How many times have you heard a business owner say, “I’ll sell this darned thing to the next person who walks in the door”? Just as often, you have probably heard a prospective buyer say, “If only I could find the right business, I would buy it in a minute.” Best estimates indicate 2.5 million small businesses change hands annually, meaning that one in every fifty Americans either buy or sell a business each year. Although quite minor in comparison to real estate or security transactions, sales of businesses represent an important and ever-increasing element of today’s economy.
I am always amazed when I hear energetic and creative people reject investments in small businesses based on excuses like: “no good opportunities exist” or “I have no training in that field.” More truthful reasons would be “too much risk perceived” or “a small” business is too unstructured for my comfort level” or “I don’t really understand how to value or buy one.” This article will address the complex and confusing world in which entrepreneurs buy and sell their companies. The imperfect nature of business valuation will be discussed along with the illiquid secondary markets in which small business sales must find a home. Please keep in mind the valuation portion of this field is more of an art than a science. Further, keep in mind that your author is a “working stiff” earning a living selling businesses rather than writing about marketing techniques.
Understanding Buyer and Seller Motivations
Sellers never really seriously consider selling when everything is going great. Buyers never buy unless they are convinced they can out-perform a previous owner. The true reason for selling must be the first piece of information obtained by the prospective buyer. Likewise, sellers can obtain top value and favorable terms if they fully understand a buyer’s needs, abilities, and sincerity level.
Obtain Credible Financial Information
You don’t go hunting without a gun, and likewise shouldn’t seriously consider buying a business without first obtaining credible financial statements. Tax returns will always supply minimum gross sales and net income, but suffer from the same defects as any other financial statements prepared “in-house” when it comes to co-mingling of personal expenses. These vital documents need to be adjusted (normalized, as it is known in the industry) to reflect results if the business had been independently managed. Income statements must frequently be adjusted because of a failure to totally report sales, excess perks, salaries to self and the amount of assets and working capital needed to operate the business. As we will see later, a restatement of the balance sheet to reflect current fair market asset values is also an important adjustment in most sales of small businesses.
Analysis of Financial Information and Trends
A buyer is primarily interested in future profits. But an analysis of historical trends is the starting point for forecasting the future. Observing trends and obtaining specific reasons for extraordinary results is the most important element here. A proforma income statement using your new debt service and operating costs and the former owner’s gross sales and margins generally gives the best results. Don’t forget to include additional working capital for the cash usually taken out of the company by the departing seller. Since most businesses do not show a stunning financial history, don’t throw in the towel at this point if you are still bullish on the company’s future due to qualitative reasons.
Most business owners have misconceptions of their real value to the company. You must find out if the owner can be replaced without a substantial loss in business. Sometimes, a change in ownership will bring back lost customers, but there are times when the current clientele has a special relationship with the current owner and they will disappear when ownership changes. In addition to in-depth and frank discussions with the owner, a buyer should interview the companys key personnel, suppliers, competitors, accountants and bankers. If such interviews are not possible, in-depth industry research or reliance upon the analysis of a broker is important.
Special attention should be given to understanding the unique market niche this company possesses. You must be convinced this advantage will continue after the transition to new owners. It is important to find out who really does the work in the company. How are the assets being used? How much can sales be increased with more intensive use of existing assets and personnel? Have your attorney review the company’s supplier and sales contracts, and all leases and loan covenants.
Determining the Actual Value
Now the tricky part begins. In its simplest form, there are only two ways to value a business. One involves “capitalizing” the net income stream the business is expected to generate. That involves expressing in terms of one lump sum how much that income stream is worth. The other requires that you assign a dollar value to the company’s assets. The only universally accepted method of valuing a business is outlined in Revenue Ruling 59-60 of the lntemal Revenue Code. Unfortunately, this guideline is very broad and vague and applies only to corporations which constitute less than five percent of all businesses sold. The best business appraisals use several valuation methods and then compare the results using common sense to decide which of the methods ought to be given more weight in the particular situation.
A popular valuation concept is known as the “Excess Earnings Method.” This type of valuation gives weight to both the company’s earning potential and its asset base. Intangible or goodwill value (over and above the value of the actual assets) is allowed, but only if the goodwill component is deserved due to profits in excess of reasonable returns.
Goodwill is not a reward for funding losses or start-up costs. It is not a payoff, at the expense of the new owner, for long hours at low salary, or a company without debt, or one with fully depreciated assets. A legitimate mistake most sellers make is thinking they should be rewarded for profitably running a business which has not paid them a fair salary or a return on investment of the company’s assets. Payment to you and adequate return on your years of invested capital must occur before you can fairly say the company is a real winner that deserves an excess goodwill payment.
When it comes to turning that expected stream of net income into one lump-sum value, an important decision you face is choosing the correct capitalization rate. That is, choosing the correct rate of return you need to receive on your investment. Most buyers and sellers make value decisions based on emotional reasons rather than sound financial analysis. If that expected income stream has a lot of risk associated with it you must increase the required rate of return. That’s why low-grade bonds pay higher interest rates because in buying them you are facing a risk that the bond issuer will default. For example, if you are buying a company whose only assets are U.S. Government Treasury Bills, you could capitalize its net income at seven percent (or conversely multiply net earnings by 14.3 times) to arrive at a value you would pay for that company. If the company’s sole assets and returns were based on holding New York Stock Exchange stocks, that capitalization rate would be 15% (a multiple of 6-2/3 times earnings to be used), which reflects the approximate long-term New York Stock Exchange return. Such returns are higher on average, but far riskier in the individual case.
Venture capitalists look for returns from 25% to over 50% annually on passive investments in start-up companies. This wide risk/return range supports the finding of more knowledgeable brokers and business appraisers that a capitalization rate of between 20% and 40% (earnings multiple of 2-1/2 to 5) is appropriate in valuations based purely on capitalizing earnings. Use of the “Excess Earnings” method requires an even higher capitalization rate since the majority of that method’s valuation comes from the asset base and the goodwill is intended to be only the “icing” on the cake.
No valuation is complete until you stand back from it, apply your common sense, and determine if the result is realistic.
Preparing the Company for Sale
The fact that businesses are hard to sell and qualified buyers hard to find artificially reduces the fair price buyers should receive for a business. Likewise, buyers tend to shy away from a purchase if the payback period extends over seven years or if the down payment is prohibitive. This leads up to the all-important concept: Price Does Not Equal Value. You won’t get full value for your company unless you market it properly. As we found out during the recent stock market crash, every investment must be sold at the right time to realize the best return. A small business is no different. Unfortunately, most small business owners do not time the sale of their businesses very well. Since 95% of all businesses are sold for reasons outside the control of the owner, it is not surprising that most owners are ill-prepared for the transfer.
Most businesses terminate due to financial insolvency. A sale of an insolvent business is improbable because there is nothing of value to sell that will generate on-going income. Divorce, partnership dissolution, and inability to continue due to health or age account for the balance of small business transfers. In my experience, few businesses sell because their owner desires to “strike it rich” by selling at the right time.
You would think successful entrepreneurs would be better prepared to face the inevitable sale of their small business, yet that is not the case. People do not plan for a transition because they feel it is too remote or because “business is too good to think about selling.” The more successful a business has been, the more difficult it is for the owner to conceptualize himself or herself away from the business.
The highest value will be realized for a company if a logical and well-supported plan for its sale is formalized. First realize that there is no substitute for accurate record keeping in the years just prior to a sale. The less footnoting and explanation you or your broker need to make to a new purchaser, the better your chances of creating a “believable” scenario about the future success of the business. Don’t expect a buyer to treat you fairly and with compassion if you have not treated the government fairly with tax payments or if you have suspect dealings with your customers or suppliers.
Remember that a purchaser is not buying your past profit history. Your established system and unique market niche is what the buyer really wants. The best method of selling a business is to show a new buyer how he or she can pay for the purchase out of the first five years of company cash flow.
Keeping the Sale Confidential: The Big Myth
Like excess touching of a flower arrangement by curiosity seekers, too much exposure will certainly damage the flower of a small business. On the other hand, good exposure to the light of day, a healthy pruning and a strong dose of fertilizer could be just what your small business needs to make the public aware of it.
Sellers are genuinely concerned about damaging their business by letting the public know it is on the market. In my experience, most damage is not caused by the business being for sale (everything is for sale if the price is right), but rather by the seller’s obvious loss of interest in the well-being of the company. Rare is the individual who can continue full steam ahead with business while at the same time forging into the totally new area of selling that business. The time commitment, frustration, confusion and personal rejection associated with the negotiation process will damage day-to-day operations. If you are going to sell it yourself, I suggest you plan properly by notifying key personnel, customers, suppliers, and your accountant. Rumors of businesses for sale circulate wildly, so use that medium in a manner most advantageous to you.
Sellers of businesses are at an extreme disadvantage versus buyers. Buyers always fit into two classifications: (1) Someone looking to buy a job, or (2) sophisticated investment purchasers. It is not uncommon for a buyer to look at ten different companies before buying one. As a seller, on the other hand, you sell a business once in a lifetime. You might know your business, but you probably aren’t current on the negotiation and marketing process for the sale of that business. Since buyers desire to pay the minimum for your company, the only chance you have to obtain a premium price is to package your business well. Your ability to project a positive future image will be bolstered by outside professional advisors.
Some closings are so complex the participants don’t realize they are over until the legal bills arrive. Others are simply concluded by a handshake and an exchange of the front door keys. A good attorney will protect you as necessary yet not lose sight of your bargaining position in the transaction. The attorney’s major role will be to insure that you (the buyer) receive a clear title and are adequately secured in any note which will be carried back. Assets and liabilities to be included in the sale, warranties, collateral, future relationships, default procedures and other standard items will need attention. Legal problems often occur in that gray area between oral acceptance and final contract signatures. As Texaco, Inc. found out in its litigation with Penzoil, the pop of a champagne cork can manifest enough intent to bind the parties by oral agreement for the sale of a major company. Be cautious in your preliminary negotiations and seek counsel prior to final closing.
It’s Not Over ‘Til It’s Over
Unless you are one of the 25% of business sellers who are fully cashed out, you will need to carry some form of indebtedness on the company you have sold. Horror stories abound about retirees called from the golf course to run devastated companies they formerly owned. Most of these tales are exaggerated and could be prevented by better structuring of the sale. If you sell a business for an exorbitant price and too little down, you probably will get it back because the debt load will be too much for the new owner to bear. The best transactions have a reasonable enough down payment to ensure a commitment level by the buyer, a secured note to create an annuity for the seller, and a variable earnout to reward both buyer and seller for a smooth transition of the business. Unrealistic expectations over terms kill more deals than price negotiations.
There are no absolutely right answers or strict rules in the world of business sales. There are only good methods and techniques which will answer the key questions about the future success of that company. Sellers should not deceive themselves about their company’s real value and should be realistic about the pressure they are receiving to sell. The seller should understand that there is a small number of potential buyers who are financially and professionally qualified to run their business.
The best transactions are structured in a way which gives immediate cash flow and long term financial reward. A good transaction will create a tax-favored retirement annuity for a seller along with the personal satisfaction of knowing the business will continue with competent management. If done right, the process of changing ownership of a small business can be satisfying and a “win/win” situation for both buyer and seller.
Art Berry is presently with Arthur Berry & Company, Inc., a firm specializing in the valuation and sale of small businesses and commercial real estate. He holds a bachelor’s degree in finance and a master’s degree in business administration from Boise State University. He also serves as an adjunct faculty member at the [Boise State University] College of Business.
Continue at: http://www.arthurberry.com/valuation2.htm
The text above is owned by the site bellow referred.
Here is only a small part of the article, for more please follow the link