Friday, June 24, 2011
Moving on Without Moving Out
This really is not about good guys or bad guys in the buy sell stage Dave and I are probably in for the next year or so...it is about the 50/50 structure and the lawyers that allow their clients to enter into a business marriage in the early days without an adequate framework for the sale of the company later. A little effort on your lawyers' part in the writing of the corporate documents to allow for clear conflict resolution methods and a formula for a buyout and you can save a lot of grief later. Dave and I will work out my exit over the next year but having a better set of corporate docs would have been so much easier. This is really the most important thing you can do before incorporating. Conflict and spirited discussion are good things and useful if resolved, but you need a mechanism to break a deadlock if you happen to have one. Dave and I are both good guys. We are part of a great family and each have enormous talent, energy and business strengths. We each want the best for our families as well as our extended network of stakeholders at Factory Five Racing. We have argued, discussed and gone through many business struggles together over the years and built a great little company in FFR. Now I find it time to move on...so why is the buyout so hard? I want to sell and Dave wants the company....perfect.
Its about Valuation:
The quick review. Without talking about FFR I will speak about generalities that we all are faced with in the 50/50 business world. All of us closely held company owners face an interesting valuation dilemma when we want to sell and that general concept is what this note is about. So how to begin? Start with each person stating what they want. The value of the company has to be said out loud by the buyer and seller to get started in my opinion. Easy right? Wait till you hear what each of the owners think the company is worth and why. A fascinating and eye opening discussion. If there is logic behind your pitch it will lead to a discussion where the two(or more) of you are within a few million. Time to stop and regroup since you are close. So let's look at how you can get close.
We will assume you have a generic 10 million annual sales company with a generic 10% net income that we have talked about before. When I say generic I really mean just that, it amazes me how different companies of the same general size, have almost identical financial statements. I will bet almost every 10 million dollar manufacturing company can relate to these ratios we use here. So am I talking about FFR...of course not, but these round numbers give you a rough idea about small business realities that we as owners face every time the topic of value comes up. So back to the math. As one of the thousands of closely held subchapter S corporations in the country you sell $10 million of widgets or services a year and you split the 1 million(10% net for discussion) in net income between the shareholders while holding some percentage of the cash for investment back into the business over the years as retained earnings. This formula is key. How much of the net income goes to new products? How much of the million goes to facilities or new productivity enhancing equipment? Valuation has to take into account the profits and the future...that's why you see huge valuations over the 5X number for real growth companies and 3 X or less for flat or shrinking margin/sales firms.
The goal in the business world(not the lifestyle business world but real business) is the growing company. A company that grows steadily at any rate is valued at future earnings instead of historical earnings. A big deal. If you see a company sell for 5 years of earnings and they are looking forward the total starts looking brighter. This is where the sweet spot is. Show no growth or small growth below 5% a year and you are relegated to the 3-5 X historical earnings rule...bummer. I will take the 5 X future earnings please:) So grow your business. It makes a dramatic difference.
For discussion purposes let's stick with the rule of thumb for a flat/no growth business. 3 to 5 years of earnings and the assets that are in the company are used to value for the "average" business. If you are like me, you are a bit of a heady entrepreneur though, "average" is not you. You are a maverick, a risk taker, you have worked harder and for longer hours than anyone can imagine building this company. No one understands but you about the blood sweat and tears it takes to start a small business...to guys like me the company is like a child. Well wake up all you owners and captains of small industry. Your company is worth 3 to 5 times profits if you stop growing, and you may get some of the cash from those assets only if you are lucky. Madly in love with your accomplishment? Don't sell...seriously...don't. I am in the end phase of asking myself these questions too. I love FFR. Can I really sell it? If you want to move on and chase the new company drug again...then yes should be the answer. So let's talk turkey and see what things sell for in the real world. You can do it too.
Once you find out what other people sold their companies for you will either feel better or worse about your exit. So in our pretend generic company "z, inc." we have a 3 to 5 million dollar income side of the deal(3-5 X 1 million) and lets say that there is a million in assets and retained earnings over the years that have been invested in the company. 4 to 6 million for a typical company that is not growing much but has some good will and the a reputation thrown in to close the deal. You didn't borrow over the years because you made money. Not bad. Now you are not even valued at 1x sales or even close to the 10 to 15X sales and valuations you hear about on the stock market....but those companies are growing fast supposedly and have a market for their stock with transparency in their financials...you don't...you are a generic 50/50 closely held small company. 80% of the small company equity sales that closed before the financial melt down probably followed this path. Summing it up: You pay the 20% capital gains on your half of the total and retire or move on with some kind of deal worth half of 5 million bucks minus a half million in taxes. At the end of the process in the sale of 50% of a 10 million dollar company you get 2 million in your bank account if it was an all cash deal.
But it is rarely an all cash deal:
If your partner that wants to buy you out doesn't have 2.5 million in cash.....and they rarely do....hey, we started the American dream to live the American dream. We didn't sock away all our money under the mattress, we raised families, took vacations, bought houses(yes, maybe a bit more on the toy side if you are nuts about machines like me) ....life happened to you, the small business owner. A million....sure...we can probably get our hands on that if pressed so lets start there. Heck, start with whatever cash you can reasonably raise for the buy out whatever the number is. If I was buying out my partner I would go to the table and talk framework possibilities again with the million bucks in hand and a firm grip on reality with regard to what is possible. I need 2.5 million to fairly reward my 50% partner and we have a million bucks. Let's say the company makes a million a year if all the earnings are taken out...but the company has to invest something over the next years, so lets say half of the million a year in income is available for me to buy out the other holder of stock. I can probably get some kind of loan and lever myself up a bit and the possibility of a deal starts getting closer. I give her a million up front, a half a million in payout for 3 years and an extra year of payout to reward her for taking risk on the payout(a cash deal is 2.5 million remember...a deal involving risk we will call 3 million). The company pays me a salary after I buy it of a nice 250k a year, I can retain 250k in earnings to grow, and there is a half million a year left to pay off the debt. Done.
Before the world financial mess a few years ago you could have probably financed the whole 2.5 million total...but not anymore. It took us eight months to sell a 150k condo, what are the odds with a softer asset like a business...you be the judge. Future payouts are tough because anytime a closing is held without wrapping up payment, there is an increased chance for conflict...what do you do as the seller if I have a couple bad years and can't pay you the half million next year? Yikes. So be careful with future payouts. Word them well for both parties. Set a minimum payment and a bonus for me if I pay you early. Keep me excited to be on my own rather than a prison sentence where I feel I will never pay it down.
The best examples of a fair buy/sell that I have seen revolve around an offer for the company that goes both ways. If I offer my partner 2.5 million for his/her half of our generic 10 million company then he/she has the option of buying ME out for the same amount. This only works if both of you actually want to run the place...but talk about getting on the same page quickly...that works! It really skips all the bologna when you know that your offer can be turned around and used to buy you out...nice. This is my favorite way to enter into a buy sell and the way lawyers should word corporate partnerships and the bylaws/documents in my opinion I love it.
Bad times and value shift:
If times get tough in the future or have been tough for a few years in our fictitious company(lord knows it has been hard at FFR) it changes everything. Even a single year of poor profit performance before the sale ruins the 3 to 5 times earnings rule as you are valuing earnings going rearward remember? Lets say we are just like every other company that got hit hard with the economy and made it through the last few years with 200k of profit per year instead of the usual million. 3-5X this new rate is now 600k to 1 million and the assets are still worth a million. Now we are talking about TOTAL company value of 1.8 million. Your half is now supposed to sell for 900 grand if a cash deal. 20% capital gains comes off to the tune of 180k so you are left with 700 grand for your half of your American dream....right.
A half a million bucks is not going to buy a ten million dollar company that will probably make a million a year again when things pick up in the overall economy...so the deal is dead and no one is to blame. This is why poison pills and a few years of poor financials don't realistically reduce the value of the company as much as you would think...just like my situation after a few hard years at FFR, I will wait the bad times out since I see such incredible potential going forward that really can't be valued accurately right now. As I have said before...wait a year or two and try again. So if you may not be able to sell yet, what do you do? You move on without moving out.
Here are a few tips as you try to move on while still owning the company. Unlike company "z, inc." I have plenty of real world decisions I have made in the past few years(some good ones, some not so good) that I can share from my own experience with the Smyth, FFR and Local Motors threesome.
1.Be honest and open about what you are moving on to next: The Power of going public.
In my case two years ago I went onto a big forum and announced my next project...the diesel sports car. No secret behind doors r&d work this time. Wide open and take your hits. You better have a thick skin because people say what they think these days on the net. During these last two years anyone who has followed my public Smyth facebook page or ffcars.com has been privy to an exciting launch of a new vw based kit car that uses the vw jetta almost in its entirety as the base for a re-bodied and reused green sports car concept. The use of a modern economy car with a stamped steel body and no frame was unique. Adding a partial frame to a frameless design(modern compact cars are a shell and have no frame) was a different and a really new idea. You can determine how novel your idea is by how many people criticize or don't understand what you are doing...we had lots of this in the beginning. VW beetles in the old days had a solid frame underneath that made the dune buggy kits easy to make since the major structure was there in the Bug floor and frame. In the Smyth car we added a frame to a car that had no frame...and it worked out fabulously and it worked out publicly.
By keeping the project open and public I avoided(or rather faced head on) the potential conflict that could have arisen over any overlaps between my new company Smyth performance and the companies I share ownership in FFR and LM. Jay and Dave have and had access to every detail of the Smyth project live as it was being built. All three companies have strategies and products that they hold as valuable. Publicly talking about the positioning of the new company has allowed candid feedback and processing between us. There may not be agreement but there is discourse. When a Boston Globe article came out on Smyth Performance a year ago, Dave did not pull any punches...he told the reporter of his concerns. This is a perfect example of the benefits of this open and public communication: Dave was openly and publicly upset with a car that was "GTM like".
In the early days of the Smyth diesel sports car project I used a mold from the trash at FFR to lay up parts of the GTM. These pieces were then cut up and placed in some areas of the car to see what a cut jetta could look like with a low sporty body on it. At the time the idea of the "mini me" GTM was a fun way to describe a new smaller sports car being built down the street. When the conflict became real, I was able to change the project scope by designing a new body without GTM shapes. I even put the Jetta trunk on the back of the car with the huge VW emblem in the middle. By the time the car was done we had a Toyota inspired front end, a Dodge Neon windshield and a Nissan/Cobalt/VW rear end. Without a public outlet to identify this conflict early it could have been a disaster. Stay open and stay honest(public if you are able) in your new venture if you are keeping the old company. Now we have three companies doing executing three very different product strategies and though there may be some bruised feelings about how we arrived here, we all can get along since that will be good for business.
2. Don't take employees from the other company you own:
When starting a new company it is tempting to surround yourself with people you trust. Those people usually have worked with you in the past and you are familiar with them and how good they are...that's why you hired them at the other company after all. Even if you don't actively recruit the people from your other company, many will seek you out for a job in the new place. If they seek you out I am sure you are ethically OK...but don't do it. If you value the other company you own you should keep them there. In my case I want FFR to succeed wildly and grow...FFR and LM are my two biggest assets. Now if someone gets laid off I think you actually have a moral duty to keep them gainfully employed, but if the original employer wants them back and ends the layoff you should honor that. Resist the urge to get competitive, it is about supporting all your assets...not one over the other.
I put a survey up on the Smyth Facebook page a while ago and I asked Smyth fans if they were doing an FFR after the Smyth car. Almost half of the respondents are planning on a factory five build after cutting their teeth on the simpler Smyth Jetta kit. 15% are VW all the way and will never do anything but VW/Audi. around 35% say the FFR kit is too rich for their blood. By appealing to a new base of customers in the VW segment of the market I am able to grow FFR, LM and Smyth at the same time. Synergy is real. You have to have the discipline to make products that complement the other companies. It is a fine line but one that will pay huge dividends when you go to harvest your companies in a sale. When I go to sell Smyth performance the product line will have a vw sports car, a super high mpg pick up kit and another high mpg aero van or car someday. Why launch a v8 powered hyper car when FFR already has the positioning in the market? If you find yourself tempted to go after your other company you have personal issues that you must resolve...you own the other company...help it succeed.
3. Don't use your assets from the other company unless you pay for them.
This one is easy to say but hard to do. Look, if your company has a corporate truck and you need to bring a new washer home go ahead...I have done it myself. I have moved boats with company trucks. Dave drives a company leased Honda or a Factory Five car home every night. Owning a company has great perks. Owning a car company is a great lifestyle for a car guy...half of the things you do for fun as a real car guy are done at work...the perfect day job. But don't take the company truck when the guys need it. Use it on the weekends or off hours. It is yours after all...you still own the other company and it is still a closely held firm...but don't get in their way. Your employees have a job to do and you don't want to put them on the spot. You are the owner but you are the one that has to be respectful.
In my case I can still use the trash...the trash? Yep. The trash. The guys laugh at me as I crawl through the bins in the reject pile. In the manufacture of heavy machinery there is an amazing amount thrown away. Use it if you want. When welders, broken compressors or other machines are no longer usable in a company they are usually perfectly suitable for home use. Document the things that go home of course for tax reasons(hard to do trust me)...but most of the stuff is junk that is fully depreciated and has to be repaired before you can use it anyway. I grab metal scrap and laser pieces all the time. The reject pile at FFR has had some great parts in it over the years. I may not use them as they are but I sure might use the stuff in mock ups or test parts like I used the gtm parts. Tubing, plates,body parts you name it. If it is valuable it is not thrown away in my opinion. So to me it is perfectly ok to grab and go to town with it. Have fun dumpster diving.
The other big asset is usually customer lists and data. Though there are many cases legally about employees in an investment or insurance company taking unprotected data and starting a competitive investment firm, I believe you are in a different category as the owner. Sure you have a right to move on....heck you have a right to move on and compete outright with the other company if you want...but don't take the customer lists or hard earned prospect databases etc. In starting Smyth performance it would have been easy to send a mailing out to all the prospects on the FFR mail list. I think we must have a half million names and addresses from 15 years in business. Don't use it unless you do it above board. By above board I mean paying for it. Lists are sold every day. If you use it without paying the owner I don't think you are being fair. If I want to use the list I will ask FF licensing(our company that owns all the IP for FFR) for a price and I will pay it.
4. Embrace ownership not management.
If you are moving on without moving out you need to get one thing through your head. Though you can try to run both(or more) of your companies, it is best to run one. Steve Jobs might be able to be CEO of a few companies at the same time but you are not Steve. Run one place and run it well. I own half of Factory Five Racing and I currently can't take 20 bucks out of an FFR account. That is called letting go. I don't recommend going that far as every officer should have signing authority, but you see my point. I have no say in the day to day operations of the company other than my informal observations and criticisms you see here on these pages, if the management of a company can't take a bit of constructive advice from an old pro like me then they shouldn't be running anything. A great example is FFR pricing. My view for years(well publicized)has been that FFR is giving away their cars and not keeping up with the real costs of doing business. I push hard for these price increases because I want the best for FFR and all of its stakeholders. But that is all I can do and it is by choice. If you excuse yourself from running the business like I did in 2001 or 2002, you can move on....if you control the business you may be opening yourself up to conflict. If Dave makes an extra million this year and has happy employees and customers with good benefits and a bonus...well, he gets an A plus from me as an owner. He will have done it on his own and he should be rightfully proud. If FFR struggles and the opposite path occurs he owns that too. By backing out of the managing of the business you are free to move on without moving out...it is your company...but let it live or die on its own.
5. Offer your existing business the chance to invest in the new business....and do it again every year or two.
I know I said I was moving on, so why offer ownership to the old company? As famously documented last year in Scott Kirstner's Boston Globe article, Dave is not the biggest fan of my new diesel car project. I have been public with this Jetta kit idea for years, rejection is nothing new to anybody who has tried to explain a new approach to any business. But Dave's rejection over the years of Smyth Performance is a big deal, not because I take it personally, but because with rejection comes the freedom to do what I want to do. After I ship the first cars this summer and things get going and are a bit easier to see, I will offer a stake to Jay and to Local Motors as well. Since I own a part of Factory Five, Local Motors and Smyth Performance , it is a natural thing to do...offer them again a piece of the opportunity. If they bite and go along this time(it will be LM's first shot)you can probably cut a deal and get to the state of active synergy rather than the passive synergy you get without cooperation. Three companies working together with mailing lists and other overlapping hard and soft assets is a much more effective way for small companies to go out into the world's car market. Small firms excel when they focus on a niche and dominate it. If Smyth performance tries to be everything to every car enthusiast we will fail miserably. If I stick to the Jetta platform and the cars that are derivitives of that platform I will experience the wild success that comes from simplicity of message, simplicity of design, and simplicity of operations...and that is the plan.
Go ahead and make your offer directly or indirectly but then let them decide. In my case I was free to move on after the rejection of the idea from Dave a few years ago...but I will offer again. I will be meeting with Dave in August to go over a few FFR and FFL related issues(like when I might see a buck or two to feed the kiddos and send them to college...this "taxes only" level of FFR profit is not really sustainable...after 3 years of the "recession" 8-10 cars a week is our reality at FFR...restructure and get profitable in THIS business environment is my consistent advice) Either way Dave gets another crack at participating in Smyth Performance then I can call Jay and Sergio right after to give them a shot...all good either way.
So now the crystal ball.
In closing I will predict some fun tidbits.
Factory Five Racing: I will be keeping my half of FFR while finally being able to step down as an officer and maybe even as a director now that I am convinced they are paying Licensing and their quarterly taxes. I think FFR will have success with a small car project but will continue to struggle making money with the complexity of a product line that will have five platforms. I would have never gone with such a wide line and believe it or not I would raise prices at least 5 grand on the Coupe, GTM and Spec car. I am proud of the fact that the success of the Smyth concept/diesel on facebook and ffcars.com helped pave the way for FFR to start their own version of a small 4 cyl subaru kit car. Jim is a talented R&D guy with a budget and is a real Subaru fan. Don't be surprised if the Subie powered car is faster than the high line GTM. I will continue to press for a Chevy(ls engines are the bomb) powered 33 kit from FFR and I think they will see huge success there since the hot rod market is 80% Chevy guys...maybe making the 33 a ten a week or more kit for FFR. Replica Cobras are always a great project and will continue to be the ultimate toy for big boys. FFR is about 33's and Mark IV's with regard to profitability...focus on those two cars, raise prices to keep up with the consumer price index(see "the price is right") and enjoy your success guys. Laser wins, shotgun loses in this business climate that is our new reality.
Smyth Performance: I will do well in the sporty diesel/1.8T/VR6 VW commuter car that we invented with the mixed frame technology(unibody plus a frame add on), and I think that the VW Jetta sport truck kit will take off and make Smyth Performance a 5 million dollar company within 18 months...and that is just the pilot launch. Since it is a titled car the talks I am having with potential investors revolve around the manufacture of the Smyth car in a new company with all remanufactured parts as a completed car in 2013. Local motors and their microfactories may play a nice role in this or if the fit is not right we can begin making limited test batches of finished rebuilt cars/trucks. Jetta four door cars at the end of life come in, and a "new" G3F or Jetta truck comes out for 20 grand. The greenest car manufactured in 2013 is really to be a Smyth remanufactured car that has enough added value to justify the money. I can smell another few hits here as well as the real opportunity to expand into car manufacturing instead of just building kits....and we don't need to hold our breath and wait for the laws to change. Kim and I are investing all the available assets we have to capitalize on this opportunity that will need all the money and more to grow quickly(goodbye Ferrari collection). Once the proof of concept is accomplished through the execution of the Smyth kits we move to making finished cars. Since we are using the Jetta as the base and not manufacturing a new car frame we are drastically adding value,but it remains a VW titled vehicle. I will wait till I am at that point later in the year to ask for the help but that is the plan for real growth. I want to make a difference by re using all these old cars...the aircraft guys do it all the time...why not cars?
Local Motors: After seeing Jay and the DARPA car with Obama it is clear that Jay has the ear of some really smart investors and supporters. They will be a driving force in the co-creation of new car/truck related product and concepts and Jay Rogers will continue growing the valuation of Local Motors beyond the 30 to 60 million dollar mark within the same time frame. This is Jay's exciting story to tell so I will end it there. What a great triple play.
Moving on without moving out indeed. Sounds like a plan.