FBB Group’s own Chris Fagnant joins Nana Bonsu on the Build Value By Choice Podcast to discuss making your business more sellable.
Chris has unique experience that gives him an expanded understanding of the manufacturing industry as well as the business sellers perspective. He uses this background to help businesses identify and optimize value. So when sellers are prepared to market they can get maximum benefit from their investment.
Podcast Transcript
Looking At Your Business From The Perspective Of A Manufacturing Business Broker & Ex-Business Owner
NANA BONSU, HOST, BUILD VALUE BY CHOICE PODCAST:
Well, hello! And welcome to this week’s episode of Build Value By Choice. I am your host, of course, Nana Bonsu, and our website is www.infhorizons.com. Make sure to subscribe and leave us a rating or a comment, because that helps the show grow and help more people to know about it. So, also you can check us out on Facebook or on Instagram or LinkedIn.
Today’s episode is going to be talking about businesses becoming sellable, being able to sell businesses, and specifically we’re going to focus on the manufacturing industry. And today I have a great guest to offer you. The theme of this podcast episode is going to be looking at your business from the perspective of a manufacturing business broker who also happens to be an ex-business owner. So he’s rode it in your shoes and now he’s on the other side and he’s helping to advise and guide businesses toward the exit.
Today’s guest is Chris Fagnant. Chris’s role as a business broker is born out of a lifetime of experience living and working in a family-owned business. He grew up in the heat seal lid business initially. Chris pursued more corporate opportunities and spent 17 years working in the restaurant industry prior to his return to his family’s business in manufacturing in 2010. From 2010 to 2021, he was the President of Qualtek Manufacturing, and his focus was on leading the resurgence of advanced manufacturing.
In parallel with business management, Chris has invested in commercial real estate and managed properties associated with the businesses. With over 2 decades of hands-on experience in small and medium-sized businesses, Chris helps people make sense of the market when the time comes to buy or sell. When he details the various rules and responsibilities that he’s had in his career, the one constant thread linking them all together is his ability to build relationships with people. His goal is to help people make confident decisions in a complicated environment. Welcome to Build Value By Choice, Chris.
CHRIS FAGNANT, BROKER ASSOCIATE, FBB GROUP:
Great to be here. Thanks for having me.
NANA:
Wonderful. So I want to kick off by asking what inspired you to become a business broker, and what led you to focus on the manufacturing industry as a business broker?
CHRIS:
Sure. Well, the short answer is I was asked [laughs] to become a business broker. I… kind of along the theme of building relationships, we had established a relationship with the business broker who sold Qualtek to my family back in 2000, and when we completed the sale – and I’ll get a little bit more into this – but the sale and partial shutdown of our business in 2021, the broker, Ron Chernak, who had sold us the business in 2020, reached out to see if I’d be interested in joining his firm. And it was one of those things that had not really occurred to me, to be honest with you. It wasn’t on my radar. The piece of it that really drew me in was the opportunity to share my experience, both as a business owner, but having gone through the sale in a good and bad situation, kind of all at the same time. And to be able to share that with other business owners, other people who are considering selling, so I can help, you know, help them through the good, help them through the bad, help them avoid certain things and take advantage of others. So to me, it was an opportunity to put a lifetime of manufacturing experience to work for other manufacturers.
NANA:
Yeah, that makes logical sense. In your opinion, what are the key factors that determine the value of a manufacturing business?
CHRIS:
You know, manufacturing businesses are going to come down to people, productivity, execution. You know, the business’s value is going to be a function of how much cash flow it’s able to generate, like every other business. You know, the ability for, you know – or I should say every other mature business – the ability for that business to demonstrate, you know, bottom line cash flow. Whether that’s a Seller’s Discretionary Earnings calculation, or an EBITDA debt calculation. The things that determine the value of the manufacturing business are tangential to that cash flow. How did you get there, you know, what is the gross profit, and how does that distill down to net profit? And are they doing the things that healthy businesses need to do? Do they have HR policies in place? Do they have quality policies in place that are followed and demonstrated? Do they have, you know, operational excellence throughout the organization, from receiving raw material to finished goods going out the dock? And then, I would say on top of that, you can get into some of the more specifics, like what supply chain are they a part of, or are they selling directly to a customer? Do they control their own product lines? All of these things have the opportunity to add or detract from the value of that business depending on how they’re executed.
NANA:
Wow. Yeah, thanks. Thanks for sharing that. I want to pivot back to what you had said about, you… the reason why you’re where you are now is you sold your family’s business that you were running. Now, can you tell us what that experience was like? What, you know, what helped, you know, make the process successful for you? And what can listeners that may be looking to go through the same process a couple years from now… what can they learn from that?
CHRIS:
Sure. So the business that we owned, the business that I ran, was a metal stamping business. And so from an industrial manufacturing standpoint, stampings are generally utilized where you need high volume of a particular component. And the world that we lived in was very tight-tolerance metal stampings, usually made of stainless steels, aluminum, copper, materials like that. And then we controlled the front and back end of the process. So, the tool and die making, which is the… kind of building the machine that’s going to make, you know, be put in a stamping press, and that machine is going to make the parts. And so we specialized in progressive tool and die making.
And then we also controlled the back end of the stamping process after the parts had come off the press. We would do heat treating, metal finishing, so chemical processing of metals to allow… to preserve them and allow them to live in various environments for… kind of indefinitely. So passivation, electro polishing, anodizing of aluminum, these are somewhat typical processes, but we were able to develop specific processes for specific parts for specific uses, based on the customers needs.
And those… the two main industries that we served, almost for the whole 20 years we own the business, were aerospace, on one hand, and the supply chain that fed up into Boeing ultimately, and then on the other hand, medical device. And so, the beginning of 2020, you know, in March of 2020, the aerospace supply chain, some people may forget, but Boeing was in a kind of rough spot before COVID started… and then COVID started. So the… the outcome of that was, for us, a 95% reduction in demand from our largest customer. And so we were put in a position where we had to make a decision, we had to pivot, we had to do any of these sort of… terms that have become kind of colloquial business terms lately. But the we had to make a decision, we had to move forward with something.
And so, while on one hand we were in the aerospace market, on the other hand we were in medical device, specifically respiratory medical device, and in a respiratory pandemic. And so where we saw one customer, you know going to the floor, we saw the other customer going to the roof, and we… we did what we could to try and maximize the factory’s output by moving employees around to meet that demand. And in the near term, what we saw was an opportunity with our largest customer. Although the aerospace, you know, demand wasn’t there, our customer kind of faced the same thing. They, too, were part of this Boeing supply chain. And so, you know, they had an opportunity because they weren’t as busy. They weren’t, you know, they had people that they could deploy to do other things. And so we worked with them to sell that aerospace division to them. So it was an insourcing project for them. It was an opportunity for an exit out of a customer base that was going to have zero sales for what amounted to at least 12 months, and, you know, could have been longer. And it was kind of a win-win for both organizations. And so the success of that process was one, identifying who that buyer was going to be, because rather than just jump right in with the deal with that customer, we did look at what the market was telling us. And at the end of the day that part, that piece of our business was most valuable to that client.
And so, you know, from a success standpoint, what we did was we leveraged relationships with the right people. So we went up through the organization, the corporate levels of the organization, to ensure that we had advocates for our business that were willing to go to bat for us all the way up to the to the leadership of what was a publicly traded… what is a publicly traded company. And that, in my opinion, was the key strategy. You know, the value came from what we had done for the previous 20 years. You know, what we had done was continue to improve their part, to continue to invest in research development to make things better, to implement – and help them implement – quality standards that went well above and beyond what the part was when we first started making it, and when we had kind of inherited it from the previous manufacturing team that had it elsewhere. So the relationship building, or I should say the reputation building for the previous 20 years was, you know, we already had that in our back pocket. We were able to point to that through the relationships we built with key players in the corporate structure to say, “Look, here’s what we’ve done, here’s what we can sell to you.” And it makes it a simpler transition, and makes it far more valuable to them than to, say, try and go out on their own and recreate that wheel.
From a success standpoint, it was leveraging those relationships, but then being willing to see it through to, you know, for what is a very long process. You don’t sell a business and get a check next week. It’s, you know, people who… you know, who, say, sold their homes – even, you know, even very high-value homes – can still, you know, you can still close a transaction on something like that in, you know, a month or two. For businesses it takes much longer, and you have to be, you have to have the endurance to get through that whole process. And so for us it was a seven months, you know, due diligence process if you want to refer to it like that, we, you know… say 3 months of it was the actual due diligence of the financials, the performance, you know, metrics, and sharing that information. But the remainder of it was planning. It was get in touch with the customer, or the the buyer, in our case, and say, “This is how this is going to play out if you buy this business. These are all of the various factors that need to be addressed before you can even come in and start moving equipment, transferring people, transferring knowledge,” all of that. All of the tangible things that were coming down the line. So there was months and months and months of communication, information sharing, gathering, and being willing to do that, in some cases, around the clock, because you’re doing it in an environment where it’s not public knowledge, right? You’re not going out and telling everybody that this is what was going to happen. And so, you know, all of those factors, you know, going back from developing the relationship and… or the reputation, and doing things right all along so that you’re even in a position to sell that business as it is and as it can be for the buyer.
NANA:
Yeah. And I mean that’s… yeah, I was actually… you already answered a question I had about how long the process took and all of that.
So, then the… how far in advance did you, you know – and this is, you probably knew, you know it looks like, it sounds like you knew the buyer – but if you don’t know the buyer, how far in advance would you advise? Because that seems like, you know, you’re essentially working on your business so you’re able to build a relationship.
So how important, I know it’s, you know, I know how important you stress relationship-building is, how far in advance because if you’re able to do it in seven months because you knew the buyer in somewhere.
So how far in advance should businesses plan and, you know, build relationships if it’s not an ongoing thing that they do? And then the other thing is, did you open it up for that competitive bidding, or you kind of, you know, through relationship building you just kind of knew who you wanted to buy your company and just kind of try to move things that way?
CHRIS:
So the answer kind of the last question would be you know we, we did open it up to the market in a sense where we… you know, again, you know, relationships-wise, we had some of these relationships already but some of them were introduced to us because of our circle of influence and because of you know, network of trusted advisors, right? So we had spent years previously, you know, with the idea that, you know, this business was intended to stay in the family with current ownership, and do a generational transition. But it… even with that, it was still preparing the business for a transition one way or the other.
Even though we had planned on a, you know, a transition within the family, we were still positioning the business and running it as though that transition would be like a traditional go-to-market. So, putting things in place within the business so that you’re… we were tracking cash flow in a way that would make you know would translate to what the market would want to look at. We were putting leadership structure in place that the business could run without the President or CEO being present on a, you know, day-to-day basis if necessary. You know, putting in place the the structure of the business years in advance. And so when we talk to business owners who are considering a sale, you know, three years would be a kind of like the front end, the short end of the timeline, in terms of what most people need to prepare the business for sale.
Now there’s always scenarios that come up and you know, things happen and you have to make decisions. You know, suddenly life changes. And it’s always possible to do it, but in those scenarios, unfortunately, you you may be leaving money on the table depending on how well-prepared the business was. And so, that preparation time, as much time as you can have, and in some cases from the day you buy the business, there should be some amount of thought being given to what does it look like, you know, upon the exit of this business? You know, most businesses should not be… considered to be a lifetime appointment. [laughs] And so –
NANA:
As much as we all like to think we’re not going to live forever, right?
CHRIS:
– Right. And so, if you run your business in a way that eventually it can be… it can run and operate without you as part of the day-to-day decision making, you’re already on the right path to preparing that business for sale now. We can get into some of the things tactically that are important, and I think it’s valuable to kind of connect those dots now, but it’s, you know, you –
NANA:
Yeah, sure.
CHRIS:
– from an accounting standpoint, you want to make sure that the books are as clean as possible and not in a “ethically” clean, but more along the lines of… you know, there are personal expenses for business owners that get wrapped up in the business whether you like it or not. You know, if you’re running your own business, you are probably working north of 50-60 hours a week, and, you know, your meals end up being eaten at work, your car might be a company car, your cell phone is probably used primarily for business. And some of these, you know, call them minor expenses can be wrapped up in the business’s books, and you want to work towards getting those out.
In any business valuation, M&A advisors, accountants, companies that are able to do certified appraisals, they’re all going to look at these personal expenses and account for what we refer to as “add-backs”. So getting, you know, allowing the business owner to to get credit for expenses that wouldn’t necessarily be there without that business owner being in place. So, you know, getting to the actual final number of what the cash flow of the business can be. But even though you have the ability to do those calculations, the closer you can get to true business expenses being represented in the… in the gap numbers, allows the prospective buyers to look with confidence and not have to do any mental gymnastics about how the business might look under their ownership. It’s already, you know, as close to that state as possible when they buy it.
So that’s a… that’s one of the ways that where you might want a couple years out ahead of time so that you’ve got two years of tax returns to show, “Hey this is… these are clean books, you know, the very few owner’s expenses wrapped up in here,” or you know, expenses related to business structure, that isn’t going to be there when the buyer purchases the business, right? You know, if you know going into it that there’s a whole division of your company that the buyer isn’t going to want – whomever that buyer might be – then you want to start showing in the books, you want to isolate things so it’s easier to show, “Hey, these expenses are related to this part of the business,” and that’s you know, being wound down or it’s unrelated to the purchase profile.
NANA:
That is… and as a matter of fact, it was interesting, somebody was asking yesterday how much time in advance people should plan for this. And I gave them three or five years. And you know, you just reiterated it, because you need to first, you know, restructure and transform your business. And then you need like you know, another year or two to be able to show the results from that to, you know –
CHRIS:
Yeah.
NANA:
– to get the benefits of the restructure and the transformation that you’ve done.
CHRIS:
One thing I want to add on, because you just reminded me with what you said, that timeline of being able to show what the business can do? So when we say you know, “Hey, three years would be pretty ideal,” One of the things to consider, especially in manufacturing, is one of the things we hear the most is you know, “Yes, okay, the business is going to be you know, valued based on cash flow, but you know our business, we’ve been reinvesting in the business, so we have not been putting that value to the bottom line,” And so you’re not going to see as much of the value if you do the valuation that way.
And so one of the things we tell folks is if that is the case, then, you know, from this conversation, from a point in time, it would be valuable for us to show, “Hey, up until, you know, February 3rd of 2023, we were running the business this way. And from that point forward for the next two years you can see that we adjusted the way we were running the business rather than doing the types of things that we would have done under the circumstance where we intended to own the business for 10 years down into the future. We started preparing it for sale. And thus, on that day you can see we’re driving cash to the bottom line because we’re no longer reinvesting in certain ways for the long term. We’re strategically positioning the business for sale.”
And when you take, you know, ideally you want to look back three years and show a runway of success or what the business can do. But if you’ve got three years, one of them was, say, the the previous way of running the business than two of them are, “Hey, after this point in time we had a conversation with Chris at the FBB Group and told us to do these things,” we can demonstrate that quickly, you know, be able to turn that switch on and put money to the bottom line that has value as well. And then buyers would be able to see that and recognize, “OK, I can see the before and after, it makes sense.”
NANA:
Is the amount of time different if, for instance, instead of, you know, business owner wanted to sell, like in your case, you know, you had initially your family business, you have initial plan to transfer down to subsequent generations. And, oh, by the way, it just so happens only 30% – according to Family Firm Institute – only 30% of businesses successfully transferred from the first generation to the next. I can’t remember exactly what generation yours was with the, but it’s just like 12% from the 2nd to the 3rd. So is the time to try to prepare for transfer the same or fewer than how much time you need to plan your business for sale?
CHRIS:
Yeah, that’s a good question and it’s… it can be a sliding scale. I think that really, really depends. But the organizational structure is going to drive that.
So if the family has… has had succession planning as part of their strategic vision for the business, they likely will have gone through some of the, you know, gone over some of the hurdles that are in place with regards to transitioning a business within the family. And often times that’s going to be you know, first and foremost, who’s running the company? What, you know, what positions are they filling, what functions are they, you know, are they covering in the business and are there outside, you know, out of the family people? So we’ve got you know, experience with that in my family. We had at one point a CEO who is not part of our family, we had hired him from the outside. He helped identify and grow areas of our business. He, you know, really helped streamline a lot of things, and there was incentive structure for him that was very different from the incentive structure for the family. But, in the end, the communication was there that, you know, hired gun CEO knows that you know the intention is to transition the ownership within the family. The communication is the most important thing that everybody has an idea of what the strategy is long term.
So from a timing standpoint, you know whether you’re transitioning the business, internally or externally, it’s a years long process. And I mentioned it earlier but I kind of, you know, maybe circle back on it, the trusted advisor group. So you know for most people, it’s going to be a CPA accounting firm, somebody that understands the business from the outside, by the numbers… legal, you know an attorney, who is familiar with the business, the business dealings, the type of industries it’s in, but has a transaction background, so understands what it would take to to move a business through a transaction, whether it’s internal or external. And then estate planning, and I would also add to that financial planning. So, estate legal planning, getting entities in place so, you know, you can do a tax-efficient transition of ownership. And, you know, timing-wise, estate attorneys can help you identify “Here’s how long it takes to get those things in place,” if they’re not already there, just so it gives you an idea of how long that timeline’s going to stretch. And then financial planners so that you have an idea of what your exit number is.
In the the business broker world, the especially at FBB, we use the term “freedom point” as a way to identify how you know when it’s time to pull the trigger. And so if you don’t know what that number is financially, what the ownership needs in order to walk away from the business, it’s going to be impossible to make a decision, or you’re making a decision without the right information at hand. And so, financial planners can help put a number to the puzzle and say, “If we do all these things, this is where we got to be.”
That network of trusted advisors is going to help you identify what that timeline looks like. You know, if you’ve got a lot of things in place already, you might be able to shrink that timeline to one or two years. And if you don’t, then you’ve got to plan and those folks will be able to help you put a vision to that that timeline and then execute against it, you know, year-in, year-out.
NANA:
That’s one of these value adds that we offer, which is we tell business owners, say, “Come take a free assessment with us.” So we’ll help you look at what areas of your business, You know, you may have some hidden risks that would trip you up, or you may have some assets there, some treasures in your business that, you know, could add even more value to your business. So definitely, just like you said, I mean that’s essentially what we play, the trusted advisor area, where we help businesses, just look at them realistically, about what the risks are, or how they can protect themselves and then help, you know, help collaborate with their CPAs and their attorneys, right –
CHRIS:
Absolutely.
NANA:
-to make sure that they take care of the different aspects of those specialties.
What are some of the common misconceptions that business owners have when it comes to selling and manufacturing business?
CHRIS:
Probably, Well, the number one misconception is how the business is valued. So I’ve touched on it already, you know, cash flow is king in this scenario. And so if businesses are going into it thinking that top-line revenue is going to be the main driver, if they’re going into it thinking that a specific IP is going to be the main driver, unfortunately those things outside of… outside of very specific circumstances, they generally aren’t the the main driver of evaluation for a business.
But speaking to the things that kind of go in order, if you will, kind of… I like to joke that you know everybody, every buyer, every, you know, private equity firm, every, you know, sophisticated buyer, entrepreneur coming in is looking for a Unicorn. And in the manufacturing business, you know, small business to mid-size business, you know, it’s something along the lines of, you know, “I’d like $1,000,000 in Adjusted EBITDA.” “I want a company that has a diverse customer base where, without too much customer concentration, we want to be able to show a great people culture and the ability to hire and grow and add workforce when necessary.” “We want a, you know, 75% utilized factory floor with the ability to add new machines to the existing building.” So these are all kind of a, “If you can do these, great, you’re going to get the best possible valuation.”
Now let’s assume you’re missing one of these pieces [chuckles] and so then it just comes down to what is possible, what can be done to address it? So going after the items that are going to drive value in the business, it’s going going to be – in manufacturing – labor efficiency, raw material efficiency, but even before raw material efficiency, it’s going to be – especially today – relationships. Demonstrating that you have relationships with material suppliers. Because in the last two years we’ve seen perfectly healthy companies get their knees cut out from under them if they just couldn’t get raw material. And if they couldn’t get raw material, often times it was a function of not having the right relationships with the right suppliers.
And so if you’re a business that is trying to make decisions on how to, you know, build the value of your business for say the next three to five years, looking at the suppliers that you have. Are they the right suppliers? And if so, really foster that relationship. Look at, you know, your payment terms with them and make sure that you’re paying a day early every single month, and that you’re giving them plenty of heads up on forecasts, and getting as close as you possibly can to those forecasts. Taking material when you say you’re going to take it, you know, hitting your schedules, keeping regular, you know, lines of communication. And, you know, again building those relationships with the material suppliers goes a long way, because when we end up in a situation like we did in 2020-2021, those suppliers are going to call you first at the top of the list, and not last to tell you the bad news. You know, they’ll call you first to give you first right of refusal, so to speak… even though you’re most certainly not going to get that in a contract, but the relationship for first right of refusal [chuckles] to be able to ensure your continuity of business. And so beyond raw material that just, that’s a highlight, because it’s usually one of the largest expenses for manufacturing.
But you think of people as being somewhat similar in strategy. If you’re not maintaining good HR policies, you know, good people development internally, making sure your, you know, benefits packages are competitive and that not only they’re there, but that your people know they’re there. Those things are going to really help differentiate you as a business if you can point to actual metrics that say, “Look, our retention rate is better than industry,” you know, “Our ability to develop from within. So here’s these middle management employees who started as interns, and work from intern to employee, and from employee to supervisor, supervisor to manager.” And so being able to point to some of those practices. And you know in in our world, in metal stamping, tool and die making, apprenticeships were a key piece of that people development, being able to point to what we’ve done as a company. And so, and in many manufacturing industries the apprenticeships are the model from which you get, you know, a green employee who knows very little but has all the drive and ambition, and you get them to a seasoned veteran expert in their field.
And having those apprenticeship programs in place, they can be a very valuable thing, because – I think I maybe mentioned it earlier – but you know a business may have you know may have the ability to grow by adding machinery to floor space and add capacity from a, you know, mechanized standpoint. But if you don’t have the people to then either run those machines or manage the team that runs those machines, you know, they’re just not that valuable. And so the ability for a buyer to seek growth potential in a company is paramount, and being able to connect the dots between operationally you’re able to do these things, you have the ability to get the raw material in when you need it, and you have the people to execute upon a, you know, operational-excellence type format. Those are the ways that you really demonstrate that the business has value.
NANA:
Yeah. So people, process, operational excellence, good potential relationships, this control of… some kind of control of your supply chain, those kind of things. So I mean this actually logically, you know, it leads me to think, so how would you compare and contrast between a sellable manufacturing business and an unsellable manufacturing business?
CHRIS:
I will… define “unsellable” in a way, in a specific way and then kind of get to the “sellable”. You know, “unsellable” is the assets are outdated, the cash flow is minimal or non existent, and it, you know, business is in, is distressed, right? You know there’s there’s enough buyers out there right now that, you know, they have the sophistication and they have the patience to wait for the right deal to come their way, or, you know, to go out and find the right deal and be persistent that, you know, 95% of buyers are not out there looking for distressed businesses.
Now there is such thing as there there are firms that look for distressed businesses to buy them, pick them up very cheap, actually, put debt on the business and kind of look for a business owner that’s willing to ride it out and and kind of roll the dice, to say, “I’m willing to to risk taking on debt in order to grow the business.” It’s just rare. It doesn’t happen very often, and usually in those scenarios it’s not a good situation for the seller. And it’s a high risk for the buyer. So it’s, those… in that scenario I’d say “unsellable” is they can’t hire people the the workforce is either aging or not capable of doing the work that they have. The equipment hasn’t been invested in and is towards the end of its life, and then maybe you know even location, that the building is incapable of sustaining the business.
So there’s those things to look at in terms of “unsellable”, but as you as you transition into “sellable”, and and levels of how ideal that sale is going to be, that is where we get into conversations with owners, and the sellable business that you know isn’t going to self as a multiple of cash flow becomes an asset sale, where they may have a lot of valuable equipment, but the cash flow doesn’t really support a Adjusted EBITDA or SDE calculation to determine the the value of the business. And in that scenario, the business owner is faced with the opportunity to sell the assets of the business in a way that maximizes that, rather than just a, you know, auction and getting rid of things at a very low price. The potential opportunity there in terms of finding the right strategic buyer in that sense is, you know, can that buyer come in and fully depreciate the assets that they’re purchasing? And so, there’s an advantage to that buyer to purchase in an asset sale rather than SDE or Adjusted EBITDA.
And then as you move up the line in terms of sellable, it goes back to the things that I mentioned before, right? The cash flow is strong, gross margin is strong, the people culture of the operations, the quality, all of those kind of key metrics for a manufacturing business are in place. And any combination of those, the more you have, the more likely you’re going to get an extra you know half… half a turn or full turn on the multiples.
NANA:
OK, that’s great. So you have used a couple of acronyms, and I want to make sure that we don’t kind of take for granted, everybody may be familiar with those acronyms. SDE and EBITDA. What do you they stand for, and when do you use, you know each one?
CHRIS:
So SDE is Sellers Discretionary Earnings and Adjusted EBITDA or EBITDA on its own, Earnings Before Interest, Depreciation, Taxes and Amortization [sic]. So the the Adjusted EBITDA would be what I mentioned earlier. If there’s expenses in the business that don’t relate to how the business is going to be sold, and who that, you know, the buyer for the business is coming into what they’re buying, you can adjust that EBITDA number and say, “Look, we’ve got $100,000 a year that we spend on X that isn’t really relevant to the business you’re buying. Thus, you know, we’re going to add that back in.” And they actually go both ways, they go you know, positive and negative, right?
Let’s say for example… well, I’ll finish the thought on EBITDA. So EBITDA, kind of is a rule of thumb, generally for businesses that are doing $1,000,000 or more in net profit or operating profit, so cash flow of the business, that’s generally when you want to use that EBITDA number. The Seller’s Discretionary Earnings is usually, you know, $1,000,000 and under in cash flow. And part of the reason for that is, as I mentioned earlier, the size scale of the business, usually the owner has more of an involvement in the business. So if the owner is working full time – or maybe even they’re working more than full time – and the buyer coming in is going to say, “Well yeah, I don’t want to work 80 hours a week. I will run the business but I’m going to then have to hire somebody to help me run it after I buy it, because I don’t want to work two jobs.” Then SDE often ends up being the calculation we’ll use because we’re capturing that owner’s time and how much the, you know, the business can support their salary, and adding in what, you know, the new buyer would have to pay for, say, additional help, you know hiring additional employees.
The EBITDA number, generally we use that if the owner has worked themselves out of the business, right? That salary doesn’t need to be accounted for. So does that…?
NANA:
Yeah, no, that’s great. I think it helps in terms of level setting the, you know, essentially what it comes down to is, you know, typically if the businesses are smaller, you use the SDE in the sellers discretionary income. Seller being the owner of the business that is being sold. And if it’s higher than $1,000,000 in annual sales, you tend to look at Adjusted EBITDA, especially adding back like things like the owner’s salary if the owner is not going to be part of the of the future, you know, business that’s being sold there, right?
CHRIS:
Yeah.
NANA:
So, yeah…
CHRIS:
And I would specify actually it’s $1,000,000 of… of EBITDA. So $1,000,000 of cash flow, not revenue. You might, you know, I would say, a business could be in that $5 to $10 million in revenue and only you know, and doing, you know, $1,000,000 in cash flow, you know. A business that does $5,000,000 in revenue and $1,000,000 in cash flow is worth more than business that does $10 million in revenue and $1,000,000 in cash flow in most cases, right? [laughs]
NANA:
Right. Yeah, that means more efficiency.
CHRIS:
Yeah.
NANA:
Yeah. So, I mean, last question is what challenges do you see in the manufacturing industry and how that would impact the sale of manufacturing businesses?
CHRIS:
Sure, the… I mean, workforce generally is the number one topic that comes up if you ask manufacturers. I like to… kind of peel back a little bit, zoom out and say, you know, if you… historically in the United States, you know, we have decades of offshoring, of, you know, pushing industry out of whole cities, regions of the country in favor of welcoming other, you know, whether it’s, you know, high-tech service, other industries in maybe for the sake of tax base. But the globalization of commerce, it has a huge impact and can very drastically swing demand for manufacturing in a given area.
And so, in the United States, we are still the second largest manufacturer in the world. And there were, if I’m not mistaken, there was a period of time in – during COVID – where the United States by GDP was the largest manufacturer in the world. We surpassed China for periods of time as they were shutting down because of their restrictive policies. So even though we point to the offshoring of work, it does need to be seen that manufacturing is still very strong in the United States. And because of that, the supply chain needs to be strong. And so the things that… you know, the things that make manufacturing businesses – or I should say that, you know, the industry – relevant and able to grow and healthy, they… they’re influenced by public policy.
So from the federal level, you know you we saw things like the was it 2… 273 tariffs? I’m forgetting the number now, but back in 2017, the tariffs that were were put on China to restrict the Chinese steel and aluminum from flooding the market and driving prices down, and all of those things, that the tariffs had the intention of protecting industry. And in a weird way, they actually ended up hurting it, because it ended up just driving up the price of domestically-produced steel and aluminum and other raw materials. And that hurt American manufacturers because now there were not tariffs on fully assembled parts and goods coming from China, but there were tariffs on raw material. So now a company in United States is more likely to buy a finished good from China than a finished good from the United States. So you see how sometimes –
NANA:
Yeah.
CHRIS:
– public policy at the top, it can trickle down and really be negative if it’s misguided, and, you know, and those sorts of things.
Now, then you take the next step: state-level and local. So this is where I say if you’re a manufacturer, you got to be involved in your local manufacturing community, your statewide manufacturing community, and your national, you know, community. And a lot of ways people do that is through trade groups, right? There’s plenty of other opportunities to do the same thing, but be involved, because if policies are changing locally that don’t allow you to do your job, don’t allow you to do business, or at least do business competitively, you want a seat at the table before that decision is made.
And so being involved, you know, I think… another example I’d like to use is people, you know, the politicization [laughs] of global warming is kind of, has become this, you know, it’s very confrontational. You know, you’re on one side or the other. And rather than look at global warming, I think it’s important to look at local policy around environmental restrictions, environmental policy, environmental expectations. Because, you know, you might see a policy get put in place that seems like a good idea at its outset, but really has longterm effects on the industry that that community depends upon. You know, in Colorado we deal a lot with water and water quality for, you know, a million reasons heading downstream, right? Everybody on the western slope of Colorado, that water that hits our mountains and flows downhill, goes to California, goes to Arizona, goes to New Mexico. And so everybody is very aware of what happens to water here. And so we’ve had stormwater regulations put in place, very well-meaning, and they need to be there, but the way that it was rolled out ends up penalizing certain businesses and industries and not even touching others.
So for an example, we had a property, a part of our manufacturing facility where we had a stormwater permit. We had to report any heavy metals, nitrites, you know, chemicals that can make their way into the water stream that were concerning. And so we measured and we put in place protocols to avoid those types of things. But our building was next to a highway, and the highway had rainfall that went on it and flowed onto our property and we couldn’t stop that from happening. We had a business to the… immediately next door that because they weren’t manufacturing, they didn’t have to have a stormwater permit. So they could do whatever they wanted and their water would flow on our property. And so this policy was well-meaning and actually it needs to be there – I’m an advocate of it – but then rolling it out, you’ve got to roll it out in a way that all businesses are aware this is the expectation, and if you really want to do that level of testing and reporting, do your local municipal systems have the ability to actually handle that and make good decisions based on it?
So that’s what I’m getting at, is maybe don’t pay attention so much to the global warming, but the local warming or the local environmental policy, the local… just business environment policies, right?
You know, how your communities are interfacing with business is very important. So I hold that up as one of those areas that, you know, businesses need to be aware of, though if you’re in a place, if you’re in an area where those decisions are being, you know, made that are going to affect the ability for your company to do business, it’s going to reflect negatively on your valuation. You know, buyers are going to look at what the business environment is like where you’re at. So if you have the opportunity to advocate for it, you could you can put position your business long term better when it comes to that transaction point.
NANA:
No, that’s great. Thanks for sharing your insight. So how can people get in contact with you, follow you or if they need to get some more of Chris?
CHRIS:
So my email address is very simple, it’s chris@fbb.com, that’s probably the easiest. You can find me on LinkedIn, Christopher Fagnant, My last name F-A-G-N-A-N-T, and fbb.com is a great resource for all kinds of these things. Actually, we have a page on there that explains the difference between SDE and EBITDA, so if my explanation wasn’t clear enough, we have it in writing on the FBB website. And you can reach out at any of those places.
NANA:
No, that’s great. Thank you so much again for your time and for sharing your valuable insight, it’s really helpful. And to our listeners, thanks for tuning in to Build Value By Choice. Don’t forget to subscribe, share, leave a rating. And we can’t wait to share with you next time about how you may transform your business, so that when it comes time to exit, you do so without any regrets. And we’d like to celebrate your success. So bye for now.