By Miles Stover
In the last few months we have discussed how accounting is the language of business. We have discussed how organizations such as banks look at your ratios when they evaluate loaning you capital. We have discussed how budgets can be used to tell you if you are on track toward profitability. You have done your homework, worked long, hard hours, and things are headed in the right direction. So what do you do with those good results and the knowledge of what it takes to run a marijuana-related business successfully?
Generally you have three choices. One, keep things going at the present location with the goal of increasing revenue and increasing profitability. Two, go outside and acquire another location. (Getting into any other niche/segment in the industry – called vertical integration — is beyond our ability to discuss in this short article, but could be explored further down the road. It is also worth noting that Washington does not currently allow licensed marijuana businesses to be fully vertically integrated. Producer/processors can have dual licenses, but retailers must be separate.)
The third option is that your success attracts the attention of other investors who want to acquire your operation.
Each avenue into the future has different issues to consider and evaluate. Let’s discuss the more important ones.
BUYING AN EXISTING BUSINESS
Buying an existing business is less risky than starting from scratch. When you buy a business you take over an operation that is already generating cash flow and hopefully profits. Thanks to your past experience in budgeting, management and ratio analysis, you know what to look for.
You are probably looking to buy an established customer base and employees who are familiar with all aspects of the business. You don’t have to start from scratch again because you know the formula for success. You also know what not to do, and your hard-earned experience should eliminate most of the hassles you initially went through to get licensed and approved.
On the other side of the equation is the fact that buying a business is often more costly than starting from scratch. However, financing is usually easier to access as bankers and investors generally feel more comfortable dealing with someone who has been successful along with a location that has been successful, or at least has a track record to evaluate.
This does not mean you can skip your own due diligence, because you do not want to get stuck with obsolete inventory, disgruntled employees or a poor distribution chain, among other negative factors.
Buying a new operation in a new location requires several things to happen, including identifying the characteristics your new business/location must have (such as number of employees, revenue levels, geographic location, cost of doing business in the new area, proximity to your existing location, possible sharing of senior management talent, local government attitudes to the sale of your products, etc.). When considering a new location, you need to ask yourself the same questions you did when you originally started the business, but this time around you should know what the answers sound like.
The emerging legal cannabis industry is also creating other industries. Maybe you have noticed that there are now business brokers who are offering to help you acquire a new location. This resource, after you tell them what criteria and existing conditions would make an acquisition interesting, can assist you in the process you are embarking upon. If you choose this method of investigating potential new locations, the broker you selected (after interviewing several) can prescreen candidates/targets, assist with the paperwork and negotiate some of the business points unique to acquiring an existing business.
Because the industry is so new, the cost of these services is highly negotiable as the brokers are motivated to get a few sales under their belt, too.
Whether you conduct the investigation yourself or use the talents of a business broker, make sure you investigate the following items:
- Inventory. Know what is on hand and what has been sold during the last fiscal year. This is a good indication of the market they served. You don’t have to accept all types and levels of existing inventory in any acquisition — everything is subject to negotiation. Look for items that require special expertise to sell. Are there special licenses or permits needed for different types of inventory?
- Furniture and fixtures. Investigate the market value of what you are buying. Identify the items that are leased. Identify the leasehold improvements made, and find out what level of maintenance will be required. (If the building is to be leased, interview the landlord and see what the lease conditions are.) There are a lot of display cases, equipment and fixtures on the market now. Buying the existing furniture and fixtures might be part of making a deal happen, but you should be aware of the ability to buy used furniture and equipment.
- Legal documents. Definitely review all contracts that the potential seller has in place. Evaluate if you need to assume any distribution agreements or employment agreements or if it would be helpful to do so. Are there any agreements or contracts you will have to accept or reject so you are in control of your new business under your conditions. Obviously, look closely to see that the business you will operate is set up legally in the area you are considering acquiring. Don’t assume anything!
- Verify past revenues. An excellent way to do this is by reviewing tax returns for the period your target has been in business. The models you might be presented in the sales negotiations might not match the actual results. Most business people are very reluctant to “play games” with tax returns and the government. Interview their accountant. Use the accounting skills you have been using to compute many of the ratios that investors will be using from the tax returns. They have the credibility that an “internally prepared ratios analysis” might not have.
- Financial statements. Remember when we talked about Robert Morris & Associates (RMA) in the September issue of Marijuana Venture, and how that organization allows you to compare your operation with competitors on a number of different levels? Now is the time to look at them again to compare your targets’ results with your industry. Dun & Bradstreet might be a place to look, but only to corroborate what you are seeing with RMA statistics.
- Sales records. In addition to the records and matching tax returns, identify the business’ largest customers. Look for cycles and the breakdown of individual product sales.
- Liabilities. When considering buying another company, you have to make a decision as to the type of sale it might be. The two most popular methods are using asset purchase agreements or stock sale agreements. Asset purchase agreements are more popular by a factor of 100:1. Stock sales involve buying not only the ownerships’ stock of the company but all of the liabilities known and unknown. It is a strong recommendation to consider just the purchase of the items you want and let the seller deal with his or her liabilities. Your attorney will have an opinion that should be taken into consideration.
- Accounts receivable/accounts payable. It is generally not uncommon to buy accounts receivable in a sale. However, in the cannabis industry, it’s more uncommon due to the prevalence of cash sales. Buying accounts payable is possible if you are buying items such as vehicles, floor equipment and fixtures. Make sure the leases and contracts you are being asked to assume can be assumed. Don’t take the seller’s word for it. Read the documents and contact the proper parties. Verify the payment record of the seller as you might be assuming a poor credit history.
- Location and market area. It is vital you check with the regulators as to the number of licenses they might be issuing. Your target’s operation could change quickly with new competitors coming in to the market. This is a significant area of concern as the regulators are also learning what makes sense. You do not want their learning curve to come at your expense.
- Miscellaneous. A good diligence plan will include: a review of the insurance rates in the area; reviewing salaries and wages in the area; and determining if there are any special OSHA requirements. Are there any special city taxes specific to your industry being imposed? Talk with the local police as to problems they have encountered. Talk to the neighbors and determine their attitude about the business. Although you might not need to change their minds, knowing what your neighbors think about your business is good information to have.
If you are going to transfer any staff or managers from your existing operation to this new operation, keep them in the loop as you get close to a decision. That way, nobody is surprised.
So, your diligent investigation hasn’t produced any flags that shout: “stop now!” The next question is: How much should you pay for the operation?
Valuation
The basic methods used for determining price or establishing a potential sale price are: multipliers, book values, return on investment and capitalized earnings. These are the methods lenders and outside investors most commonly use. If it’s possible to use one of these methods, you give yourself the best opportunity to get access to outside capital. Here are basic definitions of these four factors.
– Multiplier: Multipliers can be as simple as a calculating monthly gross sales, annual sales or after-tax profits. Most multipliers aren’t based upon strict fact. For example, within some industries, buyers and sellers agree that certain businesses sell at four times their annual gross sales or two times annual gross sales plus inventory. The legal cannabis industry is so new, there is no multiplier that has gained universal acceptance. It usually takes time for a multiplier to become accepted and serve as a starting place for negotiations within an industry.
– Book value: Because book value is a technical term and has been used as a basis for sales for many years, it is a more accurate way to determine the price of a business. To arrive at a price based upon book value, you have to find the difference between the assets and the liabilities on the balance sheet to arrive at the net worth. This amount is typically identified on a properly prepared balance sheet. Taking the net worth and multiplying it by a factor is a way to get a book value. There are some complicating factors when determining assets and liabilities but any qualified accountant can get you through this analysis quickly. Again, this is just a way many sales have been determined in the past and can be a good starting point because it has been used so often. Investors and lenders are generally comfortable with this approach.
– Return on investment: The most common way of evaluating a business is by its return on investment, usually referred to as ROI. This is the amount of money a buyer will realize from the business profit after debt service and taxes. Investors and lenders typically will set an ROI requirement for a business – say 15-25 percent.
Many parties buy a business solely because of the potential it has to earn money compared to the money invested into it. A potential buyer will determine the return they require on an investment. The decision usually comes down to the seller identifying the ways they see the buyer generating a return, and the buyer determining if they are comfortable with the argument and if the ROI is acceptable for the perceived level of risk.
– Capitalized earnings: Using capitalized earnings might be the most commonly-used method to value a business, but it’s not necessarily a scientific approach. Basically, the equation is projected earnings times the capitalization rate equals price. As an example, after you have analyzed the market, the competition, the demand in the area of the location and the organization of the business, you determine the projected earnings could increase $25,000 per year and your cap rate percentage is 18 percent, then the value of the business would be $25,000/.18, or $138,888. Again, the industry is so new there is not an established cap rate. However, if you are seeking outside funding, lenders will likely have a cap rate in mind that they will want to see met before investing.
Doing a Deal
When all is said and done, and both parties have an idea as to the price of any acquisition, you have taken the first step in negotiating the deal. How the deal is structured now becomes the most important detail to attend to. There’s still plenty to consider about how deals can be put together — financing, structuring the deal and alternatives to cash. As important as to how you might structure the payment is to understand the common mistakes made. This is a lot to think about in such a short article, but by starting to think about making an acquisition or what others might be thinking about when they make you an offer are good first steps.
Miles Stover is the founder and president of Turnaround, Inc. and TurnRight, Inc. For more than three decades, he has worked hands-on with organizations from start-ups to Fortune 100 companies in a variety of roles.