Updated: Apr 12, 2021
Some years ago I was early into a CFO assignment and I needed to put together a debt schedule. This company had several debt instruments with related collateral and covenant obligations, and both I and the various lenders needed to understand the entire debt picture. I began with what I thought would be an easy step: collecting all the loan documents. What I thought would take an afternoon ended up taking several weeks. I received responses to my inquiries such as, “Oh, I think Bob signed that one, go ask him if it is on his hard drive,” and, “Sally was here when that one was signed, but Jenny is using her computer now so you might want to check there,” and, “oooh… that one is probably in one of the boxes in the warehouse.” After multiple weeks of searching, we embarrassingly needed to turn to a couple of the banks to ask them for new copies of our obligations to them that we had lost. This move didn’t increase their confidence in the company.
Then a sales tax audit happened.
I put in place internal policies that all company information (not just bank documents) needed to be in a centralized location. This got a lukewarm reception. Then a sales tax audit happened. A period from three years earlier was being audited. Several hundred invoices needed to be pulled to definitively show if the company had paid sales tax on each. And each time an issue was found, the auditors embraced the opportunity to dive deeper and made even more information requests. Unfortunately bank documents weren’t the only type of company documents that had been scattered about. Invoices had been stored in boxes in various warehouse locations and no one was sure exactly what filing system had been used. This time instead of weeks, what could have taken an afternoon took months of searching. An intern was even hired to go through each box. In addition to the company spending money it shouldn’t have needed to, this poor intern spent a large part of her summer doing meaningless work in an un-airconditioned warehouse. Oh, and taxing agencies don’t stop their penalty and interest clocks while you are looking for the information they’ve requested. Those clocks keep on ticking. Internal resources (the time paid for the intern, senior people at the company, and me) plus the penalties and interest all summed to tens of thousands of dollars. All completely unnecessary.
So what does this have to do with business valuation? Everything.
As we’ve written before, business valuation has to do with future cash flows of the business and the riskiness of those cash flows. Two companies with the exact same cash flows can sell for dramatically different prices. This is not just theory. We see it happen all the time. When buyers start determining what they might want to pay for a company, they start attempting to quantify the odds that they’ll get the required return on their investment. Obvious things like over-reliance on an owner or a large customer concentration will increase the risk and therefore lower the amount the buyer is willing to pay. Information management is less obvious, but just as critical.
When buyers realize that a company is poor at keeping its information straight, they start getting nervous about gremlins.
When buyers realize that a company is poor at keeping its information straight, they start getting nervous about gremlins. Is there a covenant default that the company is unaware of? Even if there is not one now, does the company’s sloppy approach mean it will be less likely to recognize such a thing in the future? What about lease obligations? Will the company miss an opportunity to renew a lease because they are not staying on top of notice duties to a landlord? And what if an audit happens? Can the company just click a few buttons, and get what is needed to an auditor? Or will this turn into a fiasco that will be thousands of dollars of lost opportunity while the team scrambles to comply with things rather than spending their time making more value for the customers? All of this will make a buyer pay less. A less sophisticated buyer might not put this in terms of cost of capital, but they will still internalize it and the proposed price in their letter of intent will definitely reflect it.
So what can a business owner do? Start fortifying your information management strategy now. This takes time and you need to get this in place long before an audit or sale of your business.
1) Require that all company information reside in a centralized, shared location that team members can easily access. No information should live on anyone’s individual hard drive. People leave and hard drives can die. Redundant cloud storage is easy and cheap these days. We like and recommend Tresorit because of its zero-knowledge, end-to-end encryption (which most competitors don't offer) and strong defenses against hackers, but many companies use Sharepoint, One Drive, and Google Drive with success.
2) Require that all support (yes - every receipt and invoice) for all accounting entries be scanned and attached to the accounting record. Most modern accounting systems have this ability. If yours doesn’t, it’s time to get a new accounting system. Quickbooks, Xero, Microsoft Dynamics, and Netsuite all make this easy. It is getting your organization to have this discipline that is the challenge.
3) For documents that have action items associated with time triggers (such as loan documents, leases, and recurring maintenance plans on equipment), consider software that will give you a heads up. As your business grows it will be impossible to keep this all straight in your head or on a spreadsheet. Software does it better. Several applications do this well. One of our favorites is Kastrack.
4) Many business owners think they are better at this than they are. They become so embedded in the business that it can be difficult to see things objectively. A deep company diagnostic can let you know exactly where you are.
Whether your company revenue is $1 million or $100 million, investments in these initiatives will yield large gains until you’ve made this a core strength. You’ll both improve the ability of your organization to react to change now and realize a much higher valuation later. If you’ve done this well, yes, you could actually have an extra pot of gold on the day you sell your business.