they talk about exit, they are giving themselves a range of three to five years.
[Speaker 3] (50:06 – 50:07)
Okay, good.
Gerhard (50:07 – 53:01)
That’s the ideal situation. Some of them, they say, Okay, I want to sell this year. And they’re and they are not prepared at all.
So those are the situations where you have to explain to them that it’s it’s doable, theoretically, but it’s certainly not ideal. Because especially when it comes to getting that support that we talked about, ideally, you can build those relationships with M&A advisors, or financial consultants, or attorneys. Ideally, you can give yourself a couple of years, at least to build those relationships, because you don’t want to go with the first one, right?
You want to at least interview five M&A advisors or investment banks, you want to talk to five financial consultants, you want to talk to five attorneys and CPAs and whatever is required. So some business owners don’t realize that this that it’s a process. And they also don’t realize how emotional that process is.
Because once they they realize, Oh, oh my god, now I gotta let go. Yeah, that’s not easy. Right?
That’s not easy. Right. And another, another fact that a lot of business owners underestimate is okay.
What I what what what am I going to do once the business is sold? So they have no succession strategy for themselves. Right, right.
Okay. So that that is that that is all the stuff that usually estate attorneys take care of, right? When it comes to expectations, regarding business value, unfortunately, I would say 90% of business owners overvalue their business.
And that’s, that’s part of the emotional process. It’s really, really sad sometimes to see business owners that, for example, they expect a value of 20 million for the business. And then they bring an M&A, an M&A advisor in our investment bank, and they do a valuation, it turns out it’s only 5 million.
Armando (53:02 – 53:03)
Yeah, it’s a substantial difference.
Gerhard (53:04 – 53:46)
And they are shocked. And then, and that’s when the emotional piece gets even stronger. Because then they get defensive, and they are like, Oh, my God, I’ve put all my, my sweat and blood and tears into this business for the last 20 years.
And now you’re telling me 5 million, that’s, that’s it, or even less, right? So, unfortunately, I would, in my experience, and I don’t know what your experience is, but in 90% of the cases, the expectation is higher than what it’s actually worth. Right?
Armando (53:46 – 54:23)
People think that yes, people often think their companies are worth more than they can actually sell it for. But it only gets back to the point of when it comes time to exit, you know, three to five years ahead of time, or maybe, you know, five years or 10 years ahead of time, getting some good conversation with people who actually understand the market in that company. So they do have an idea realistically, of what the value is today.
And are they willing to put in what it will be what will be required to make it that higher value that they really want? Or is it exactly visible with their company?
Gerhard (54:24 – 54:54)
Exactly, that’s a very important piece. Oh, that’s, that’s actually the most important piece of planning your exit ahead of time, at least three to five years, because, as we said, if your expectation is significantly higher than the actual value of the business, and you have a certain number in mind, those three to five years, the right advisors can tell you how to get there.
[Speaker 3] (54:55 – 54:55)
Yeah.
Gerhard (54:56 – 55:41)
Right. So if, if you think your business is worth 20 million, and then the evaluation comes in, it’s only five, then the right advisors can develop a plan with you how to potentially get to those 20 million in five years. It’s very challenging.
And it requires a lot of effort. But it’s still better than being disappointed. And, right, literally, I mean, in a lot of these situation, there’s there’s no deal, because the business owners are like, okay, at that price, I’m not gonna sell.
Armando (55:42 – 55:53)
Yeah. And if the owners are at that point, exhausted, they’ve already expended all the all the have to go any further. Well, then that’s, that’s not a good situation to be in.
Gerhard (55:53 – 56:25)
It’s, it’s a very emotional process. And it’s mentally exhausting. That process is so mentally exhausting.
And another reason to bring in advisors is selling your business is a full time job. You cannot sell your business and continue running it at the same time for six months or nine months or 12 months, it’s just not possible. That’s, that’s another important reason to bring the right advisors on board.
Armando (56:25 – 57:07)
Yeah. And it gets to the to the, you know, kind of reemphasizes that, you know, the importance of a plan. So I imagine that modeling, you’re helping them see and putting together for them with the variables and the KPIs.
And that can be extremely, extremely helpful, it gives them a target, a realistic target, given assumptions, which can change, of course, and I’m sure they do change. But at least if they can, if they can see a picture and see steps along the way to get there, and you can help them measure improvement on say, a month to month basis, if not week to week basis, then it can feel reassuring that that they can and will get there at a within a certain time frame.
Gerhard (57:08 – 58:29)
Yeah, thank you, Armando, because that’s, that’s exactly what we do. So when we work with a client, and once the initial assessment is done, and the key performance indicators that drive that specific business are identified, and defined. And then we start working with the client on improving those KPIs.
A very important piece of it is to review the progress regularly. So with every month and closing of the financials of the business, we update the management report, and we update all the KPIs. And they’re all organized in a nice KPI dashboard with charts and visualization.
And we update all these numbers and charts on a monthly basis. And then we meet the business owner and monitor the progress. And that’s where you can really see and feel how the business is improving.
And that’s the most, that’s the most rewarding part of what we do.
Armando (58:31 – 58:47)
I can imagine that the owner seen a map that way and monitoring that progress, can feel reassured that it’s working. And if it’s not, make a course correction, try something different and see if that will make those numbers look better.
Gerhard (58:48 – 59:40)
Yeah. I mean, that my major client, I’ve been working with them for nine years now. They were my first, my very first client.
And I’m still working with them. And it’s, I mean, it’s, it’s so much fun every day. It just doesn’t get boring.
Because finance is so much more than numbers. Right? It’s, it’s really, it’s really exciting to see.
And that’s what I try to, that’s the message that I always try to send. It’s so much nice to see how financials that are, that are apparently so boring, how those financials can actually help to improve your business performance.
Armando (59:41 – 1:00:26)
Yeah. And I’d like to make a distinction that I’ve heard before, you know, when you, and I’ll go back to the beginning of the conversation we had, you talked about financials often are produced to get the annual tax returns done. And that’s kind of the bare minimum, which is in fact, what often, often happens.
But a distinction there, that I think is worth mentioning is those financials are looking at historical data, looking at things that happened last week, last year, to get the tax returns filed, because Iris says so, and then paying those taxes. What you’re doing is using that same data and changing the data and changing the output and changing the input so that that data becomes a tool to help navigate going forward.
Gerhard (1:00:27 – 1:05:51)
Yes. All our management reports go at least 12 months back because the historic data is important to measure the performance that you, or hopefully the improvement that you’ve put in place. So it’s important to measure historic data, but all our management reports always look 12 months into the future on a rolling, we call it a rolling 12 month forecast, right?
So we do the budget. And then with every month and closing when we update the management report. So for example, I just did that for three of my clients.
So they sent me their January financials. I take those financial statements, I put them into my management report, I update the management report, all the KPIs, all the charts that are in the management reporting tool. And then I update the 12 month forecast.
So the 12 month rolling forecast now goes from February 2024 until January 2025. So when I do that next month, February goes from forecast into actuals. And then the rolling 12 month forecast is extended until February 2025.
So it’s that rolling along with the actuals, and then extending your outlook into the future. It’s so important that you look at least 12 months into the future to identify potential cash needs. The smaller the business, the more important that becomes.
A lot of businesses don’t realize, especially in the manufacturing industry, when they predict a peak in sales. Let’s say in Q3 of this year, they are predicting that their monthly sales go from 2 million to 3 million, or even to 4 million, because of some seasonal. Oh, for example, this year is election year, right?
Right. So some businesses are impacted by that. Firearms industry for just as an example, they are impacted by by election.
So they predict a peak in sales in Q3. And they do not realize that such a significant growth in sales needs to be financed. Because they need to invest in in in building up that inventory first.
So with that forecast, and the forecast is not only income statement forecast, the forecast goes all the way from income statement through balance sheet, cash flow statement, and all the KPIs, you will see, oh, I need to build up inventory, that means I have to buy raw material now. So from a cash cycle perspective, it’s so important to realize that you have to invest in that growth first. And that you might need cash for that investment.
And it can’t be as simple as extending your working capital line of credit, right? What a lot of businesses have, yeah, that they what that they usually don’t use, but in such a in such a situation, they might need half a million dollars to build up that inventory. Because depending on the industry, from paying your vendors for the raw materials that you need to make your product and paying your labor to make the product and maintaining your infrastructure to make the product, all that advanced cost until the customer pays you.
That can easily be a cycle of six months, or a period of six months, right? So you might need some financing to to invest in that growth. And that’s something that business owners sometimes don’t realize.
So looking into the future, I’m not a big fan of five year projections. Because today’s world is so fast changing five years, projections don’t make a lot of sense anymore, in my in my opinion. What you definitely should do is rolling 12 months.
And then maybe have a midterm midterm plan for the next three years. That’s ideal. That’s what we actually implement for a lot of our clients, because they don’t have that at all.
They don’t have financial planning at all. And it’s so important.
Armando (1:05:52 – 1:06:49)
I can see this be very, very helpful since they haven’t had that before. I just want to recap a little bit here. So you said that in terms of a business owner, you’ve got a variety, you’ve got some startup businesses that you’re helping to get the modeling together for them now.
But you’ve got others that are 20 to 25 million in revenues, maybe 150 employees on the high end, but a real variety, but it sounds like the the steps you’re taking, you know, by focusing first on those financials, understanding what’s there, making sure they’re nice and neat and clean, and capturing the right data in the right categories, maybe the right units or sales categories, etc. That that becomes your foundation going forward. And then your 12 month rolling numbers, of course, are measuring, you know, how are we doing?
And what should we expect in the future, that that that’s really where you are with those companies. So Gerhard, anything that we haven’t touched on as we as we wrap up here?
Gerhard (1:06:50 – 1:06:55)
I think we’ve covered pretty much everything that needs to be covered.
Armando (1:06:56 – 1:07:15)
Okay, good. So Gerhard, somebody let’s say somebody heard this conversation and wants to talk with you because they like what they’ve heard and, and they’re seeing that their gut is telling them that they might want some help and they might want to have a conversation with you. How should they reach you?
What’s the best way through your website, email, phone? What what is what is it?
Gerhard (1:07:16 – 1:07:33)
Yeah, they can either go on our website http://www.kratzakconsulting.com. And there’s we offer free consultation. And on the website, they can also book the financial assessment that I talked about earlier.
Armando (1:07:34 – 1:07:34)
Okay.
Gerhard (1:07:34 – 1:07:37)
And there’s a phone number and email is everything’s on the website.
Armando (1:07:38 – 1:07:45)
Okay, so I’ll just spell your name just so that it’s clear. K R A T Z as in zebra er kratzakconsulting.com.
Gerhard (1:07:46 – 1:07:58)
kratzakconsulting.com. Okay. So they find the contact information there.
And then they there they can also book a free consultation. Okay, which we are always happy to provide.
Armando (1:07:59 – 1:08:16)
Excellent. Good. Gerhard, thank you so much for the conversation.
I really appreciate what you do. You know, the financials are, of course, a core to what happens. But often, people see numbers, they get glazed over a bit.
Like you said, it’s not the most exciting and sexy thing out there.
Gerhard (1:08:16 – 1:08:22)
But no, definitely not. Great, Gerhard.
Armando (1:08:22 – 1:08:23)
Thank you.
Gerhard (1:08:23 – 1:08:32)
Well, thank you very much for having me, Armando. I really appreciate it. And I very much enjoyed our conversation.
Thank you so much. Same here. I did as well.
Thank you, Gerhard.
Armando (1:08:32 – 1:08:55)
Hope you enjoyed this episode of the Founder’s Guidepost. Whether exit is on your immediate horizon, or maybe 10 years down the road, there’s something here for you. Wondering if you’ve missed anything in your planning?
Schedule your 30-minute founder’s strategy call at axiomcorp.com. And congratulations on your business success. You are the American success story.
Leave a Reply