Summary

In this conversation, Sharon Heaton, an M&A advisor, discusses various aspects of selling a business. She emphasizes the importance of building a transferable company and transitioning from an owner-dependent to a management-driven company. Sharon also explains the factors that affect the valuation of a business, including EBITDA and company characteristics. She provides insights into valuations in government contracting and the challenges of earnouts. Additionally, Sharon discusses the contentious issue of networking capital and the tax considerations involved in converting ordinary income to capital gains. In this conversation, Jon Stoddard and Sharon Heaton discuss the topic of seller financing and its implications for capital gains tax. They explore the concept of the installment sale doctrine and how it allows for the payment of taxes over time. They also highlight the importance of having an interest rate on seller financing to differentiate between ordinary income and capital gains. Overall, the conversation provides valuable insights into the tax considerations involved in seller financing.

Takeaways

Building a transferable company is crucial when considering selling a business.
Transitioning from an owner-dependent to a management-driven company increases the value of the business.
Factors such as EBITDA and company characteristics impact the valuation of a business.
Understanding valuations in government contracting requires industry-specific knowledge.
Earnouts can be challenging to structure and should be fair and clear.
Networking capital is essential for the functioning of a business and should be neither an increase nor decrease to the purchase price.
Converting ordinary income to capital gains can result in significant tax savings. Seller financing can be a strategy to manage capital gains tax by spreading the tax liability over a period of time.
The installment sale doctrine allows for the payment of taxes on seller financing as it is received, rather than upfront.
Having an interest rate on seller financing helps differentiate between ordinary income and capital gains.
It is important to consider the potential risks and benefits of paying taxes over time, as tax rates may fluctuate.

 

 Watch the Interview:

Transcript:  

Jon Stoddard (00:00.106)
Welcome to the top M&A entrepreneurs today. My guest is Sharon B. Heaton, who has a book out called, Lift Off, 12 Things You Need to Know Before Selling Your Business. Now, let's talk a little bit about Sharon's resume. 30 years in M&A, she's worked on hundreds of deals. She was a, she is a recovering attorney. She was a senior staff to a US Senate. And who is the Senate? Who are you working with?

Sharon Heaton (00:28.682)
I worked both for the Senate Banking Committee and the Senate Finance Committee. So I worked for Don Riegel of Michigan and a little bit for Patrick Moynihan of New York.

Jon Stoddard (00:37.806)
Interesting, okay. And then she just recently pointed to the Fed Investment Capital Advisor Committee to help her raise fines, funds for small businesses. Fantastic, you're gonna talk to me about that a little bit later. So welcome to the show.

Sharon Heaton (00:51.722)
Well, thank you very much. Thank you very much, John. It's a pleasure to be here.

Jon Stoddard (00:55.09)
And congratulations about this new book. You have 12 things you need to know before selling your business.

Sharon Heaton (01:00.786)
very excited about it. I feel like I've been doing M&A for quite a while and we keep on getting asked the same questions. So I thought it might actually be a benefit if I sat down and wrote down the answers to the questions that most business owners have.

Jon Stoddard (01:13.93)
Yeah, and I think that's gonna help you get more business than a book. That's what I have for everybody else. So let's kind of jump into this. I read the book, I have some questions about this, and the first one I wanna talk about is, how do you decide when you take on a client, what questions do you ask the seller to determine if he's really, she, he or she is really wanting to sell to go to the next phase?

I've talked to thousands of business owners over the last 10 years and, you know, oh yeah, I want to sell, but sometimes it's just taking the temperature to see what's worth. And sometimes they'll just reverse their kisses. Yup.

Sharon Heaton (01:53.802)
I completely agree. Selling your company is a very difficult thing to do. Most business owners have been working on that company for five, ten, fifteen, twenty years. And that company is very much like a child. And there's a strong emotional attachment to it. Along with the question of, who am I? I am the CEO of this company. And if I sell it, then who am I then? So there's a lot of personal considerations. It's one of the reasons why we call it liftoff.

as opposed to exit planning. With exit planning, you might as well be thinking about talking to baby boomers and bringing a coffin into the middle of the room and saying, hey, lay down on it, let's see if that works for you. Reality is, this should be aspirational. This should be lifting off to your next stage in life. There was a time in your life when you were in school and a time in your life when you were married and then had young children, then older children. There's a time in your life where you have your company and a time when you don't.

and understand that it's a stage of life. It's not an exit.

Jon Stoddard (02:54.942)
Yeah, control the language and you can control your attitude. There you go. I like that because normally if you're in high school, hey, what's the next stage in life, I'm going to go get a job. We're going to go to college. There's aspirations to go to the next level, right? It's not just I'm dead, I'm gone. It's to the next level. But what kind of, it's like specific questions. See, I had a conversation with somebody who goes, you really want to dig into them and find out like what are they starting to plan for the next stage of life? Are they going on vacation?

Sharon Heaton (03:09.586)
Hahaha

Jon Stoddard (03:24.31)
Or are they going on a walkabout in Australia for two years? Well, what are they doing? And you want to make sure that is there and it's visualized and concrete in their head.

Sharon Heaton (03:37.262)
There are definitely business owners who have that concrete image. I want to go out and buy a boat I want to spend more time fishing. I'm going to go travel. There's definitely people who have that But there's other people who basically say I'm just done. I've been doing this There's nothing more for me to do here and I don't quite know what I want to do with my life and You're right. You do need to be concerned about whether or not those people are serious. So you have to talk to them I think a huge amount

of being an M&A advisor is talking to people, both the sellers and the buyers, to make sure that their goals are in alignment.

Jon Stoddard (04:14.53)
Let me jump over to this and thanks for that answer. Let me jump over to what's my company worth? How do I get this? And I wanna jump into this because you talk a lot about EBITDA and it's a multiple of EBITDA and there's buckets that need to be checkmarked to give it a high score. And you guys gotta get the book to see this. Valuations, margin, and company size, revenue, customer concentration, reoccurring revenue, stability.

Sharon Heaton (04:23.658)
Hahaha

Jon Stoddard (04:44.022)
Uh, vendor concentration. That's a new one that I didn't think about, uh, that you brought that in. And that has to do with a lot with government contracting and everything else, and then, uh, processes. But if anybody follows Warren Buffett, Charlie Munger, they are not a fan of EBITDA because it has a, uh, you know, sometimes it's over inflating the actual cashflow of the business.

Sharon Heaton (05:07.91)
I'm gonna start a question before the question of how do the value of the question value the company and start with is the company even sellable? There are a lot of business owners out there that think that the company has been doing very well. They've been making money on it. So it must be transferable. And the first question is, are you ready to sell? The second is, do you have a transferable company? And the third is, what is the value of that company? So understanding whether or not it's transferable.

Jon Stoddard (05:16.716)
Yeah.

Sharon Heaton (05:37.45)
It goes to the question of, you know, it may not have value. A company in its purest form is a machine that takes in revenue and throws off profits. If it's not doing that, the machine isn't functioning very well. But that can work pretty darn well in your hands. The question is whether or not that machine itself is transferable to another party. It may be, if bizarrely enough, the business owner is not too important.

and getting business owners to understand that if they're the sole decision maker and are dealing with customers and quality of service and all the other things that make that company run, that company may not be transferable until they have people who are not owners playing those kinds of roles. Interestingly enough, that's also one of the factors in determining the value of the company. If in fact the company is done, everything in the company is done by the ownership, that company is...

significantly less valuable than if in fact there are trained management people who are helping run that company.

Jon Stoddard (06:40.446)
Yeah. So how do you score that? Is it just by, you know, how many hours the CEO works and say, you know, because the CEO wants to have their fingers in, or maybe there's just a nose out, their fingers out or whatever, you know, because I've looked at businesses where how much time do you spend on the business? I go, well, 20 hours a month. Great. That's a pretty high valued business because it's running by itself.

Sharon Heaton (07:06.462)
The hours that the owner spends on it is important. I talk to people about it in terms of, okay, you were the owner of this business. If God forbid you were to walk out into the parking lot, get struck by lightning, what happens to your business the next day? If the business can't function without you being there, then you really don't have a company, you've got a job with staff. And those are changes that can be made. I was meeting with one business owner.

and it was a food services company, they had about $25 million in revenue. Margins were attractive, seemed like a pretty good company. We sat, food services, basically they were doing home delivery of meals. And it was a very interesting company, nice margins. While I was sitting there talking to the owner, we were there for about 90 minutes. And in that time period, at least four or five different employees came in and said things like,

Jon Stoddard (07:42.102)
and a fruit service business?

Jon Stoddard (07:48.449)
Oh, okay.

Sharon Heaton (08:03.014)
Mary didn't show up today, what should we do? We can't find the invoice, where should we look? The sink is backed up, who should we call? And after the fourth or fifth of these interruptions, I turned to the business owner and said, I'm not sure you've got a company. You're the one making all of these decisions. If in fact, you got struck by lightning, what would happen? And he said, well, clearly somebody else would have to do this. I'm looking for a buyer who's going to step into my shoes. And I said, your shoes are unfillable.

you're working 90 hours a week, you're making every decision, that's not what a buyer is going to be stepping into. You've got to figure out how do we structure this so it's actually a real company and it's not just you making all the decisions.

Jon Stoddard (08:49.11)
Yeah, I love that. That's a great story. Have you ever read Michael Dell's book, the first book he wrote out where he talks about, you know, he was doing about $50 million at the time and somebody came in and asked for the keys to the Coke machine. And he goes, why are you asking me that? Why are you asking me that? He goes like, because you're the only one with the key. And he goes, I realized I have to delegate if I ever wanted to grow.

Sharon Heaton (09:03.515)
No, I did not remember that story.

Sharon Heaton (09:12.87)
It's very interesting. So many business owners are in fact subject matter experts. They started their company because they really knew something very, very well. And they can provide a terrific service or product as a result of that. That's great, but you've got to be able to graduate out of that. If you're the sole subject matter expert and you're the one who's delivering the quality of services and products, then again, you're an individual contributor. You're not really a business owner.

Jon Stoddard (09:21.675)
Yeah.

Jon Stoddard (09:41.046)
Yeah, let me ask you about those characteristics of a business and the valuation. And I mentioned earlier, margins, company size, revenue, customer concentration, and the list. How do you score those? I mean, subjectively. If, for instance, reoccurring, it's profitable, it's healthy margins on the top. I'd say income margins are right in the middle, but reoccurring revenue is about 50%.

Sharon Heaton (10:12.846)
There is no single formula for determining the value of a company. Here's a couple of elements to it though. M&A is considered the last art of finance. And why is it an art of finance? Well, the finance is everyone understands the numbers, but the art is a critical component to it. So, for instance, let's say that you have a company that's got declining revenues. Well, that doesn't look particularly good. On the other hand,

Jon Stoddard (10:16.77)
Yeah.

Sharon Heaton (10:37.542)
Maybe you've got declining revenues because you're giving up, let's say, residential construction work and you're going into commercial construction work. Well, that commercial construction work is probably worth more because you're gonna have repeat buyers. So you might in fact be strengthening the company by reducing down your revenues, depending upon the character of the revenue that you're bringing in. So each company is its own snowflake. You need to look at each one to determine what are its strengths and what are its challenges.

and every company that I've ever seen has challenges. Trying to hide those challenges is not a smart thing to do.

Jon Stoddard (11:11.245)
Yeah.

Jon Stoddard (11:14.774)
Yeah, sounds like a bad time to kind of sell a company if you're transitioned from residential to commercial or, you know, right in the middle of it.

Sharon Heaton (11:21.938)
Well, you certainly don't want to be going into office commercial properties at this point. But if you're, let's say, a landscaper and you've got a bunch of homes that you do, if you are working, in fact, for a developer and you're doing commercial landscaping, that probably is going to have a higher multiple than the residential work would have. So, you know, each industry is different.

Jon Stoddard (11:25.942)
Yeah, definitely not.

Jon Stoddard (11:44.558)
Yeah. And so how do you, when you bring that into it, like how you decide you just, you just, if you put a list together and you put your SIM together or your teaser together and you say, Hey, I'm just going to list margins. It's a, you know, 60% company size 57. And you're just kind of trying to highlight it's a marketing document, right? I mean, you're just kind of trying to do you leave out the ones like stability of employee relationships or, you know,

If the employees are leaving a little bit higher than a normal because it could be HVAC and then down at the bottom, people just, there's a lot more turnover.

Sharon Heaton (12:23.082)
Now, figuring out the value of a company is in fact a process. So let's talk about it from my perspective as an M&A advisor. M&A advisors get most of our compensation based upon successfully closing a deal. So the first analysis that I need to make is A, is the company sellable? And B, is the owner looking to sell it at a market-based price? If I think this company is worth 25 and you think it's worth 28, we'll bridge that gap. If I think it's worth 25 and you think it's worth 60?

we're probably the wrong people to work with you.

Jon Stoddard (12:56.37)
You're in a different planet.

Sharon Heaton (12:58.154)
And that happens all the time. We talked with one company that had $2.5 million of EBITDA. They were very attractive margins. They were in a very attractive field. We could probably even get them a nine or 10 multiple. And I said, wow, we can get this company with $2.5 million of EBITDA, about 20, $25 million in purchase price. And I spoke to the owners and they said, under no circumstance would we think about selling for less than 40. Like, okay.

That's great and I certainly hope you get it. But we're probably not the right people to do that because we don't believe that that's feasible. It's next.

Jon Stoddard (13:36.026)
Yeah, and you don't even engage with them in like, where did you come up with that number? Yeah.

Sharon Heaton (13:39.486)
Well, we did. We talked to them extensively. We showed them the market comps. We showed them other things going on. But at the end of the day, the business owner is the one with their hands on the steering wheel. They're the ones who get to make these decisions. And just because I think the decision is wrong doesn't take away their right to make that decision. It just has an impact as to whether or not I think that's where we should spend our firm's time.

Jon Stoddard (14:00.67)
Yeah. And where do you get the market comps? Is it like PitchBook and other companies like that?

Sharon Heaton (14:05.478)
Market comps are challenging in the privately held market. PitchBook is a wonderful resource, but they do the best that they can with privately held companies. And the best that they can do is not very good because most of that data is not public. It really is very helpful to work with an M&A advisor who is expert in a specific industry. For SB Liftoff, our particular industry is government contracting. We understand what those various multiples are.

If you're in the designation of the full and open, if you have IT work versus cybersecurity, et cetera, et cetera. You definitely want to work with M&A advisors, as well as lawyers and accountants who understand your industry. You shouldn't have to be explaining to them how that works because that experience will help determine their knowledge of the valuation for your company.

Jon Stoddard (14:55.902)
Yeah, when you say government contracting businesses, do you mean any government contracting businesses like technology IT, which is the hot in that market? They're just eating them up like crazy.

Sharon Heaton (15:10.114)
Our experience at SP Lift Off is primarily focused on the federal government contracting market. And while the federal government contracting market is huge, it's somewhere in the range of about half a half a trillion dollars a year, about 500 billion. So it's quite it's quite large. Well, there's a lot of government spending that is non discretionary. So I'm talking about the discretionary dollars that go to contractors. There are other firms that very much focus on.

Jon Stoddard (15:15.82)
Yeah.

Jon Stoddard (15:25.462)
That's all?

Sharon Heaton (15:39.194)
state and local markets. But it's very hard to be knowledgeable about thousands and thousands of different markets where the federal government, while it's very complicated, it is essentially one market.

Jon Stoddard (15:50.962)
Yeah. So what drives valuations in GovCon deals? I mean, I'm a military veteran myself, and I've worked with a couple stuff and I like the set of sides and the points everybody gets, but it's kind of hard to look at when you have one customer and maybe five year contract and it's just one customer eats up 90% of your time. And what happens at the end of five years?

Sharon Heaton (15:54.904)
Oh, well.

Sharon Heaton (16:14.406)
Well, a government contracting company, a federal government contracting company is going to have one customer, which is the federal government. Having said that, the federal government is huge. And there's a zillion different agencies and offices and entities that can be your client. So when I'm talking about customer concentration, I'm not talking about the federal government, but I'm talking about, let's say all of your work is in the Department of Veterans Affairs. Okay, that's fine. That's a little bit of concentration.

Is it all coming out of one office or are there 10 different offices at VA that you're working with? Because that's the kind of lack of concentration that could make a huge difference. Truth is, valuing a GovCon company is not dramatically different than valuing a commercial company. There are a bunch of factors that make a big difference. And the first one really is visibility of future revenue. Is there a sense that the revenue that you've seen in the past

is likely to continue to occur in the future. Because while buyers really wanna pay based upon past performance, they're really buying for the future. So understanding what the future of that company is like is hugely important to the seller to get a good valuation and for the buyer to decide to go forward with the transaction in the first place.

Jon Stoddard (17:35.586)
Yeah, how do you, what kind of narrative can you offer on that? Let's say if I have a government contract of businesses doing, you know, 5 million, $20 million, and my contracts up in two years. And I know that there's going to be a hell of a lot more bidders this time that are qualified, they're ready for the bid, whether that's set asides because the guy's a military veteran or, you know, a woman owned or wounded or whatever, and it's a whole bunch of.

They're going to get extra points to get that contract. And I'm going to have a lot of competition because they're going to out underbid me, maybe.

Sharon Heaton (18:07.434)
Bye.

Sharon Heaton (18:12.022)
A smart government contracting company recognizes that all a government contracting company is a portfolio of its contracts. And if it's got one contract, that is less valuable than it has 10. And what you need to be looking at is when are those 10 contracts coming up for re-compete? When do you lose your five years of revenue? And properly structured, you almost want to think of it like a bond letter. Yes, I have 20% of my revenue coming up this year.

but I've got 20% of my revenue coming up for the next five years, so that each year you've got 80% locked in, and you're only competing on that one. If in fact 80% of your revenue is tied to one contract, it's going to be extremely difficult, if not possible, to sell that company before that we compete as one.

Jon Stoddard (19:02.41)
Yeah. Is there exceptions to that unless it's a strategic buyer that wants that specific contract? Yeah. Everything, right.

Sharon Heaton (19:08.798)
There are exceptions to everything, John. That is kind of the way it works. In GovCon, the truth is in the general market, employees, highly skilled employees are extremely valuable. So whereas 10 years ago, that was not necessarily the case, we're seeing deals being done because the acquirer wants to take on the employees of that seller. So if you have a company that's, let's say, has a...

Hali SEI clearance, very highly skilled work, and 16 employees who have that kind of background, there might be buyers, even if the economics of that company aren't so interesting. So you really need to look at each company to say, what are its strengths and what are its challenges, and own that so that when you talk to buyers, you can be honest with them and get to an LOI that's based upon reality, not based upon moonbeams and rainbows.

Jon Stoddard (20:04.89)
Yeah. When you buy these companies, you said in the book that most all government contracting are bought with stock sales versus asset sales because it's everything with certifications and everything that come with it. Right?

Sharon Heaton (20:15.571)
That's good.

Sharon Heaton (20:22.498)
As a general matter, M&A is generally done where the buyer is buying the assets of the seller. And when I say buying the assets, it's not only the things that you can see, it's the customer lists, it's computers, it's all the employment relationships. It's considered buying all or substantially all the assets of the company. And that's primarily done both for liability reasons and for tax reasons.

In GovCon, you basically have a company, a seller, that has a bunch of contracts. If you were to sell them as assets, then the buyer and the seller need to go to the government hat in hand and ask for approval to transfer those contracts. It's called a process called novation. If in fact you do it as a stock sale, those contracts go over automatically to the buyer without having to get prior government approval. Well, that prior government approval might be fast.

but it rarely is. So you definitely want to do that stock asset. In addition, there are some valuable assets that a GovCon company has, like past performances, CPARS, ISO certifications, MCCI certifications, that will not transfer in an asset sale. So a lot of the value of a GovCon gets lost in an asset deal versus a stock deal.

Having said that, there were times to do an asset deal, and we have done them, but they are as of specialized circumstances.

Jon Stoddard (21:53.13)
Yeah. Tell me about, you know, if I was a military veteran and wounded minority and I had a bunch of set asides and then I decided to sell my business in a stock sale. Does the buyer have to have those same set asides or what, how does that work?

Sharon Heaton (22:12.01)
The answer is practically yes. Any buyer can buy that company. But 30 days after the transaction, the buyer has to certify to the government as to whether or not they continue to meet the set-aside characteristics of the contracts that were granted. As a general rule, if the buyer does not meet those criteria, the government will not cancel those contracts. You get to serve out the remainder of those contracts.

Jon Stoddard (22:41.314)
Could be two, three years, whatever. Yeah.

Sharon Heaton (22:41.406)
However, it could be two, three, four, five years. It could go on quite a while. But it might be very challenging for that buyer to re-compete those contracts. So when you are paying a multiple of EBITDA, you're basically assuming that's an ongoing company. And that means you're gonna be able to re-win that work. If in fact you don't meet the criteria that's necessary for that set aside, then you're probably not gonna be able to re-compete it. So the buyer's...

willing to spend less money for that company than somebody who does meet that criteria.

Jon Stoddard (23:16.894)
Is there a way to work around that? Like keep the prior owner on as a consultant or contractor, or do they have to own a percentage of the company to go to the next contracts?

Sharon Heaton (23:26.618)
It definitely goes by ownership. And one of the things about federal government contracting is you want to know the rules and you want to obey the rules because they are fairly significantly enforced. I have people turn to me all the time and say, well, I understand that's what the rule is, but how do I get around it? And the answer is, you don't. You figure out how to live within it or go someplace else. It's particularly important in something called the affiliation rules.

Jon Stoddard (23:28.397)
Yeah.

Jon Stoddard (23:34.188)
Ugh.

Sharon Heaton (23:53.442)
where private equity is very interested in getting into government contracting. They like the recurring revenue, they like the stability of it, etc. But if you are a private equity that have funds under management, you can't really buy a designation company. And a designation company is one that's small business, women owned, service disabled, veteran owned, minority, etc. And the PE firms really can't do that. And I've had many a conversation.

with PE firms saying, okay, so I understand the rules, how do we get around them? And the answer is, you don't.

Jon Stoddard (24:27.146)
You don't. Yeah. Let me go to a different subject and the ways to get paid. That's the, just the, you know, buyout, the rollover, the seller financing and the earn out and your conversation about earn outs, why that's the dread. And this is not, this is not new because I've talked to a lot of guys on my show. They just don't like earn outs. They're, what is it about

Jon Stoddard (24:56.966)
increasing revenue, increasing profit companies, like it's on a growth stage.

Sharon Heaton (25:02.41)
Earnouts have a terrible reputation and historically they've been done very, very badly. They've been done largely with the buyer and the seller saying, okay, the seller has 15% margins. If the 15% margins continue afterwards, then the buyer will continue, will pay additional sums to the seller. Well, the problem is margins are based upon both revenue and expenses and the...

buyer is 100% in control of what those expenses are going to be. All you need to do is hire five or six highly paid people and you've just blown the net income for the company, which might be good for the buyer but destroys the earn out for the seller. So earn outs have to be structured in a way that are fair and clear and binary. Either they've been met or they've not been met. And there has to be as minimal judgment involved as possible.

Jon Stoddard (25:43.49)
Yeah.

Sharon Heaton (25:58.354)
So we particularly like doing earnouts based upon revenue. That is, if the revenue comes in the door that we predicted, then you're gonna pay us more. If the revenue doesn't come in the door that we predicted, you're not gonna pay us. And that's kind of fair. It depends. And that's a negotiated point. Very often it has to meet about 80 or 85% in order to get some compensation on that earn out. Again, in the government contracting space,

Jon Stoddard (26:12.362)
not gonna pay us or sliding scale. Yeah.

Sharon Heaton (26:27.546)
it can be based upon winning or losing a re-compete. So we did a deal a couple of years ago where the sellers were getting a huge amount of their revenue and profits from one particular type of contract that was gonna be coming up for re-compete in about a year and a half. The parties came to an agreement and the seller stayed with the company after the transaction solely for the purpose of trying to win that re-compete.

upon winning that recompete, they won, they earned the rest of that earn out, but it was extremely good for the buyer. So the buyer won because they were paying for something that they got, and the seller was able to focus on just that recompete as opposed to all the other aspects of the company that they'd been focusing on before.

Jon Stoddard (27:17.994)
Yeah, interesting. Let me, I'm gonna bring up a screenshot of the valuations of HVAC companies that you talked about. Two different companies, residential and that. So let me bring this screenshot.

Sharon Heaton (27:27.932)
Absolutely.

Jon Stoddard (27:47.182)
So can you see this right here? That's the residential company. Yeah, so you brought, yeah, you have the book. You had, so you made an example of these two residential companies and the valuation and you gave a bunch of different examples like in the years and that. So tell me how this plays out here. What is this, you know.

Sharon Heaton (27:50.374)
Now I can, yes I can. Fortunately I also have the book here so I can do it in the book. Ha ha ha.

Sharon Heaton (28:11.602)
Certainly. Here was the basic point that I was trying to make. HVAC has gone through an unbelievable roll up in the last 15 years. It's been unbelievable. And it used to be that it was a three or a four multiple, but over time, as buyers began to see the recurring revenue associated with them, that became got higher and higher. So the multiple range for a HVAC company

Jon Stoddard (28:17.324)
Yeah.

Jon Stoddard (28:21.781)
It's crazy.

Sharon Heaton (28:40.262)
ranges between three on the low side to as high as 10 on the on the upside. Well, wait a minute here. If I've got an HVAC company with two million of EBITDA and I sell it at a three multiple, that's six million dollars. Happy days. But if I take that same two million and get it at a 10 times multiple, I've now sold it for 20 million. Same two million of EBITDA, one time it's worth six and the other is worth 20. Why?

because you've got to look at the character of the revenue and the character of the company. So the examples that I put up here basically are saying, okay, the margins on one company are very stable, but the amount of recurring revenue is going up quite substantially. And the revenue has been going up in an attractive way. In contrast, company number two,

I'm actually showing the revenue declining. The margins are not, the margins have also declined a little bit and the adjusted EBITDA has about remained the same. But we've gone from in case number two, 0% of recurring revenue up to 20%. So the company in 2018 with zero recurring revenue and $8 million in adjusted EBITDA is actually worth a lot less.

then the company has $75 million in revenue and 20% recurring revenue. That becomes a big deal. For company number one, I'm showing 15% recurring revenue in 2018, going to 40% recurring revenue. That is extraordinarily attractive. And they were able to do it with essentially maintaining their margins. They weren't buying the business. They were actually maintaining their margins. So I would argue that company one is more valuable than company two.

but Company 2 is more valuable today than it was five years ago because of that recurring revenue.

Jon Stoddard (30:43.682)
Yeah, so what is happening to company two that you see? They're definitely not doing a good as job of turning assets into cashflow. They're not productive, not effective at it, but it could be something internally say, geez, you know, it's fixable. Can we get this fixable? Do you take those projects on or you just, you set those projects aside?

Sharon Heaton (31:09.394)
We absolutely take those projects on. If you're a business owner, you should be thinking about selling your business three to five years in advance of you actually doing it. When I look at this model number two, to me, that looks like a business owner that said in 2018, hey, I think I wanna sell my company, but I'm not sure I'm gonna get the value for it that I want. What is it that I need to do to change my company to make it more valuable? To bring that EBITDA multiple from three

to 10. Now, I don't think this is going to be a 10 million dollar, a 10 multiple company, but you're certainly going to be able to move it upstream and get a higher EBITDA multiple. And that's real value in that owner's pocket. So this seems to me like a company where somebody said, huh, I need to restructure my company. I might need to make some significant investments in my company to get to a better result than I was otherwise at.

Jon Stoddard (32:06.438)
Yeah, I agree. I mean, how do you find a company three years in the past and say, let's work with them?

Sharon Heaton (32:14.37)
What I've learned is that virtually every business owner thinks that they want to sell in five to seven years. And I've determined that the reason for five to seven years is that it's far enough away that I don't have to do anything about it today. But it's close enough that I can see the liquidity events in my future. And as soon as somebody says that to me, I start to say, what is it that you're doing today so that you can maximize your value in the five years that when you want to sell?

Jon Stoddard (32:31.745)
Yeah.

Sharon Heaton (32:42.898)
What are you gonna do differently today so that you get the result that you want in five years? Often the answer is, I'm not gonna do anything differently. I'm just gonna continue to grow my company. Well, you might have more time, you might own your company for longer and that's terrific, but it doesn't necessarily mean you're gonna get a better purchase price. And oh, by the way, there's a huge amount of risk in owning a privately held company. So you really need to be thinking very strategically about where are you and where do you wanna be?

If we come in and we do evaluation of your company and we say, terrific, your company is worth $20 million, and they say, but I wouldn't consider for selling for less than 30, like, great, let us tell you what a $30 million company looks like. And this is what your company is gonna need to look like in order to get that purchase price. Do you wanna take on the investments and the time commitment and the hard work necessary to do that? If you do, absolutely, let's go forward. But if you don't,

then maybe you should be thinking about that $20 million exit today and kind of lift off to your next goal in life.

Jon Stoddard (33:46.718)
Yeah. So do you prescribe that and get paid for that three years from, you know, in the past? Like, Hey, I prescribed going from 20% recarving revenue to 40% and leave them to them, their own devices to figure it out or?

Sharon Heaton (34:01.374)
There are a lot of growth consultants out there and that's not primarily what SP Lift Off does. We are M&A advisors. However, we will do valuations. And I think that doing a valuation of your company to find out what is your value today is marginally helpful. It's nice, it might be a great report card, it might make you feel terrific. But what we do in our valuations is not only tell you what the value is, but why.

Jon Stoddard (34:06.23)
Yeah.

Sharon Heaton (34:28.37)
What were the reasons that we did this multiple? What were the discount factors we put in? And we provide all that information to say, this is your roadmap. If you wanna turn this company from being a three or a four or a five multiple into being a seven or eight or a nine, this is what it is you need to do. And if you're doing that three to five years before you go to market, you can make those changes. If you're doing evaluation and you're going to market in six months, it doesn't make any sense.

because you're not going to be able to change any of those factors. It's good to know information, but it doesn't give you the tools you need to really be able to make those changes.

Jon Stoddard (35:06.03)
Yeah, that's good advice. Let me ask you, jump over to net working capital and why that is such a contentious issue. I don't know, you go like the SMB market, all the small business owners, you know, if they have any new working capital or cash in their accounts, they wanna take it out and the SBA replaces it. So why is that such a big deal? I mean, to me it's like,

Sharon Heaton (35:12.178)
Ha ha ha!

Jon Stoddard (35:32.806)
I don't like it. I don't like it when the owner takes it out. It's just like, oh, okay. It's just like taking all your blood out of your body for a couple of weeks here. Why would you do that? Yeah.

Sharon Heaton (35:41.486)
Let's talk about a couple of things that networking capital is and is not. What networking capital is, is the fluid in the gears of the engine that makes the engine work. If you can't have that engine function, then having the engine isn't useful. And the networking capital is the liquidity that gives you the opportunity to do that. Having said that, most of these transactions are done on a cash-free, debt-free basis.

Sharon Heaton (36:11.058)
gets to take the cash that's in the company at closing, that's their money, but they have to pay off any and all debt, including lines of credit or equipment financing, et cetera. There are some exceptions like accounts payable that are just kind of ordinary course of business. What networking capital is in a formulaic way is current assets minus current payables. So,

Current assets minus current liabilities. The current assets are primarily working, it is primarily AR. It is primarily the accounts receivable that company has. Now, as I said, the cash that's there, the seller gets to take. So that doesn't go to the buyer unless there's a problem. But let's say your AR is

$3 million and your AP is $2 million. That means that your networking capital is $1 million. Now it's

Jon Stoddard (37:18.486)
Let me interrupt you because how deep do you have to go investigate in the agent report on that AR? Yes.

Sharon Heaton (37:25.138)
Substantially, if there is AR that's more than 120 days old, you've got to seriously wonder whether or not that's ever gonna be collected. We have structured deals where the seller does not hand over that AR, but they're the one responsible for collecting it. So the accounts receivable they hand over is everything 90 days and less, and anything 90 days and above stays with the seller, they try and collect it, and when they collect it, they get to keep it.

but it's not been transferred over to the buyer. That's an unusual circumstance. What tends to happen, and this is very odd, we spend more time negotiating networking capital targets between buyers and sellers than we do on the purchase price.

Jon Stoddard (37:56.909)
Yeah.

Jon Stoddard (38:08.606)
I know that is why is that it is just weird. Like, hey, this is the cut blood in your body. This needs to be there for you guys to operate the machine to operate.

Sharon Heaton (38:11.666)
because people...

Sharon Heaton (38:18.162)
There you go. I think that sellers on one hand think that it's the cash and the balance sheet, which is not for the most part. And second that, well, this was monies that were earned while I owned the company, why shouldn't I get them? But there's also monies that you borrowed in accounts payable while you own the company and you're not taking that either. So it's a way of just kind of looking at, as you said,

What is the liquid in the body? What is the blood that's necessary to make that company work?

Jon Stoddard (38:50.57)
Yeah, I have to tell you this. A lot of people don't really know the language of business, which is accounting. And if you don't know what those liabilities on the balance sheet, you don't really understand what your working capital is or the needs of the business.

Sharon Heaton (39:03.566)
It gets extremely complicated when you've got a seller that, let's say, has a product that they sell, and they get payments along the way. So they might get four payments of 25% of their payment all the time each time, but the product doesn't get made in equal components. Maybe the first payment or two is maybe only 15% of the work, but they've now gotten 40% of the money.

well, or 50% of the money. That indicates that you've gotten some money from the client that you actually haven't earned yet. And that becomes very complicated at the time that you transfer the company. And that's when networking capital calculations really tend to be much more challenging and trying to explain to both parties what's fair. The key element of a networking capital is that it should neither be an increase nor decrease to the purchase price. It should be the blood that's necessary for that body to work.

It shouldn't be a way to try and improve or lower the purchase price.

Jon Stoddard (40:05.866)
Yeah, I mean, if the cash in the account is in excess of what the accounts payable is, then you work that out. I got that.

Sharon Heaton (40:12.47)
Exactly right. And that's where some level of empathy between the buyer and the seller is so important. The buyer needs to understand what's going on the seller side, and the seller needs to be empathetic to what's going on the buyer side. And if you take it from that approach, the networking capital target in those negotiations are not quite as painful.

Jon Stoddard (40:32.49)
Yeah. All right, let's go on to this last subject I wanna talk to you about, taxes on the sale. And I love the way you say this, converting ordinary income to capital gains.

Sharon Heaton (40:45.566)
When I was in law school, I took a lot of tax classes. And it took about three or four classes for me to realize that virtually all of tax law was about whether or not something was gonna be characterized as ordinary income or capital gains, because that made a huge difference as to what the tax rate was. So today, the capital gains rate is approximately 20%. It's kind of historic lows. The...

Jon Stoddard (41:00.759)
Yeah.

Sharon Heaton (41:13.25)
Ordinary income rate is about 37, 39, maybe 41, depending how you look at it. Not including state, just talking about federal. So, hey, listen, if you're going to make $3 million on your company when you own it, you're going to pay that at ordinary income rates. If you made $3 million on the sale of your company, that's going to be at capital gains rates. You immediately have at least a 20% upside for you in the cash that you're going to put in your pocket.

Jon Stoddard (41:18.486)
Not including state, yeah.

Sharon Heaton (41:43.134)
So understanding what's capital gains and what's ordinary income is a critical component when you're selling your company.

Jon Stoddard (41:49.326)
Let me get a couple examples. Do you ever advise people to go to SBDCs to avoid that capital gains tax?

Sharon Heaton (41:56.49)
We don't do a lot of tax structuring. One of the things that we are is humble enough to realize that the tax code is above our pay grade in terms of manipulating it. There are people who are very sophisticated at it. One of the things you need to understand is if you do those kinds of transactions, it's going to be complicated. It's not going to be a simple thing. So if you're looking to have control over your money and be able to spend it as you want,

Jon Stoddard (41:58.732)
Yeah.

Jon Stoddard (42:07.934)
Ain't less of it!

Jon Stoddard (42:17.687)
Yeah.

Sharon Heaton (42:25.502)
you're probably going to have to do minimal tax planning and just kind of bite the bullet. Absolutely, absolutely. And there are people who are extremely good at that. And, you know, we basically refer people to those kinds of people.

Jon Stoddard (42:29.919)
You need some my wealth of manager help you out. Yeah

Jon Stoddard (42:41.898)
Yeah. Let me, and I know you've already qualified this, but doing seller financing. You know, seller financing could be as a debt and you turn that, you could just chop up the capital gains tax over a period of time versus ordinary income.

Sharon Heaton (42:58.558)
The seller financing is itself part of the purchase price, so it is a capital gains. What's very good about seller financing is twofold. One is there's a doctrine called the installment sale. That is you sold your company for $30 million, but you only received $20 million cash or close. And hypothetically, you did $10 million in seller financing. That would be a lot, mind you. Well, you're going to pay taxes on that $20 million.

Jon Stoddard (43:01.9)
Yeah.

Sharon Heaton (43:27.35)
not on the 30 million. And you're going to pay the taxes on that 10 million as you get it. So you're paying that tax rate over the next several years. That's good in that you don't have to pay it all upfront when you don't have the money. It's a little bit of a risk because those tax rates might go up or down. But you're paying it at capital gains rates. You're not paying it at ordinary income. On the other hand,

Jon Stoddard (43:52.022)
Ordinary income, yeah.

Sharon Heaton (43:55.694)
If you have seller financing, you darn well better have an interest rate on it. You know, you don't give somebody $10 million and say, just give me 10 million back. You say, I'm lending you $10 million and I want a 6% interest on it. The interest is ordinary income, but the principle is capital gains.

Jon Stoddard (44:08.3)
Yeah.

Jon Stoddard (44:13.93)
Yeah, beautiful. Look, this is a nice book you have, SB Lift Off. Thank you so much for being a guest, Sharon.

Sharon Heaton (44:21.322)
Truly my pleasure, John. Thank you so much for inviting me. Have a good day.

Jon Stoddard (44:24.19)
All right.