Why is this so important? Please think about it from the buyer’s perspective. You have 100% of the knowledge, history and experience with your company and they have NONE.
They have a very short period of time to evaluate your company and to conclude whether they should walk (run) away or engage further.
The quickest macroscopic litmus test they can perform is to evaluate the economics of your business model. How are margin expectations set and managed?
A favorable answer could present like this:
- We price our products and services with a target gross margin of between 35% - 40%.
- We model our cost of goods prior to pricing to ensure that the proper cost inputs are factored in.
- We review our cost factors on a monthly basis and make proactive revisions.
- We do a final economic analysis to determine the actual gross margin achieved.
- We have a hard cap on SG&A of 15%.
- Our entire organization is focused on achieving a 20% bottom line.
An unfavorable answer could present like this:
- We would like to achieve a 25% “profit” (completely unclear as to whether this is gross profit or bottom-line profit.
- We are not big enough to have an estimating department and a purchasing department.
- My team is pretty good about understanding customer needs and ensuring that we are highly competitive in the market.
- We strive to get every bit of business that we can so we lower our prices when necessary.
- I am not sure that we have SG&A numbers.
The first answer gets an A+ from the buyer and they immediately start thinking that this is a company with a culture that would fit in great.
The second answer gets an F and suggests complete incompetence. The buyer will conclude that any profits achieved are due to a unique product or service or is relationship based.
Which response do you want your company valuation based on?
Real Life Example – I bought a company in health care sector that covered 800,000 covered lives. In this example, revenue is generated based upon a fixed rate per member per month (PMPM). The company charges a fixed rate and they have to pay all costs out of the revenues.
I asked the doctor why he just raised the PMPM from $12 to $15? His actual response was “$12 was not enough”. I calculated breakeven at $18 per month. Hence, he just signed a new contract to lose 86,400,000 (800,000 x 3 x 36).
This should be all the encouragement you need to prepare your margin response!