Rose Stabler

Selling Your Company? What Is It Worth?

When it comes time to sell your business, knowing how to enhance its value and PLANNING AHEAD are key to doing it ON YOUR TERMS.

Selling a business can be complicated and very time consuming. Since the average business sale transaction takes anywhere from FOUR TO TWELVE MONTHS, business owners need to be in the right frame of mind when they embark on the process. A big mistake that is often made is not planning well enough in advance to optimize its value and not having a strategy for exit.

THE CONCEPT OF VALUE was set forth as early as the first century, B.C., when Publilius Syrns wrote his Maxim 847: "Everything is worth what its purchaser will pay for it," or as an early British economist, Samuel Bailey wrote in 1825, "Value, in its ultimate sense, appears to mean the esteem in which an object is held." So, a closely held business may have a high value to its owner resulting from the efforts expended to build it, but it may have a lower value to a potential buyer who may be more interested in return on investment than past efforts of the Seller.

Thus, a proper valuation of a business will result from a dispassionate analysis of the firm's objective and subjective factors such as: the firm's financial condition, future income and expense risk factors, market and industry considerations, management and marketing functions, and the perceived esteem with which the business is held by its industry.

VALUATION METHODS

Two methods commonly used by BUSINESS BROKERS / INTERMEDIARIES to determine fair market value of privately-held businesses are the Multiple Method and the Discounted Future Benefits Method.

Multiple Method

The most viable valuation method for small businesses is the multiple method. This formula applies a multiple factor to the previous year or current year projected Discretionary Earnings figure to arrive at a purchase price. The Discretionary Earnings figure is a combination of several factors: Seller Discretionary Earnings (SDE) = Pre Tax Profit + Owner's Salary + Additional Owner Perks + Interest + Depreciation + Adjustments for One-Time Events. Note: Net working capital and real estate would be additive values. Typically, small businesses will sell in a range of one to four times multiple of this figure. This is a wide range, so how do you determine what to apply? In general, a one to two times multiple is for those businesses where the seller is "the business" or is "a one-man show." In other words, if the seller leaves, so too can the customers. Businesses with declining revenues, and high-risk businesses, such as restaurants, are in the one to two-and-a-half times multiple range. Three to four times multiple is for businesses that have been around for several years, have shown sustainable growth, have a solid base of clients, assets that will not have to be replaced in the immediate future, are involved in growth industries, and have expansion possibilities. Of course, there is a lot more to factor into the equation such as current economic and market conditions and the CATEGORY OF BUYER that the business will bring.

Examples of Positive factors that raise multipliers include: aProprietary products, with strong brand and/or patent or trademarkaDiversified customer base - no one customer more than 10% of sales aStrong management teamaWeak competitors and a healthy market share for your companyaProducts that are early in the Product Life CycleaAbility of the company to meet some growth with current plant and equipmentaNo pending legal or government actionaFinancial ratios that are near or above industry averages aand these OTHER POSITIVE ASPECTS.

Examples of Negative factors that lower multipliers include: aProducts that are just like competitors aOne or a few customers make up more than 25-30% of sales aStrong competitors and a weak or declining market share for your company aProducts that are near the end of the Product Life Cycle aMajor investment needed soon in plant and equipment aPending legal or government action aFinancial ratios that are below industry averages aand these OTHER NEGATIVE ASPECTS.

About the factors listed above ---if your company has one, or even a few, of the negative factors --- you are typical! There is no perfect business, but buyers will use these factors to negotiate the price down. You should address POSSIBLE PROBLEM AREAS and outline how the negatives can be overcome by a new owner. Buyers will look at the price of the business and determine if they can make sufficient profits to earn a livable salary, pay the new debt service, and provide a reasonable return of their investment. Ultimately, this is the test to see if the price and terms of any deal are reasonable.

Discounted Future Benefits Method

When forecasted future earnings can be reasonably developed, then the Discounted Future Benefits Method is often preferred by some buyers. This method utilizes one of several forms of forecasted after tax earnings over a period of five to 10 years. These earnings are then converted into a value using a present value concept. This method is more applicable to larger businesses that have stable or predictable earnings. Buyers often expect a 25% to 35% rate of return from an acquisition.

Buying A Business - Does The Purchase Price Make Sense?

When considering the purchase of a business, how do you determine if the price is sound? The following formulas can help quantify that answer.

While this is not meant to be a foolproof analysis, it can help validate the purchase price based on real-life criteria. It takes into account that you:

• need a livable salary
• will have debt payments
• will need working capital at time of purchase
• will need cash for a down payment
• should expect to receive a reasonable return on your cash investment (ROI)
• will want a safety cushion to fall back on

For a simple assessment of a business opportunity, let's assume the following scenario:

• Asking Price for the janitorial company is $500K.
• The janitorial company and the buyer are both qualified for SBA financing.
• Current Federal Prime Rate is 5.25%.
• A SBA loan can be obtained at 7.25% for 10 years.
• Working Capital needed is $25K.
• Seller's Discretionary Earnings is $178K.
• Expected Return on Cash Investment (ROI) is 25%.
• The owner is paying his nephew $20K more than a regular employee could expect to earn.
• The current owner is taking a salary of $60K.

A 20% cash injection as a down payment is a typical SBA requirement, which means $100K in liquid funds is required. Based on a $425K loan ($500K purchase price - $100K down payment + $25K working capital) at the assumed terms and by using an amortization calculator, you would find that the annual loan payment would be $59,880.

The Table for Seller Discretionary Earnings delineates the owner's total bottom line benefit as a result of owning the company. This is the total non-business related benefits going to the owner and family members on an annual basis. One-time, non-recurring or unusual expenses are typically things such as a new phone system, website development, outdoor signage or moving expenses. See the Table for other items that are used to arrive at SDE.

Fair market wage is an amount that the owner would pay a hired employee for a particular job. For instance, if the owner has been paying his nephew $40K for a job a new hire could do for $20K, the excess wages of $20K would be added to the benefit column in the SDE Table. As for paying yourself a salary, you can determine what you consider fair wage for what your role would be in the company -- or you can put all of the other numbers into the equation and see what is left for salary. If it adds up to your satisfaction, then so far....so good.

ROI for the purposes of this exercise is calculated by multiplying the cash investment by a reasonable interest rate that should be expected on the investment. This is a subjective percentage and a change in this number can substantially change the result of the analysis. Investment options, such as putting your money in U.S. Treasury bonds has little risk, therefore only 4.5% interest is received. The stock market option, on the other hand, has a higher risk with a higher average ROI of 11% (source: Ibbotson Associates). Venture Capitalists investing in risky internet start-up companies might look for 45%+ ROI. None of these options, however, puts the investor in the driver's seat -- there is absolutely no control over the performance of the funds in which they invest.

Historical data indicates that a 25% ROI is reasonable for a medium to low risk small business acquisition. The greater the risk of the business, the higher the rate of return should be.

As evidenced by the 25.8 million small business owners across this country (source: US Small Business Administration), there are many people who choose to have complete control over the ultimate success and performance of the money they invest through business ownership.

Let's plug all the numbers into the Final Analysis Table to determine the soundness of the purchase price of the business opportunity at hand. The return on the cash investment was calculated by multiplying $100K (cash down payment) by 25%.

After deducting wages, debt service, and a return on your cash investment from the earnings, the business still generates $33,100 in additional funds to take vacation with the family, or increase marketing efforts for the business. You almost have enough to hire a manager to run the business for you. Now would you buy this business under these circumstances? It would appear, yes! Of course this is a simplified assessment and not all factors are considered, such as growth potential, equipment condition, and other issues that should be considered when determining risk and working capital that might be needed to keep the company viable and growing.

Inc. Magazine - "It's a Seller's Market for Buying Businesses."

It's all about supply and demand.

Potential buyers and sources of capital for the acquisition of profitable privately-held companies is plentiful while the supply of businesses on the market is not. This makes a profitable, established business a hot commodity and in demand. Inc. Magazine spells it out in this month's issue, "The Most Valuable Businesses in America."

During my first conversation with Darren Dahl in February, in preparation for his writing the article for Inc. Magazine, he wanted to understand what drives the value of a business and why some businesses are more desirable than others. I first described the Houston marketplace, which enjoys one of the top economies in the nation. Location, location, location is always a value driver, and a business location is no exception. I've been writing about Houston's hot economic climate for over a year now and told Mr. Dahl that Houston is a "bulls eye" target for business acquisitions because of it. We cannot satiate the marketplace of buyers because there are not enough businesses currently for sale.

Good businesses are in short supply. The number of buyers looking to buy a business far exceeds the number of businesses available. So when a new business hits the market it will usually sell very quickly if the owner's expectations are realistic, if their financial history and data are upward trending and in good order, and is marketed properly. We have buyers lying in wait for businesses such as these and are ready to act quickly when one comes along. They know that if they don't pull the trigger, they will miss out to someone else who will.

One of our "Serial Entrepreneurs," as described in Inc.'s article, agreed to a conference call with myself and Mr. Dahl, and pretty much described what makes him tick and what he looks for and why. Entrepreneur Gary has been working with Don Piercy, one of our staff of professional brokers, for several years and has four businesses in his collection and is currently in the process of acquiring his fifth. We thank Gary for taking time out from his very busy schedule to share his viewpoints.

In continuing the issues surrounding value, while a price tag can certainly be put on any item for sale, including a business, price doesn't mean value. Value is in the eye of the consumer. It is the perceived benefits that the business represents to the market of buyers that makes it valuable. Perceived benefit, or value, looks different depending on who's looking. And, ultimately, the price that will actually be paid will be determined depending on how MANY are looking. Which means if lookers are plentiful, demand is high. The price will reflect that demand.

I further explained that while the reasons that business owners of small privately-held enterprises sell do not vary significantly, the reasons for buying do. I described the various categories of buyers and their respective acquisition criteria and told Mr. Dahl that the price each type of buyer is willing to pay directly correlates to their motive for the acquisition. This is why it is important for business owners to know who the most likely buyer would be for their company prior to going to market.

It was then that Mr. Dahl decided to focus his article on the buyers rather than on the attributes of the business. Inc. Magazine's article covers the U.S. market as a whole and does not describe all buyer types. But it definitely describes the current Seller's Market that exists for profitable businesses for sale today.

In closing and of particular relevance, is that 8,000 Americans are turning 60 every day, which means about 20% of businesses owned by boomers will be on the market within the next couple of years. About 60% to 70% will be exiting within a decade, which means we will experience what is expected to be the greatest wave of business transfer activity in U.S. history. The future large-scale baby boomer exit will make for a buyer's market for businesses rather than the seller's market that exists today.

Not only is this important for those owners of small businesses who are considering their exit, it is essential to the economic vitality of our country that these firms successfully transfer to new ownership. The estimated 25.8 million small businesses in the United States have a huge impact on our economy. Outlined below are powerful statistics that speak to the importance of the continuity of these enterprises. Small businesses --

• Have generated 60 to 80 percent of net new jobs annually over the last decade
• Employ 50.6 percent of the country’s private sector workforce
• Represent 97 percent of all the exporters of goods
• Represent 99.7 percent of all employer firms
• Generate a majority of the innovations that come from United States companies

Source: U.S. Small Business Administration