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Business owner dependence: The risk hidden in most middle-market businesses

KEY ARTICLE TAKEAWAYS

Learn about how business owner dependency can hurt your company’s valuation or kill a deal altogether

Determine whether your business is too dependent on you as an owner and the steps you can take to address the issue ahead of a sale

#1 Business risk factor that handicaps most middle-market businesses

We have had hundreds of middle-market companies complete CoPilot and have learned quite a bit about the most common risks companies face. We have also interviewed a lot of business owners about their experience selling a company and some of their most common lessons learned relate directly to the most common risks we see coming out of CoPilot. In addition, during COVID we developed a version of CoPilot for buyers (private equity investors and strategic buyers) to survey which CoPilot risks were of most concern to them. 

Here’s what we found:

The number one company risk (reflected in over 95% of CoPilot assessments) is that the business is too dependent on the owner.

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This risk manifests itself in the owner being too involved in sales or operations, having too heavy a hand in customer relationships, or simply not having a deep enough bench of management talent.

The rest of the top business risks

In addition to business owner dependence, the next most common risks to round out the top five were:

2. Lead sources too concentrated (78%)

3. No bank statement review/reconciliation (79%)

4. Lack of check and cash controls (75%)

5. No formal succession plan in place (73%)

Why is owner dependence so prevalent?

You may be wondering why business owner dependence is such a prevalent risk, coming in 14% higher than the next most common risk. First, in small companies the founder/entrepreneur is going to be deeply involved in almost every aspect of the business. This is driven by necessity in some cases (i.e., can’t afford additional management personnel) and by owner preference in other cases (i.e., the owner believes no one could do a particular task as well as they do). Second, until a business matures to a certain level, it is probably not realistic to expect the owner to be able to extract themselves in a meaningful way from the business.

Why is owner dependence a risk factor?

We have asked many past clients whose businesses we have helped sell, and the number one regret they have after going through the process of selling is that they did not hire their key management team members sooner.

Business owners who have “been there and done that” learned how valuable good management talent can be for a growing business, and they learned how much better their lives could be if they could simply delegate tasks that they did not necessarily enjoy, were not very good at, or that were distracting them from adding value to the business in more meaningful ways.

Most investors will feel understandable trepidation to write a big check to acquire a company if the departing owner is intimately involved with current operations of the business. After all, they are investing in the future earnings of the company – if one of the most important drivers of the earnings, company culture, and growth of the business departs the business, an investor is likely to view the business as significantly less valuable.

Is your business at risk? How dependent is your business on you?

  • Do you spend more than 40 hours per week on the business?
  • If you left the business and did not check in for 6 months, would the business be worse off?
  • Would your management team be challenged to operate the daily operations of the business without your involvement?
  • For your top 5 customers, if you left the business would they pause to see with whom they would be dealing with or terminate their relationship with the company?

If you answered yes to one or more of these questions, your business may be too dependent on you as an owner.

How we help clients manage their owner dependence risk factor

Given this risk is so prevalent and is of such a concern to investors, how can you proactively address it sooner and avoid the same regret we see so often in business owners?

  1. Identify current dependency: We have an exercise we use with clients called the 80/20 Rule where we get owners to track where they spend their time on a daily basis, and then we analyze where the return on investment of that time is going to be the greatest. With that data, we can get to work on a plan to start delegating tasks to other team members who are likely able to do those tasks better than the owner.

  2. Develop a hiring plan: Then we develop a recruiting and hiring plan for the key members of the management team. Even though the owner might not execute on this plan immediately, giving thought to what skills, experiences, cultural attributes and other elements will be critical to these hires will help owners start to identify potential candidates for when the hire becomes financially feasible.

  3. Determine ROI: Finally, we work with the owner to understand what these new hires will mean financially for the business. Yes, they will require some initial investment, but if done right, they will also enable faster growth and will give the owner more time to spend on the things he or she enjoys (whether that’s more time on innovation or more time with friends and family).

This risk of a business being too dependent on the owner is very common, but with an intentional plan, you can start to mitigate it early, enabling faster growth, more value creation, and a better life for you as an owner.

Tools for assessing and addressing your company’s top risks

Through our CoPilot product, you can identify whether your company is at risk of owner dependency, among many other business risks. The tool also offers guidance for risk resolution, mitigation, and positioning for each risk identified in your business.

In addition to CoPilot, our firm’s Pathfinder and Exit Academy offerings provide comprehensive market preparation services for business owners who are serious about addressing key risks in their business and maximizing value prior to selling their company.

AUTHORED BY:

Bobby Motch  |  Associate  |  Class VI Securities, LLC

As an Associate at Class VI, Bobby has experience in transaction execution and board advisory services for clients in a variety of industries, including consumer products, food and beverage, business services, software-as-a-service, manufacturing, and distribution. Additionally, Bobby contributes to the development of Class VI’s CoPilot services and Class VI content creation.

The views expressed represent the opinion of Class VI Partners. The views are subject to change and are not intended as a forecast or guarantee of future results. This material is for informational purposes only. Stated information is derived from proprietary and nonproprietary sources that have not been independently verified for accuracy or completeness.  While Class VI Partners believes the information to be accurate and reliable, we do not claim or have responsibility for its completeness, accuracy, or reliability. Statements of future expectations, estimates, projections, and other forward-looking statements are based on available information and the Class VI Partners view as of the time of these statements. Accordingly, such statements are inherently speculative as they are based on assumptions that may involve known and unknown risks and uncertainties. Testimonial may not be representative of the experience of other customers. Testimonials are no guarantee of future performance or success. Testimonials are NOT paid testimonials.
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