June 2012

A buyer was interested in a building products manufacturer that did $70 million a year in sales.  Although the business was profitable, it seemed that their margins were lower than they should have been for this industry. The buyer asked the seller how they priced their products.  As the seller was explaining his pricing strategies, he happened to mention that a price increase of 1.5 percent would not really impact sales. He failed to see that the price increase of 1.5 percent on $70 million in sales would bring $1 million in profit. A smart buyer would realize how to get an additional $1 million in bottom-line profit simply by increasing prices by 1.5 percent.

A recent book titled The Art of Pricing by Rafi Mohammed went immediately to the business best-seller list, and no wonder. The author stated: “One of the biggest fallacies in business is that a product’s price should be based on its costs.”

Here are some of the author’s suggestions:

• Restaurants: Keep the entrees priced attractively, but expect to make up the profit shortfall on drinks, desserts and extras.  McDonald’s profit on hamburgers is marginal, but it has substantial profits on French fries and soft drinks.

• Television Advertising: Sell 75-85% guaranteed slots six months in advance, then sell the balance of advertising to the spot-market with little advance notice at premiums of 50%.

• Financial Printing: Price the printing of IPO prospectuses at near break-even, and then charge exorbitant fees for last minute changes.

• Investment Banks: Quote a relatively modest accomplishment fee as a percentage of total consideration, but insert a rather substantial minimum fee.

Another notable quote from Rafi Mohammed is: “Companies should develop a culture of producing profits. Through better pricing, companies can increase profits and generate growth.  In many ways, smart pricing is like hidden profits.”

This takes us back to our first premise: Small pricing increases can greatly increase profits.

There once was a family-owned bakery that had sales in the millions. The bakery sold bread to restaurants, supermarkets and some retail outlets. The founder gave each of his 5 children 20 percent ownership of the business.  The kids really didn’t want to work in the business, so they turned the operation and management over to 2 members of the third generation.  For some years the business had been operating on a break-even basis, and sales were not increasing.

The founder’s children decided that they wanted to sell the business since they were close to retirement age. A professional business intermediary was retained to do this.  He contacted as many of the larger bakeries as possible, hoping to find a suitable acquirer, but there was very little interest. The intermediary continued his search, willing to do the hard work required to find a good buyer. He finally found a successful businessman who offered a price equal to 50 percent of sales – a generous offer.

The intermediary presented the offer to the five children – all equal partners.  Little did he know that he had walked into the proverbial hornet’s nest. A huge family argument ensued, and finally the intermediary was asked to leave the room so that the siblings could decide what to do.

The offer was turned down flat. There was no counter-proposal or even any negotiation on price, terms or conditions. The offer was dead. The intermediary had worked on trying to find the right buyer, figured he had – all to no avail, six months wasted.

It turns out that the major obstacle was thrown up by those two members of the third generation who had been operating the business. They feared that they might lose their jobs even though the prospective buyer assured the sellers that he would retain them.  Were they being unreasonable? The reality is that the operators were “family” – related in one way or another to the five owners, and blood is usually thicker than water.

Flash forward some 20 years.  The bakery is still in business with very little growth and still operating on a breakeven basis.  The five owners are now in their 70s, they have never received anything for their equity, and there is very little hope that they ever will.

The above is a true story.  It shows how a family can own a business and not be prepared or in agreement when it comes time to sell it. Although the bakery is still in business, it is barely hanging on. The story is sad as well as true. The proposed deal could have satisfied all of the owners’ goals and made their retirement years a lot more comfortable.

Family-owned businesses make up a lot of the non-public companies in the U.S., and according to industry reports, many of them will be up for sale in the near future.  In situations where the family owned business is owned by more than one person, it is crucial that a meeting be held with all of the family owners prior to electing to sell, unless a strong buy-sell agreement has already been agreed to.  This agreement should establish, among other things, specific guidelines about what happens if one family member wants out of the business.

At this meeting, the company attorney and accountant should be in attendance along with a business intermediary.  The reason to include the intermediary at this early stage is that he or she knows what the pitfalls are, what buyer concerns will be, and what should be done prior to going to market.

One of the major problems when there is more than one owner is communications. For example, one owner who is active in the business decides that he needs a new, expensive car and that the company should pay for it. This is the kind of issue a decision-forming meeting should bring to light and address. Strict guidelines should also be in writing concerning salaries, benefits, etc.  When one family member wants to cash out or another one spends a lot of money furnishing their office – it is too late to have an agreement drawn up to cover these possible roadblocks. The time is now!

Much has been written about “fairness opinions” due to the financial manipulations among companies such as Enron, Tyco and others.  The conflict in the use of fairness opinions  was (and is) that an investment banking firm not only handled the sale of a company,  but also got paid for doing a fairness opinion.  For example, when the Bank of America decided to buy Boston’s Fleet bank, B of A paid the investment banking firm of Goldman Sachs $3 million as a retainer, $5 million for a fairness opinion, and was prepared to pay a success fee of $17 million if the deal actually was completed.

Keep in mind that a fairness opinion is prepared by one or more financial experts, or by a firm, to protect the shareholders; in other words, to assess whether or not the deal is fair to the real owners of the business.  It also protects the officers and board of directors from shareholders who feel that their company is paying too much for the business being acquired.  It is also apparent, from the example above, that the investment banking firm makes money, and a lot of money, through the entire purchase from beginning to end.  They don’t have much of an incentive to really come in with a “fair” fairness opinion.  However, regulators are looking at this obvious conflict of interest very seriously, and changes in the current regulations are almost sure to happen with full disclosure being only the first step.

So, how does all of this impact the privately held company?  It is vital that an owner of a privately held company who has minority or family shareholders should also seek a fairness opinion.  It may not have to be done by an investment banking firm and probably shouldn’t be prepared by the owner’s accounting firm, for the same reasons outlined above.  A third party evaluation should be done to insure that a minority owner doesn’t come out of the woodwork and claim that the business was sold for much less than it is worth – at least according to the dissident shareholder.

A professional intermediary can be an excellent resource in the preparation of a fairness opinion for the privately held company.  They can provide several valuation professionals and/or firms and also assist in the gathering of the necessary financial records.  Generally speaking, a fairness opinion is prepared after the selling price is agreed upon.  In the sale of a privately held company, the price may fluctuate throughout the negotiations, but a third party valuation can set the bar.  And, it’s very possible that using a business intermediary to market the business will bring a price above the valuation, pleasing everyone.

This is just a partial list: Church’s Chicken, Uno Chicago Grill, Charlie Brown’s, Domino’s Pizza, Burger King, Cinnabon, Sizzler.  The first response would be that they are all in the food business, and that’s correct.  Now name the second thing that they all have in common?  Give up?  Well, they (and many others) have been purchased by private equity firms.  And, apparently, this is just the beginning.  The huge Dunkin Donuts chain is being sought after by two or three private equity firms.

Why the interest in restaurants from groups that most people associate with high tech?  Many firms got burned during the dot com and high tech meltdown.  Now these same private equity firms are looking at businesses that are stable, with more predictable earnings, and that are also very familiar businesses, time-tested and still have a lot of growth ahead.

One industry expert said in Nation’s Restaurant News, “What’s really driving this is the success of these deals, the numbers that the private equity companies are getting when they sell…”  For example, he noted, “Restaurant Associates bought Charlie Brown in 1975 for $3 million and sold it to Castle Harlan seven years later for $50 million.  Castle Harlan got almost three times that price – an appreciation of $90 million with the sale to Trimaran.”

If private equity and similar firms are now buying restaurants, what businesses are next?  If you are the owner of a small growing company or chain of businesses – is a private equity firm in your future?  A professional intermediary may be able to answer that question for you and if you are considering selling – they can also help.

If Starbucks raised the price of a cappuccino, sales most likely would not be affected. If your attorney raised his or her hourly rate, would you switch law firms?  If a company or service firm does not have pricing power, then its value is less than it should be. Here are a few ways to develop or increase pricing power:

• producing a discernible branded product or service
• innovating with patent production such as Apple’s i-Pod
• providing such exceptional service that competitors are not able to replicate it

An interesting question for company management is – how should they set their prices?  Sometimes the answer is that management figures out at what price the item can be sold and then works their costs backward.  The more traditional way is to add up the cost of labor, material, and overhead plus an acceptable profit.  But times have changed, and in many cases, the power of pricing has moved from the producer to the customer.  Today, Wal-Mart tells most of their vendors what they will pay for certain items, and Ford tells their suppliers the same.  On that basis, many companies are beholden to the Wal-Marts and the Fords of the world and do not have the benefit of pricing power.