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The Complete Guide to
Business Valuation
when Buying or Selling a Private Company
By: Theodore P. Burbank, FIBBA, CBI
Parker-Nelson Publishing
17 Causeway Street
Millis, MA 02054
Telephone (508) 794-1200
Copyright 1992-2011 by Theodore P. Burbank
ISBN 9780964523753
ii
iii
This work has been written and published in order to provide insightful
and accurate information regarding Valuing a private or family business.
Although the information and data is accurate, the author and publisher are
not qualified to render legal or accounting advice.
One should not use this book as a substitute for competent and qualified legal
or accounting advice.
For the sake of convenience and consistency and because the English
language lacks sufficient gender neutral pronouns, we have used the pronoun
―he‖ throughout this book when a referring to a person generically
Copyright Theodore P. Burbank
All rights reserved under the Pan-American and International copyright
conventions. This book may not be reproduced in whole or in part, in any
form or by means mechanical or electronic, without written permission from
the author.
ISBN 9780964523753
Parker-Nelson Publishing
17 Causeway Street
Millis, MA 02054
Telephone (508) 794-1200
Email [email protected]
iv
Dedication
This book is dedicated to the memory of my good friend and colleague
John C. Dee whose friendship, counsel and encouragement inspired
this writing. May he rest in peace.
v
Introduction
Very few full time professionals are engaged in the activity of buying,
selling and valuing smaller companies (companies with revenues or sales up
to $20 million). Therefore, very little ―marketplace based‖ information is
available on the subjects. Scholarly treatises abound. However, their
academic perspectives are generally inappropriate when transferred to the
―real world‖ of smaller business.
This book is unique in that it is based upon experience gained in valuing
and/or selling over 2,000 businesses. Although produced primarily for
owners of private companies, the information it contains, is however, just as
appropriate for advisors to smaller companies and those attempting to buy
same. It is also the first work of its kind written in conjunction with an
interactive business valuation software program (VALUware). You do not
have to own the software to gain value from the book. However, VALUware
will make ―crunching the numbers‖ less tedious and automate the hundreds
of calculations typically required to produce meaningful results.
Decisions to buy or sell a business involve a difficult balance between the
personal motivations and financial realities. Thoughts of selling are often
stimulated by desires for a life style change. ―I want my life back‖ can often
summarize the personal motivation of business owners considering sale. On
the buy side, motivation usually center on issues of control. ―I’m tired of
making money for someone else.‖ or, ―I want to do-it-myself‖ are commonly
expressed buy side motivations. Money is important, but not the principle
motivation. Advisors however, generally counsel purely from a dollar and
cents point of view. This can prove harmful. With this book you will gain an
understanding of the personal and financial dynamics involved in buying,
selling, or valuing a small business. This information will help you balance
your personal motivations, the perceived financial rewards, and the risks of a
transaction.
Buy or sell decisions should be based upon complete and accurate
information. This information can be obtained one of three ways: a) engage
professional advisors, b) educate yourself (buying this book), or c) enter the
fray and learn the hard way. Our experiences suggest most buyers/sellers
choose the latter -- with disastrous results. You can choose to play the game
without knowing the rules but, will you win? A life time of experience buying
and selling will not prepare you for buying or selling a business. The rules
are different. The unique rules that apply to business sales are explained
fully with many case study examples provided.
Ever wonder if you could command the ―big money‖ others reportedly receive
upon sale of their business? As a buyer, do you wonder if sellers really expect
you to pay their ridiculous asking prices? The following chapters should
vi
provide you answers to these and other questions. In short, however, only
the right buyer will pay the right price.
Businesses and buyers can be segmented into types or groups. A business
may be worth millions to one buyer and deemed worthless by another. This
is the only book written that describes the different groupings and explains
the attendant value swings. Armed with this information you should be able
to increase the value of your business, or the business you purchase, without
significant changes to the balance sheet or income statement. Scores of value
enhancing tips are revealed in the following chapters. Value Creation
techniques need not be reserved for Public and large companies alone.
Fair Market Value vs Fair Cash Value
Knowing the difference between the Fair Market Value and the Fair Cash
Value of a business is important if you expect to complete a purchase or sale.
Why there is a difference between the two values is explained and detailed by
example. This information can be critical when setting up buy-out
agreements, in divorce settlements, and estate planning.
Transaction structure is as important, if not more important, than price.
Fairness is the test of a solid transaction and expectations of fairness will
vary by business and buyer type. Examples of how to measure transactions
against realistic expectations of fairness are provided.
A complete understanding of motivations and realistic expectations (buyer
and seller) are required for a ―win-win‖ transaction to evolve. Therefore, the
first half of this work is devoted to the motivations of buyers and sellers. In
the second portion, motivations and expectations are inter-woven with ―the
numbers‖ to produce an array of values that are segregated by buyer and
business classifications/types.
Our research, and that of others, indicates the majority of once viable
businesses will eventually just close the doors and liquidate their assets! If
this is true, and if our nation’s economic health and growth can be directly
tied to the success and vitality of small business, then a major tragedy and
well kept secret has been identified.
This book is written with the ardent desire to assist small business
owners (and owners to be) in maximizing the time, energy, and money
invested in their businesses. It will address the many questions you
have to face if you are to cash in when you cash out
vii
Table of Contents
Page Number
Introduction
Chapter 1 You can’t be fired but you can’t quit either
Expectations regarding business continuation 2
What really happens 2
Expectations vs reality 3
Why most business do not transfer 3
Most businesses can be sold 3
Obtain necessary information 4
Common reasons for sale 5
One minute quiz for business owners only 6
Chapter 2 Don’t let anyone know it’s for sale but sell it quickly!
Sell it but don’t let anyone know it’s for sale 9
Don’t know what the business is worth, but
I know what I want for it. 10
Ask twelve people and you will get twelve
different answers 11
Future of business is dependent upon who buys it 11
Light manufacturing or distribution 11
Third parties refuse to ratify the wisdom of
the purchase 12
Selling is a personal decision and not purely
a financial matter 12
What business person complains they have
too many customers? 13
A business is to its owner as a child is to its parents 13
Chapter 3 All the right things are wrong!
Highest and best use 15
Motivation 15
Alternatives to buying a business that
satisfy motivation 16
Combining highest and best use with motivation 17
View your business from the outside in 17
Chapter 4 Value, as with beauty, is in the eyes of the beholder
The saga of the rusty dusty Ford 19
What is your business worth? 20
viii
Chapter 5 Types of buyers and what they will pay
Opportunity vs potential 23
Strategic acquiror 24
Sophisticated or corporate acquiror 25
Financial buyer 28
Industry buyer 29
Chapter 6 Types of businesses and what they may be worth
Size of company 31
Product or service 32
Importance of the owner 32
Profitability and perception of future profits 33
The four major business classifications 34
Wall Street 34
Main Street 34
Upper Main Street 35
Middle-market or Limbo 35
Types of business or market served 36
Chapter 7 How to identify the “right buyer”
How to find ―Mr. right‖ 37
Profile your business 38
Profile ideal acquiror 39
Buyer profile and value 40
Chapter 8 What do you do after you decide to sell?
Help, where to find it 43
No one understands my business the way I do 45
When business owners attempt to sell on their own 47
Chapter 9 Is it an offer you can’t refuse?
Type of buyer 49
The fit 50
Resources 50
Chapter 10 Dealing with the financial buyer
The envisioned method 54
Why conventional methods do not work 54
The safe and effective selling process 56
The buying process 57
Summary 58
ix
Chapter 11 Main Street business, sophisticated buyer
Why many sophisticated buyers avoid
―main street‖ businesses 60
Attracting sophisticated buyers to a
―main street‖ business 61
Positioning your business for the
sophisticated buyer 62
Chapter 12 Bottom line or between the lines?
Balance sheet adjustments 65
Adjustable balance sheet elements 66
Sample adjusted balance sheet 67
It’s not what you see, but how you see it 68
Adjusting historic ―bottom line‖ results 69
Recasting or normalizing financial statements 70
Non cash adjustments 70
Non reoccurring expenses 71
Discretionary expenses 71
Negative adjustments 72
Example of Income Statement adjustments 73
Non financial elements that affect value 74
Outlook for the industry 74
Outlook for the business 75
Outlook for the market served 75
Regional or local outlook 75
The opportunity 76
Reason for sale 76
Summary 77
Chapter 13 How to increase value without increasing profits
Transferability of skills 80
Bankability and records 81
Information beyond the financial statements 81
Industry concentrations 82
Margin maintenance 82
Identification of buyer fitting
the opportunity 83
Prepare credible projections 83
Stability of tenancy 85
Professional assistance 85
Perception of risk 86
x
Chapter 14 Assessing risk
What is a capitalization rate? 87
Alternative method of determining a
capitalization rate 88
Summary 91
Chapter 15 Earnings computations, varying views
Industry buyer 93
Financial buyer 93
Sophisticated or corporate acquiror 95
Projections ? 97
Chapter 16 Valuation example
The company 99
Buyer identification 100
Summary of values 101
Exhibits
Comparative balance sheet 103
Comparative income statements 104
Comparative analysis of selected ratios 105
Interim income statement 106
Sales history by month 107
Chapter 17 Industry buyer valuation methods
Book value method 110
Adjusted book value method 111
Liquidation value method 112
Summary of values 113
Chapter 18 Financial buyer methods
Discretionary earnings computations 116
Weighted income computations 117
Basic method 118
Discretionary earnings method 119
Debt capacity method 120
Comparable method 121
Cost to replace 122
Multiple or weighted value method 123
Chapter 19 Methods used by corporate and sophisticated buyers
Summary of classifications 125
Favorite methods 126
Business risk worksheet 127
Projections 129
Income computations 130
Excess earnings 131
xi
Present value computations 132
Discounted present earnings 133
Discounted projected earnings 134
Capitalization of income 135
EBIT methods 136
Summary of sophisticated buyer methods 137
Chapter 20 Strategic acquiror methods
Comparison with public companies 140
Computation of earnings 141
Converting earnings for public company
comparison 141
Comparison methods 142
Summary of values 144
Chapter 21 Fair market value and fair cash value...
what’s the difference?
Valuation results may mislead 145
Case study 147
Calculate the cash value 148
The facts as supported by comparable sales data 149
Chapter 22 Financing and value attainment
Amount of financing available 152
How much might a bank lend for the purchase
of your business? 154
Will the business qualify for a loan? 155
Bankability worksheet 155
Do you want a bank to participate? 157
Chapter 23 Transaction structuring and value justification
What’s the cash price? 159
Terms or cash -- which do you prefer? 161
Summary of all cash value computation 161
Buyer expectation 162
Value justification 163
Buyer’s view of fairness 164
Chapter 24 How a savvy businessman sells his business
The winning strategy 165
Summary 168
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Chapter 25 Ratio analysis and value 173
Chapter 26 Ratio Analysis and comparison with industry 179
Chapter 27 Subtle factors that have a dramatic impact upon value 183
Glossary 189
Quiz for business owners only 197
Chapter 1
You Can’t Be Fired But You Can’t Quit Either.
he decision to sell, or not to sell your business is a difficult one. There are many
many questions that need to be answered before an informed decision can be
made. Is selling your best alternative? Will one of the kids want to take over the
over the business? Timing is everything. Is now the right time? You do not have to
sell or decide right now. You are quite busy so maybe you will look into it after. . .
Facing the issue of succession or continuation of one’s business is very much akin to
addressing the need for life insurance. Neither subject is addressed with much
enthusiasm by the average person. The prudent address the inevitable and prepare.
Although only one eventuality exists for us as individuals, three exist for our business:
Transfer to family, sell to outsider, or close down.
As with the purchase of life insurance, the decision to sell or plan a viable business’
succession can be continually postponed. Unfortunately, when a business must be sold
it usually is too late. Few people are willing to buy a business that has to be sold. Of
the hundreds of business transfers we have facilitated, less than a handful could be
classified as sales for ―desperate sellers.‖
How have other business owners addressed the continuation of their business?
Actually very little is known or documented regarding the succession of private and
family businesses. The information available usually pertains to very large companies.
Data regarding smaller business transfers and succession is generally not available.
What are business owners’ expectations regarding succession or
the continuation of their businesses?
Massachusetts Mutual Insurance Company sponsored a telephone survey of 614
owners of family businesses grossing two million or more in annual revenues. The
survey, conducted by the Gallop Organization and designed by Mathew Greenwald &
Associates was completed in September 1994. Although the majority of private
T
2
companies are considerably smaller than the sample (the companies had an average
of 50 employees) the opinions of those surveyed should be representative of most
business owners.
Questions related to succession expectations revealed: 65% plan to pass the business
on to family members or other relatives, 24% do not plan to pass to family members,
and 11% are undecided. Only 7% plan to sell or liquidate and 1% plan to pass the
business to someone outside the family. Seventy-five percent do not have a written
succession plan.
MassMutual reports that their survey is the largest of its kind ever undertaken and,
since the report’s release it has been hailed as ―the most comprehensive piece of
information on family business ever produced.‖
What really happens?
Franchisors are perhaps the best source of information on many issues relating to
small business operations as they are intimately and contractually involved in the
franchisees’ affairs. The franchisor is therefore an excellent source of information on
what happens when a franchisee decides to ―move on.‖ Do their franchisees go in and
out of business happily?
Data compiled by Quick Printing (a magazine for commercial printshops and
copyshops) may provide insight as to what is actually occurring, not only with
franchised print shops, but also private and family businesses in general.
More than 5,000 print shops were represented in the survey. Of that number 302
closed their doors and 93 sold. Three businesses closed for every one that sold! Of the
395 franchisees that ―moved on‖ (eight percent of the total) 76.5% went out of business
whereas only 23.5% transferred to someone else.
John H. Brown, author of ―How to Run Your Business so you can Leave it in Style‖
illustrates the conflict between business owners’ expectations for the continuation of
their businesses, and the reality of what actually happens.
Expectations Vs Reality
Expectaions Reality
Transferred to family 50% 15%
Sold to employees 30% 5%
Sold to outsiders 10% 10%
Sold to competitors 10% 10%
100% 40%
From an address to the International Business Brokers Association
The above data substantiates that reality is in direct opposition to the expectations of
the MassMutual survey participants. Although the overwhelming majority of
business owners wish for their businesses to continue, most businesses will simply
close down.
3
Small business is continually credited with providing most new jobs, more than half of
our gross domestic product, and perhaps 65% of all wages. Small business is the
backbone of the US economy. A mortality rate of 75% among this most important
group is a national tragedy.
Why Most Businesses Do Not Transfer
The largest single reason that most businesses are not sold or transfered seems to be
that the owners never made the decision to do so. If you do not make the decision to
sell or select a successor, outside forces will eventually combine to determine the
ultimate fate of your business. In defense of those who have not been able to come to a
decision regarding business succession, we offer the following:
1. Business owners know they are missing some important information.
2. To take action without a full understanding of ―the rules of the road‖ would be
foolhardy.
Most Businesses can be Sold
Our experience, gained in assisting more than 1,500 business owners with succession
decisions and business transfers, indicates that 90 plus percent of all businesses can
be sold if:
1. Ownership fully understands the unique environment in which businesses are
sold, and therefore avoids the costly mistakes of employing traditional sales
methods to sell their business.
2. Ownership recognizes the natural cycle of business ownership (a time to grow
and a time to go) and makes a timely decision to sell.
3. Those involved in the decision understand that personal and not purely
financial factors are involved.
4. The company is properly prepared for sale before marketing efforts begin.
5. The ―right buyer‖ and the optimum price are identified before going to market.
A timely decision to sell, coupled with proper preparation and a comprehensive
understanding of the unique rules and selling environment, is required for a business
to transfer successfully.
Obtain Necessary Information
―I am considering the sale of my business‖ is the initial phrase we hear most often
from business owners. Very few will tell us they have decided to sell. This is
understandable as information is required before an informed decision can be made.
Those that do proclaim to have decided to sell, generally have waited too long, and
have nothing left to sell. Life insurance agents are not enthusiastic when someone
calls out of the blue to buy life insurance. Ninety-nine times out of one hundred that
person has just left his doctor’s office with the bad news. You cannot buy insurance on
a burning building. You cannot sell a business for an optimum price when you are
compelled to sell. You can, of course, always liquidate or give the enterprise away. Is
that what you would choose to do?
4
Information Needed
The following are the questions most commonly asked when selling is considered:
What is my business really worth?
How can I find the right buyer and still maintain confidentiality?
Is the timing right, is now a good time to sell?
How long does it take to sell a business?
Are there buyers out there with the money I want?
Will I have to finance part of the sale?
If I do, how can I be assured that I receive my money?
What would I do after I sold?
How much money would I have after the sale?
What is an ESOP? Is it something I should consider?
What would I do if I could not get my price?
Perhaps a big company would buy my business. Would I have to stay on for
long? Would they keep my employees?
What expenses are involved in selling ?
What kind of investigation will a buyer want to perform?
The following chapters address many of these questions and will give you an insight
and an overview of the marketplace for private businesses, and what you can
reasonably expect—should you decide to sell.
What is important to remember is that the timely decision ―to do something‖ with your
business is the single most important factor impacting your ability to cash in on your
investment in your business. You cannot wait until you are compelled to sell. Waiting
for an offer you cannot refuse to come out of the blue usually happens only on TV.
Common Reasons for Sale
The reasons most often given for wanting to move on revolve around ―life-style‖ issues
such as:
Retirement
Health considerations
Relief from the ―burden of ownership‖
Boredom with the business
No time for the rest of my life
Burned out, tired, need a rest
Business demanding what I can’t or don’t want to provide
It’s not enjoyable anymore.
Things and people are constantly changing. The one constant of life and business is
that things will change. There is no such thing in business as status quo—it’s either
up or down, grow or go—no status quo. Best to consider getting out when things are
on the upswing rather than the down.
5
If you are considering doing something, you have to approach the decision in the
appropriate manner. It does not matter what the decision. The decision must be
approached in the right sequence. Ready, Aim, Fire. Not Fire, Ready, Aim. In our
instance the sequence must be Decide, Choose, Act.
When it comes to deciding what to do about your life and your business the most
important thing you can do is to resolve to do something. Reading this book is perhaps
an excellent first step. Congratulations.
Organize your questions. Get the answers. Weigh your options. Choose the
alternative that suits you and your situation best, then act. The quiz found on the next
page is for business owners only. It may help you decide if preparing your business for
sale is a timely thing for you to do.
6
A One Minute Quiz for Business Owners Only
ircle your answers to the following questions, then turn the page to see how you
you scored.
1. Is your business less enjoyable now than before? Y N
2. Does your business challenge and excite you less than before? Y N
3. Do you think of selling your business more often now than
you did before? Y N
4. Do you find yourself complaining more lately? Y N
5. Has the business come between you and your loved ones? Y N
6. Has your business begun to level off or decline? Y N
7. Are you concerned you no longer have the stamina your
business requires? Y N
8. Do you ask yourself ―What would I do if I sold?‖ Y N
9. Do you often wonder ―What is my business worth?‖ Y N
10. Would you be hesitant to personally guarantee a sizable
loan in order to grow your business? Y N
C
7
The question: Is now the time to sell my business?
To determine your answer, count your yes answers.
0-3 Yes
Congratulations! You are happy and probably quite prosperous in your
business. Keep it up.
4-6 Yes
Pay attention to your ―early warning signals‖! It’s best not to make the
mistake of staying too long! Sell while you are still having fun. Best to start
the preparation process early. The actual sale of a business can take a long
time.
7-10 Yes
Do not let time spoil the fruits of your labor. Most great men and women in
history have had more than one career. Time for you to decide that you want
a change. Choose what you want to do next, then act.
It’s either Grow or Go -- There’s no Status Quo.
8
When you have a choice and don’t make it,
that in itself is a choice.
9
Chapter 2
Don’t Let Anyone Know It’s For Sale But Sell It Quickly!
amily and private businesses are sold under very unique conditions. In fact, the
the environment and rules differ from the disciplines of selling anything else
you can imagine! Although the sale of a business is different from the sale of
of most anything else, what occurs is practical and straight forward. The unique
process that has evolved to sell a business makes perfectly good sense and is quite
logical. That is, once you understand what makes the process different. This chapter
outlines nine of the contrarieties that establish the fundamentals upon which the
methods of selling a business are grounded.
“Sell it but don’t let anyone know it’s for sale.”
In other words, maintain utmost confidentiality. Many unfortunate occurrences can
and do happen when people know, or think they know a business is for sale. A
summary list is offered below.
Employees get nervous and may leave for more stable employment. They read the
papers and just know that the ―new broom will sweep clean.‖ That may be true in big
corporate acquisitions but is generally not so in the smaller private company.
Typically, buyers will not buy unless the existing staff will remain.
Competitors may take advantage by using the prospective sale as a way to gain an
advantage and pirate customers. After a recent seminar on buying, selling and pricing
businesses, a business owner confided, ―I wish you had given this seminar last year.
Your information would have saved me $150,000.‖
His competitors found out he was trying to sell and began a campaign to lure away his
customers. ―I know you have done business with Joe for years but—did you know he
is selling out?‖ Twelve months later business is almost back to normal. Many
companies do not survive this common mistake.
F
10
Suppliers extend you credit because of your good payment record over the years. Now
they hear you are selling out. Credit managers very often get nervous when they find
out a business is ―on the block.‖ Might they change your terms to COD? What impact
would that have on your business?
Bankers have a healthy skepticism of small business. They want your business but
they have been burned in the past by others. They are painfully aware that a very
high percentage of small businesses fail. Bankers are not paid to be optimistic. Might
the bank assume the worst and not renew your line of credit?.Call your note(s)?
Customers usually lose confidence in a firm when they think it is for sale. They will
often switch to a known entity (your competition) where conditions are perceived to be
more stable. Where are you without your customers?
What else has to be sold so confidentially?
“I don’t know what the business is worth,
but I know what I want for it.”
Essentially every business person we have worked for has eventually confided that
they did not know what their business was really worth. All had an idea of what they
would like to get for their business but really did not know its value in the
marketplace.
There is published data on the value of everything from antiques to zippers and all
things in between. There is no book containing the values of businesses. A number of
treatises on valuing a business have been written but which method of the many is
realistic for your business? ―Rules of Thumb‖ have emerged to fill the value
information void but, are they accurate?
The value of essentially everything, except private businesses, can be found listed
somewhere.
“Ask twelve people and you will get twelve different answers”
If you ask twelve buyers what a business is worth you will get at least twelve
answers. There is no ready reference for either buyers or sellers to aid in determining
a business’s value. Unlike virtually every other commodity sold, there is no public
record of private business sale prices. Prices or Price Earnings Ratios are published
for Public companies but not Private firms.
If the twelve people you theoretically asked for an opinion of value were potential
buyers, the one who produced the highest value would be the right buyer because he
recognized the most opportunity. Only the ―Right Buyer‖ will pay the ―Right Price‖.
Many advisors and most financial professionals have very firm opinions on how to
determine the value of an enterprise. It is very common for their opinions of value to
vary dramatically.
What else has to be sold under conditions where nobody knows the real value but
everyone has an opinion?
11
“Future value of the purchase is dependent
upon who buys it”
Suppose you own a business and a home. So do I. We both have profitable businesses
and nice homes. Let’s swap homes and businesses just for the change and variety.
Now suppose it’s a year later. The value of our homes is basically the same. What
about our businesses? Might one of us be in trouble or perhaps both of us? What do I
know about your business? What do you know about mine?
We all have witnessed a ―down at the heels‖ business come alive and prosper under
new management. Regrettably we have also witnessed the opposite. What made the
difference? -- Right buyer—Wrong buyer.
What else is sold where the viability of the item purchased and its future value is so
dependent upon who buys it?
“Light Manufacturing or Distribution”
A majority of buyers come to us and profess to be in search of either a Light
Manufacturing opportunity or perhaps a Distribution company.
This seems to us to be a code for ―I really don’t know what I want to buy but I would
feel dumb telling you that.‖ Eventually virtually all buyers admit they really did not
know what they wanted to buy. They knew what they did not want and, as with art,
would recognize the right opportunity when they saw it.
The odds of a person buying the business that attracted them to our office are 1 in 500!
The odds of buying a company within the industry for which they initially stated a
preference, 1 in 50!
We reviewed fifty-five of our Printing Plant sales to determine how many were sold as
a result of advertisements placed offering a printing company for sale. We were not
surprised to find only one. Those who purchased the other fifty-four had come to us in
search of something else, perhaps light manufacturing or distribution.
What other product has to be sold to someone who does not know they want to buy it?
“Third parties refuse to ratify the wisdom of the purchase”
We can buy essentially anything we want and some third party will participate in the
purchase by providing the financing and thereby endorse the wisdom of our purchase.
An excellent example is the purchase of real estate. The bank appraises the property,
ratifies that we are not paying too much and gives us a mortgage.
Banks cannot lend on goodwill. They need solid assets that can be converted readily
to cash. Business equipment and inventories are not favored collateral with bankers.
What percentage of the asset value would banks lend anyway? Which asset value
would they use? -- Liquidation value, Book value, Replacement value, Value in place,
Net book value. What equity or loan to value percentage would they apply -- 50%,
60% maybe 70%? What percentage of your business’ value is attributable to the value
of its assets? How much will your banker lend you on your business’s assets today?
12
What other major purchase can you make where third parties refuse to provide
financing to any significant degree?
“Selling a business is a life-style or personal decision and not
purely a financial matter”
Financial considerations are important but do not drive the decision to sell. Business
owners generally are motivated to sell their businesses to gain a lifestyle change.
They want to sell so that they and their businesses can each move on to different
levels. The decision to sell is made from a combination of personal and financial
considerations. At some point in this balancing act it boils down to ―it’s only money.‖
Only you, the business owner, are capable of making the determination where that
point is.
Buying a business is a personal and a life-style decision, not purely a financial one.
Buyers are seeking independence, freedom to express themselves, their ideas, the
ability to take control and not have to put up with the corporate ―group think‖ any
longer. Obviously the financial uncertainties associated with business ownership are
important but financial considerations alone do not drive a buyer’s decision to
purchase. Only the buyer can weigh the perceived opportunity against the financial
uncertainty.
Advisors can address the financial aspects of a transaction but only the principals can
balance that information against the perceived personal gains. Both buyer and seller
(many sellers choose to participate in financing a part of the sale) have to balance the
imagined personal gain against uncertain financial prospects. A business opportunity,
not a business guarantee, is involved.
What other transaction can you imagine that involves such a high degree of personal
involvement and financial uncertainty?
“What business person complains they have too many
customers?”
Business Brokers! Yes, those who sell businesses for a living will tell you that buyers
drive us crazy. It seems everyone either says they are a buyer or knows one. Buyers
are a dime a dozen. Finding the right buyer, now that’s another story.
It’s always a seller’s market for viable businesses. Less than five percent of the
population are business owners. Estimates regarding how many people want a
business of their own range from 40% to a high of 70%. If we assume 20% of the 5%
are considering selling their businesses, 1% of the population owns what 40% to 70%
of the population wants to have. Regardless of the accuracy of the estimates, it is safe
to say that it is always a seller’s market. An economic down turn intensifies buyer
activity as layoffs and downswing brings more than the usual numbers of buyers into
the market.
Can you think of any other situation where a person who has something to sell
complains of having too many customers?
13
“A business is to its owner what a child is to its parents.”
Your business is an extension and a reflection of you. It’s your baby and you do not
have to sell. You have sacrificed yourself, and your family life. There have been times
when you did not take a pay check, rather you put the money back into the business --
all those long hours, your hopes, your dreams. Now you are thinking of selling? Isn’t
that like putting your baby up for adoption?
What else has to be sold in such an emotionally charged atmosphere?
This chapter has dealt with factors and conditions that combine to make the process of
buying or selling a business unique. The next two chapters focus upon basic principles
that form an intregal part of the business buy or sell process.
Addressing the unique elements of buying/selling a business plus satisfying the basic
and constant principles of human nature produce a win-win situation.
You can play the game
without knowing the rules,
but can you win?
14
Chapter 3
All the right things are wrong!
s previously stated, selling a business differs from selling most
most anything else. The conditions under which a private business is
business is sold are unique. However, two basic elements of selling
of selling remain appropriate. In real estate circles the first is referred to as
highest and best use. The second basic principle is motivation.
Highest and Best Use
Which has more value, a glass of water or a glass of diamonds? ―The
diamonds‖ you say? Obviously correct, unless you are six days in the desert
without water. Then certainly, the water will have much greater value.
The person who can put a property to its highest and best use will pay the
highest price as they recognize the optimum value. In the case of a business,
the person who recognizes the most opportunity will pay the optimum value.
Motivation
It also has been said that a business is to its owner as a child is to its
parents. The decision to sell is generally motivated by personal or life-style
considerations. Business owners do not usually sell their business for purely
financial reasons. You could say that putting one’s business on the market is
like offering the business up for adoption.
The decision to buy is also a personal decision and not a financial one. Yes,
financial considerations are an important factor but are not the driving force
behind the desire to own a business.
Both the business buyer and seller are to become involved in a milestone and
life-style changing decision -- one that could have very important financial
implications. Suffice it to say that both will be making important decisions
A
15
in a very emotionally charged atmosphere. After a sale has been
consummated, neither’s life will be quite the same.
Advisors will be able to assist with the financial aspects but may be totally
unaware of the important personal factors involved. If one analyzes a
transaction from the financial side only, it may not make total sense. A
business is sold only when personal and financial gains are in balance.
Getting back to the adoption analogy. Why is it that adoptive parents do not
want to adopt a mature child (You have a mature business)? From a purely
logical or analytical (financial) stance, adopting a mature child makes good
sense. You could choose the type of child you desire. Perhaps a girl who
enjoys hiking, fishing and camping as do you. Maybe one that has just
graduated from college. Why not? Makes good sense doesn't it? It certainly
makes good sense from a financial viewpoint. Obviously it doesn't happen
that way.
Adoptive parents want the opportunity to give to the child, to sacrifice for it.
They desire the opportunity to shape and mold the child in their own image.
The logic of adopting an older child is overridden, perhaps never even
considered.
Alternatives to buying a business that satisfy motivation
More people start new businesses from scratch than acquire existing ones.
Not very logical but it's true. What are their chances for success? Would it
not make more sense to buy an established survivor?
An ever growing number of buyers are considering franchises. Estimates
suggest that by the year 2000 seventy-five percent of all retail sales will be
generated by franchises. Franchises are very popular because the buyers
gain a business of their own. They started it from scratch, but they are not
alone. They had help and have ongoing backup.
Franchisors seldom, if ever, make earnings claims to prospective franchisees.
They can get into trouble with the FTC if they do. Franchisees understand
that it will take time to reach break-even and even longer before they are
profitable. The buyer’s prime motivation is independence -- making money is
secondary.
Combining “Highest and Best Use” with Motivation
We have discussed two seemingly unrelated ideas: First, highest and best
use; second, personal or emotional desire to mold and shape. How can you,
the owner of a mature and successful business, put these dynamics to work to
your advantage? The answer is very straight forward.
First, what does your business need? What are you failing to do that really
should and can be done? What could be done better, added or changed?
16
As the owner of a small business, your job entails wearing all ―the hats‖. You
are in charge of everything from strategic planning to taking out the rubbish.
You are responsible for it all. However, none of us is equally talented in all
directions. We are not "Round Balls." We are very good at some things, good
at others and possibly not so good at the rest. Some things we just do not
know about. Unfortunately, we generally don't know what it is that we don't
know.
There are no perfect people just as there are no perfect businesses. Every
business contains elements that represent an opportunity for someone to
capitalize upon.
Business opportunity seekers are not interested in solely making money!
They seek the opportunity to use their skills, talents and resources. They
want to satisfy the desire to "show their stuff" and to be in control. If they
can find the "Right Business" they want to be able to improve and make it
grow. Put their mark on it. Make it theirs, and, oh yes, make money doing
it.
You know your business from the inside out better than anyone. However,
it’s the view from the outside in that is most important and is the first step in
the process of determining what your business might be worth.
View your business from the Outside In
You need to complete a profile of your business, (more detail on this later).
Outline the strengths, uniqueness and areas of opportunity represented. The
reverse or negative of this profile will represent the profile of the optimum or
best buyer.
For example, your company makes a great widget, or provides a wonderful
service. You are a genius in design and a stickler for quality and service.
The company has grown quite nicely over the years and your product, or
service, is widely used in your region.
Your strong suits are manufacture and design and the weak suits are sales
and marketing, administration and finance. Reverse this profile and you see
the buyer should have strengths in sales and marketing, plus a solid
background in administration and finance.
When acquirers possessing these skills view the business and recognize the
opportunities you have prepared for them, they become very excited. All the
right things are wrong! They can fix them. They can inject what is needed
into your business. They can make it theirs. Following the adoptive child
analogy -- they will have the ability to send your child, (business), to college.
The person who sees the most opportunity will pay the highest price. What
is more important is that they can and will capitalize on the opportunity you
17
have created. The company, you, the employees, their families and yours all
can win with the ―Right Buyer!‖
Conversely, if the business is sold or otherwise transferred to someone who
fails to recognize the full opportunity:
a) you not only fail to receive the best price, but
b) they are not able to capitalize upon the opportunities.
They don't know what they don't know. The future of the company and all
that it serves is in jeopardy. Your ability to obtain maximum value for your
business depends entirely upon your finding the ―Right Buyer.‖ Obviously
this is equally important to the buyer. The next chapter further illustrates
this point.
The future value of a company ultimately depends
upon the person who owns and operates it.
18
Chapter 4
Value, As With Beauty, Is In The Eye Of The Beholder
alue, as with beauty, is in the eye of the beholder. A business that is
business that is considered worthless by one may be worth millions to
worth millions to another. So, you might ask, what is my business
business worth? A truthful answer has to be:
It depends. It depends entirely upon who is looking and upon what they see.
Perhaps we can illustrate this using Mrs. Brown’s old rusty, dusty Ford as an
example.
The Saga of the Rusty Dusty Ford
Mrs. Brown’s husband had died many years earlier. The car was his pride
and joy and Mrs. Brown had kept it stored in the barn for the past twenty-
five years.
Now she was about to move into an elderly housing complex. Having sold her
home, something now had to do be done with the old Ford. She did not know
what to do or how to go about disposing of her husband’s cherished relic.
A longtime neighbor and friend understood and sympathized with her
dilemma and offered to buy the old vehicle. He would give her $100 and
take it off her hands hoping he could recover some of his money from the
scrap value when he took the car to the salvage yard.
Fortunately, a stranger appeared before this friendly neighbor took
possession. The stranger had heard of the car being in the barn and offered
Mrs. Brown $10,000 for it, as is!
Why? The old rusty dusty Ford was a 1954 T-Bird, a classic automobile
highly sought after by auto buffs.
The stranger was a T-Bird enthusiast. Having been to the antique auto show
in Hershey, PA he knew the vehicle would have a value of at least $30,000,
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19
after an estimated $10,000 of restoration. He recognized the opportunity and
was willing to pay the optimum value.
The vehicle was saved from the scrap heap and Mrs. Brown received an
unexpected windfall she certainly could use. The auto enthusiast found his
prize and the friendly neighbor saved $100. Everyone was happy. Everyone
was a winner because the right buyer happened upon the scene.
What Is Your Business Worth?
It depends on who is looking. Therefore, the most important step in
determining the value of a business begins with the accurate identification of
the ―Right Buyer.‖
This obvious step is usually overlooked by many who will attempt to place a
value on a business. In fact, courts recently have recognized that different
types, or classes, of business buyers would place different values on a
company.
The impact of recent decisions has yet to be fully recognized by the business
appraisal community. As the business owner, you need to understand the
difference between the various kinds of buyers. You need to understand
which types are best and which should be avoided. You need this information
as you decide what you want to do with your business and as you prepare for
the next stage of your life.
The business profile, referenced earlier, is the key element in proper buyer
identification. Proper and accurate buyer identification is the essential
element in any attempt to place a value on your business.
We have been exposed to more than one hundred different business valuation
methods since establishing our brokerage firm in 1979. Many of the formulas
and computations are very sophisticated and complex. Others are brutally
simplistic. Many professional advisors have their favorite method and will
defend it vehemently as being the only way to determine real value.
Their method will be the right method only if they themselves are the
optimum or best buyer. Their valuation will most likely be wrong unless the
person valuing your business can put themselves in the shoes of the ―right
buyer.‖
Of twelve hypothetical buyers asked to place a value on your business, one
develops a price higher than the rest. That buyer will usually be your best
buyer, not only because they offered the best price, but because they have
recognized the most opportunity.
Caution: Valuation methods that produce a high value, but are methods
that might not be employed by the types of buyers you could attract to your
business, will produce only temporary euphoria, not positive results.
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Identification of the ―Right Buyer‖ before you attempt to sell or go to market
is a key element in preserving and obtaining optimum value for your
business. It is also the best way to maintain confidentiality during the
selling process.
The next chapter describes four different types of buyers and provides
explanation of why the values they perceive vary dramatically.
Only the ―Right Buyer‖ will pay the ―Right Price‖
21
Some luck lies in not getting what you thought you wanted
but getting what you have, which once you have got it
you may be smart enough to see
is what you would have wanted had you known.
Garrison Keillor
22
Chapter 5
Types Of Buyers And What They Will Pay
he range of value that various buyer types will attribute to your
business is staggering. One may see your business as worthless while
while another is willing to pay millions!
The wide range of values is in direct proportion to the amount of opportunity
perceived by the buyer. To fully appreciate this thought we first have to
differentiate between opportunity and potential.
Opportunity Vs Potential
Business owners we have served over the years have consistently stressed
the potential their businesses represent. They were unaware of the damage
they inflict on their business’s value by emphasizing its potential. It’s a
natural and innocent mistake that virtually everyone makes.
Perhaps the use of the word ―potential‖ causes a flashback to when we were
in school and teachers would explain to our parents -- ―Johnny has the
potential to do much better if only...‖
Yes, if only Johnny had applied himself he would have done much better. If
buyers apply themselves, more or better than you, then certainly they will
achieve more success than you have experienced.
The problem is that the buyer’s response to all this always seems to be—―If I
am going to do it—why should I pay you for what I will do?‖ Buyers will
purchase because of the potential. They just will not pay you for it (However,
they will pay for opportunity).
Opportunity, on the other hand, is perceived as being different than
potential. Opportunity is already created. It’s there. You created the
opportunity, and are willing to let the newcomer reap the advantages of your
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23
hard work. Any reasonable person must be compelled to compensate you for
the opportunity you have created. It’s only right. Prices based upon
opportunity are superior to those based upon potential.
Semantics? No, it’s the difference between your leaving with a nice
bonus or giving your business to someone as a going away present. The buyer who sees the most opportunity pays the highest price.
Buyers can be categorized into four broad groups. It is very important to
understand the differences between them, how they think and how to identify
them.
The Strategic Acquirer
Strategic acquirers are the best. They traditionally pay very high prices, and
virtually always pay cash! Typically you will find that they are either public
companies or very large private corporations.
The decisions are generally restricted to board rooms and usually revolve
around considerations such as economies of scale, new channels of
distribution, proprietary product lines, new technology, market share or
presence, etc.
Typically the decision makers are not buying with their own personal funds.
Public company protocol is cash deals or cash and equivalents, (stock). Price
Earning Ratios will range from 15 times earnings to OMG, (Oh my God!).
These are the transactions one reads about in the press and those of which
films, TV shows and dreams are made.
To be attractive to a Strategic Acquirer your firm should fit the following
acquisition criteria:
Sales in excess of $20 million
Proprietary process or product
Suitable levels of management in place
Unique market presence or share
Synergistic fit with acquirer’s goals
Management willing to stay
Most Strategic Acquirers have a Corporate Development Officer or
department. Research will yield names, addresses and telephone numbers of
persons you may contact. A Public Library or the Library at your nearest
Business School is a wonderful resource for this information. Stock brokers
can also assist with information through their research sections regarding
proposed plans and activities of targeted firms.
Obtaining ―acquisition criteria‖ will provide an overview of what each target
company is looking for. It is very common for these acquirers to expect
existing management to stay on for an extended period of time.
24
Generally one has to read between the lines because very often purchases
can be far afield of the acquisition criteria guidelines. Strategic acquisitions
produce the highest values because the perceived opportunity is the greatest
in this environment.
Example of why:
Major Market Widget Corp., (MMW), is a public company with 20 million
shares issued. They perceive that the acquisition of Niche Market Widgets,
(NMW), will increase the perceived value of their stock by two dollars per
share or forty million dollars! Therefore any price they pay under forty
million will be a bargain.
NMW had sales of twenty million and recast profits (more on this later) of
one million dollars, and after tax earnings of two hundred twenty thousand
dollars. MMW pays eleven million dollars for NMW. WOW! That’s 50 times
earnings, or OMG!
Sophisticated or Corporate Acquirer
This is a new and increasing buyer segment. Many casual observers fail to
recognize this group. Their numbers have increased dramatically since the
late eighties. Three major factors have contributed to this increase:
Wall Street’s LBO Mania Ends
We are all familiar with the once prevailing Wall Street mania of buying and
dividing up companies for huge profits. Junk bonds, highly leveraged deals
and stories of financial wizardry were constantly in the news during the late
eighties and early nineties.
This philosophy to riches is over. No more junk bond mania. Many investors
and corporations have recognized the solid opportunities in private sector
companies for the first time. Many have lowered ―acquisition criteria‖ size
requirements considerably as a result.
Middle Management Layoffs and Recession
Thousands of very talented, high net worth executives are being released
from their jobs as Corporate America trims down. Many turn to self
employment as prospects for future employment become slim. They always
wanted their own business anyway. Why not now?
Some will buy on their own. Others will band together, pooling their talents
and resources, and acquiring existing firms.
Interest Rates at Lowest Level in Decades
With prevailing yields on CD’s and other investments at low levels, the more
entrepreneurial are forming Investor Groups whose prime purpose is to
acquire existing companies. Many have ―on the shelf CEOs‖ with whom they
25
will do a joint venture acquisition. The displaced executive may have the
talent to operate a substantial firm but will not have enough money to buy a
suitable firm on his own.
This group brings a schooled approach to the acquisition process. They are
accustomed to Public Company PE ratios, and they expect to ―pay a lot for
the muffler.‖
The focus is on opportunity for growth and they will have criteria that is very
similar to that of the Strategic Acquirer. Size of the target company is
important but not as important as the opportunity.
Two types that fall into this group are Investment Groups and High Net
Worth Individual or Individuals.
The Investment Group, Investment or Holding Company is typically an
organization formed to acquire private companies. These groups take many
forms. An acquisition criteria that typifies both groups is as follows:
Investment or Holding Company:
Sales from 10 Million to 100+ Million,
Earnings of at least 1 Million,
Expect to invest considerable Cash or Equity,
Cash deal or some form of future payments to seller
Pay 3 to 10 times Earnings
Smaller Groups and High Net Worth Individuals:
Sales from 2 Million to 20 Million,
Expect 6 figures earnings,
Ability to leverage the buy,
Expect Seller participation in the financing
Pay 3 to 7 times Earnings
Types of businesses sought by both groups:
Manufacture or Distribution,
Proprietary Process or Product,
Niche Market or have a Specific Industry preference,
Prefer management remain or stay for significant transition period.
Our data base contains hundreds of these groups from all over the country
and more and more from other parts of the world. We receive at least one
phone call or mailing from these groups every day of the week. This group is
very aggressive. They are armed with telemarketing personnel, slick direct
mail pieces and they network extensively to maintain a ―deal stream‖.
Hundreds of businesses might be reviewed before one is selected. One to
three buys per year appears to be usual from this activity.
26
Due to focus on opportunity these buyers tend to pay very fine prices that will
take future profits into account. However, in using their own funds, or funds
by their investors, these buyers will not and/or cannot pay prices paid by
Strategic Acquirers. PE ratios seem to range from a low of 2 to a high of 10
with 4 to 7 being more common.
Examples:
A popcorn company with sales of $3 Million is acquired for $4 Million in cash.
A distributor with $25K in assets and a $50K operating loss is sold for $575K
in cash.
Both of these companies were purchased by opportunity buyers. The first was
a public company, the second a small investor group.
The pop corn company had established a loyal following, brand recognition
and channels of distribution that would be synergistic with the public
company’s operations.
The distributor had established a quasi proprietary product and unique
channels of distribution in several test markets. All the buyer had to do was
to complete the loop and reap the benefits. The buyer had the resources the
founder lacked. ―All the right things were wrong.‖
Financial Buyer
Financial buyers are the most plentiful. They tend to focus solely on the
present and past. They will attribute any improvement in profits to their
own efforts and will not pay prices based upon projections.
They will consider a price fair if the transaction can meet three criteria:
1. This group considers it un-American to pay all cash. They expect terms or the
ability to finance the buy.
2. They consider a modest return on their cash into the deal as not being
unreasonable.
3. They have families to feed so minimum living wages are expected from the
business upon purchase. A wage commensurate with their initial investment
is usually considered fair.
This group is primarily interested in purchasing a job. They will not buy
unless they can see a FIT and the potential for making the business better.
The first two groups are focused almost exclusively upon opportunity, while
this group focuses on the here and now. Therefore, Financial Buyers will pay
less than Strategic or Corporate Buyers. PE ratios generally range between
2 to 4 times ―recast earnings‖.
Without proper preparation and positioning most small businesses will
attract only Financial, (potential), buyers. This need not be the case. Every
business can be developed and prepared so as to be attractive to opportunity
27
buyers. The next chapter will provide an overview of the factors that
determine the type of buyer a business might be able to attract.
Industry Buyer
Industry Buyers can be either the ―best‖ or the ―worst‖ buyer. Many times
they are the buyers of last resort. If you have to sell, usually only industry
buyers will buy.
They are the best buyer when they have a strategic reason(s) to buy and
know that you know the reason(s). Otherwise watch out!
You would be an Industry Buyer if you were considering the purchase of
another firm similar to your own. What would you pay for your own
company? An honest answer is usually ―I see what you mean.‖
Most industry buyers look only to selected assets to determine value. They do
not want to pay for goodwill. What is goodwill anyway?
A firm’s value is comprised of several factors:
Value of company assets
Prospects for future profitability and growth
Rights and knowledge
To illustrate the difference between an Industry Buyer and others let’s look
at a purchase price allocation by the opportunity buyer when compared with
the industry buyer for the same business.
Opportunity Industry
Buyer Buyer
Value of Assets transferred $500,000 $200,000
Covenant not to Compete 150,000 0
Consulting Agreement 150,000 0
Goodwill 50,000 0
Total $850,000 $200,000
The Industry buyer did not see any value in your willingness to train or
consult (what could you teach them anyway?). They were not worried about
you competing with them after the transfer (You were retiring to Florida
anyway, weren’t you?).
Your assets did not particularly impress them either. They have newer or
better equipment. The fork lift would be a duplication. That product line
would not be compatible with their operation so why don’t you sell that
separately?
Your customer list may have been of interest to them, but with you winding
down they would probably get them anyway.
28
Before you attempt to sell your business:
Know the difference between the various buyer types.
Determine just how you can attract the best buyer.
Change you company’s potential into opportunity.
The difference between opportunity and potential is
leaving with a nice bonus or giving your business to
someone as your going away present.
29
At my lemonade stand
I used to give the first glass away free and
charge five dollars for the second glass.
The refill contained the antidote.
Emo Philips
30
Chapter 6
Types of Businesses And What They May Be Worth
here are essentially four major categories within which most companies
most companies can be classified. Each major category is attractive to
attractive to specific buyer types. The key elements that determine
determine within which group your business will be classified can be
summarized as follows:
Size of company
Product or service
Involvement or continuing importance of the owner
Profitability and perception of future profits
Type of business or market served
Size of The Company
As mentioned earlier, certain buyers will stipulate that a target acquisition
must have revenues that exceed defined limits before it is considered for
possible acquisition.
Several years ago I remember getting a terse letter from a rather large
investment group’s president in which he essentially told me not to waste his
time considering opportunities with revenues under $20 Million.
He had received a one page profile from me summarizing a company within
an industry where several acquisitions (printing) had been made by his
company. Pre tax profits for the target company were in excess of $1 million,
but revenues were only $5million! He wanted me to know I was wasting his
time with such a small company, and that I shouldn’t do it again.
A company with $25 million in revenues would have been considered even if
the pre tax earnings were minimal or non existent. Revenues, in addition to
predicting profit levels, are an indication of a company’s culture. A $20
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million dollar company is very likely to have a well defined internal structure
and in many ways its ―corporate culture‖ is beginning to resemble that of a
Public Company. A $5 million dollar firm may still be too ―entrepreneurial‖
to fit well with the larger company without each disrupting the other (culture
clash). Managing the smaller company from a distance is difficult and can
often be disruptive for the larger firm.
For these and many other reasons, smaller companies are not attractive
targets for the large acquirer, unless for a strategic reason such as
proprietary products or services.
Product or Service
Size becomes less important when you have a proprietary product or service.
The popcorn company mentioned in an earlier chapter is a good example of
this. The acquirer had a strategic reason to buy. The firm’s small size was
overlooked. The brand name, proven consumer acceptance of the product and
its packaging is what was desired.
The distributor we referred to had developed unique channels of distribution
for a product servicing a relatively small niche in a huge market. The time
and effort it would take to duplicate the company represented a significant
―Barrier of Entry.‖ The buyer recognized the opportunity and paid
handsomely to gain access to it.
When your company is a job shop without unique capabilities distinguishing
it from the pack, an all cash ―home run‖ is probably not in the cards.
Producing twenty million in revenues alone would not necessarily make you
an attractive acquisition for the Strategic or Corporate or Sophisticated
Acquirers who pay ―home run‖ prices.
Conversely, when you have a proprietary product or unique service that is
proven on a regional basis and could be rolled out nationally, that’s what
makes another story.
Importance of the Owner
Some businesses are entirely dependent upon the owner. If the owner is the
business, the business may be difficult to sell, or may sell for diminished
values. This need not be the case.
Medical, dental and accounting practices are routinely sold. These
businesses certainly are highly dependent upon the owner. One certainly
could argue that the practitioner is the business, yet the practices are
routinely sold.
Essentially every business can be organized to make it saleable. Tricks of the
trade can be transferred, transition periods established and skills taught.
Companies can be structured to make the founder less critical to operations.
32
Many owners simply assume their business cannot be sold because their
personality, expertise or knowledge is key to the company’s success. If you
believe it, it’s true.
For example, my father believed his service business was un-saleable. The
fact that I sold twenty one firms similar to his would not change his mind.
When he died, his company died with him. Someone else is now servicing his
accounts.
It is true that if a buyer perceives the owner as crucial to operations, he will
not purchase that business. You wouldn’t be likely to buy your accountant’s
practice and your accountant would probably not want to buy your business.
Neither of you perceive the skills required to operate the business or practice
as transferable.
The business and practice are saleable none the less. Our challenge is to
identify the types of persons who would perceive skills required for success as
obtainable or transferable.
Both my father and his accountant agreed that Dad’s business could not be
sold. Unfortunately, in my father and his wife’s case, perception became
reality.
The key is found in understanding the unique skills required of the
company’s succession management. Identify the elements of your business
that need to be addressed in order to make the business more transferable.
Many times the person most capable of ―doing the business‖ is not going to be
the best one to buy it! Instead of a practitioner buying the company, many
times a manager or marketer would be better for future growth and
profitability of the continuing company.
For example: a very profitable chain of retail bakeries was sold by the
retiring owners to one of their best long time employees. The new owner was
an excellent baker but a poor operator. Within weeks of the transfer,
cleanliness of the premises declined, service deteriorated, and hours were
shortened. Within twelve months all of the locations were closed. Product
quality remained excellent to the end.
Profitability and Perception of Future Profits
Casual observers and most financial professionals will agree that a
company’s profits are a key element in determining the value of the firm.
This is not entirely true!
The perception of prospects for future profits is the most important factor.
Remember, a business may be valueless to one and worth millions to another.
Earnings, or perception of future earnings, of companies at various levels will
command different Price Earning multiples. Four different groupings or
levels are identified below, and the differences summarized.
33
The Four Major Business Classifications:
Wall Street
Main Street
Upper Main Street
Middle Market or Limbo
Wall Street
These companies are usually public or large private businesses. Rules for
their acquisition and valuation are widely taught in every business school in
the country. Price Earning ratios are published daily, and transaction data is
readily available. Management’s objective is to maximize profits to satisfy
stockholders.
Earnings - Usually measured in the millions, after tax.
PE Ratios - Typically 15 times earnings to ―OMG‖, (Oh My God).
Terms of Sale - Cash or Equivalents, (Stock, Warrants etc.)
Type of management - Professional managers, many levels of
responsibility.
MAIN STREET
Main street companies, on the other hand, are very small companies, often
referred to as ―Mom and Pop‖ businesses. The rules for acquisition and
valuation applicable in this group are essentially unknown and not taught in
business schools. Data for small business transactions is not generally
available. Rules of thumb for various industries, and a hundred other
valuation methods, have evolved to fill the comparable data void.
Earnings - Typically 100K, more or less. Not pre tax earnings, but instead
earnings are reconstructed or normalized to offset management’s desire to
minimize taxes over recording profits (Discretionary Earnings).
PE Ratios - Two to Four times Discretionary Earnings.
Terms of Sale - Down payment with seller taking a note for the balance over
three to seven years. Down payment usually ranges from 80% to 120% of the
current level of Discretionary Earnings.
Type of Management - Owner vital to operations. Wears all the ―hats‖.
Little to no management depth.
Upper Main Street
These companies are somewhat larger than ―Main Street‖ businesses.
Perhaps several locations are involved. Acquisition protocol again is not
clearly defined, and comparable sales data are not readily available.
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Earnings - More than $100,000 but less than $250,000. Earnings same as
above or EBIT, (Earnings Before Interest and Taxes). EBIT-D, (plus
Depreciation) or Adjusted EBIT, (Essentially the same as Discretionary
Earnings). Many buyers will deduct a Manager/Owner salary from above.
PE Ratios - Three to seven times earnings.
Terms of Sale - Down payment plus a seller note, occasionally limited third
party financing of equipment or receivables. Down payment ranges from 1 to
2 times ―Earnings‖
Type of Management - Owner still major element of company’s success.
Levels of responsibilities and management structure evolving.
Middle - Market or Limbo
These companies usually are quite substantial. Use of Public Company
comparisons to determine PE Ratios and acquisition protocol appear
appropriate.
Earnings - $250.000 to small millions, and defined as pre/after tax and
various EBITs
PE Ratios - Three to fifteen times earnings
Terms of Sale - All cash or same as Upper Main Street
Type of Management - Segmentation of responsibilities and management
structure well defined. Owner may or may not be involved in operations to a
significant degree.
We sometimes refer to companies in this group as being in Limbo because
they may not be able to be sold. Management, and its advisors, often assume
Wall Street PE ratios and protocol appropriate to price and market this size
company.
Unless the company represents a unique opportunity, (proprietary product or
service), the all cash high multiple acquirer cannot be attracted. Otherwise,
dynamics found when selling Upper Main Street will apply. When this is the
case, it is extremely difficult to find a buyer with the initial investment this
size company would require.
Example
A long established machine tool company generating $8 million in revenues
with average pre tax profits of $450,000, was ―on the market‖ for three years
unable to attract buyers willing to pay the price. The business was priced
using Strategic buyer methods. However, the company was essentially a
very large job shop without proprietary products or processes. Although
many possible buyers toured the facility and reviewed company records,
offers presented failed to meet management’s expectations.
To make matters worse, the first group of possible suitors approached were
competitors.
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Type of Business or Market Served
This section ties in with the perception of future profits in that some
businesses and markets are hot, and others are not.
For example, at this writing, firms with medical and environmental ties are
in great demand and circuit board manufacturers have few suitors. Ice
cream parlors are in greater demand than are pizza shops. A travel agency’s
appeal decreases during periods of increased international terrorism.
Some businesses simply have limited appeal when compared with other
businesses -- septic tank pumping/cleaning when compared with a flower
shop, for example. The perception of esthetic appeal depends upon how it is
viewed, and by whom.
As you can see, many factors combine to either increase or decrease values in
a particular business. Knowing what these factors are you can often increase
the value of your business in an orderly and efficient manner. The single
most common factor limiting a firm’s value revolves around the importance or
dependency of the business upon the owner.
Proper prior preparation prevents poor performance and produces
premium prices and plentiful profits.
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Chapter 7
How to Identify The “Right Buyer”
inding the right buyer for your business is somewhat analogous to your
analogous to your daughter finding ―Mr. Right.‖ Ideally he will
he will complement her personality and skills and share her values.
her values. Together, with their plans and dreams all wrapped up in
enthusiasm, they will embark on a new life together.
If she has chosen well, their life will be wonderful. If she chooses poorly,
their life together could be, to say the least, unpleasant. It is the same with
the person who succeeds you in your business. If you have chosen the right
person all will go well. Should you choose poorly . . . Businesses are not sold
in the same way that other commodities are sold. Buying or selling a
business is DIFFERENT from buying or selling anything else you can think
of.
The process more closely resembles a father giving his daughter away in
marriage. The suitor has to be the right person, as mentioned above In
addition, a suitable DOWRY must be offered.
The union will allow your values and principals to continue. It is in this way
that our efforts and struggles are rewarded and our dreams and visions
continue to live on and flourish.
How to Find “Mr. Right”
When you know who you are, you can determine who you can become. When
you understand where your business is today, you can see what it could be
tomorrow. Finding the right buyer begins with a review of who you are and
where your business is—today.
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Look in the mirror. Your business is a reflection of you. Your business
reflects your skills, attitude, talents, personality and dreams. Should
succession management be somewhat your clone? No, definitely No!
A basic law of nature and physics is that opposites attract. New blood
strengthens a bloodline or family tree. New ideas and perspectives precede
progress. So it is that every business eventually needs a change of
management! No matter how good you are, when you stay around too long,
your grasp of the business can turn into a strangle hold.
The only reliable constant in business and life is change. It is this fact that
brings every business owner to the eventual point wherein it is time to choose
a successor. Your successor should possess skills that are complementary to
yours. Also it is imperative your successor be able to appreciate and
maintain the strengths of the business you created. In other words,
recognize the strengths and build upon the opportunities.
Profile Your Business
To properly identify the right buyer for your business you must first
understand the opportunities your business represents. The opportunities
usually are those things you have not done, have not done well or have not
done at all. What can be done is more important to a buyer than what you
have done well. In the long view it should be important to you also.
Of course your successor must be capable of maintaining the strengths. In
most cases the new management could not have brought the company to its
present level but should be extremely qualified to move it to the next.
To develop a business profile one first looks at operation items such as:
staffing
hours of operation
product or service segmentation
margins by segment
market served
competitive environment
customer base
industry trends
industry outlook
new developments
management style
sales and marketing plans
systems and controls
(both managerial and financial)
sources of supply
By examining operations in this way, a comprehensive understanding of how
the business is being run can be discerned. A review of this kind will usually
point out opportunities that can be built upon, areas where improvements or
38
corrections are in order, or trends which will indicate attention is required
either to eliminate a negative situation or capitalize upon what buyers may
perceive as opportunities .
Once a full understanding of operations and the environment in which the
business operates is described, a review of current and historic financial
information is in order. A company’s tax returns or financial statements are
not an operating manual. In fact, most are mystery novels. By first
understanding operations and the industry, much of the mystery hidden in
the financial statements dissipates.
A financial review of the company will include:
Comparative Income Statements and Balance Sheets for 3 to 5
years,
Recast or normalized Income Statements and Balance Sheets (3 to
5 Years),
Review of key ratios:
Operating ratios
Leverage ratios
Liquidity ratios
Coverage ratios
Comparison with the industry
Gross margin analysis
Expenses analysis (normalized)
Staffing analysis
Projection of future profits
Weighting of historic and projected profits
Profile Ideal Acquirer
Having completed all of the above we are now in position to identify the
profile of an ideal acquirer. The operational and financial analyses will have
identified and quantified strengths and areas in need of improvement. The
ideal candidate must possess the skills and resources necessary to capitalize
upon the opportunities identified. The ideal successor’s profile will be the
reverse, or negative, of the profile developed for the company.
For example:
Present Management Successor
Needs sales/marketing Strong sales/marketing
Strong systems/controls Maintain system and controls
Strong product development Appreciate product
Weak finance Strong finance
Average manager Above average manager
Worn out Energetic
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You can now identify your successor by the skills, interests and resources
required for your company to flourish. Those candidates that fail to fit this
profile have no reason to know you are considering sale.
The type of buyer you hope to attract can also be ratified. Does your business
fit the criteria that would make it an attractive acquisition candidate for a
Strategic Acquiror? Can you position the business so as to be an exciting
opportunity for a Corporate or Sophisticated Buyer? When the answers to the
above questions are no, then what should, or can be done to make the
company as attractive as possible to a Financial Buyer? If, because the
company is too far gone or your are in too great a hurry to leave, the only
remaining viable candidate may be an Industry Buyer.
Regardless which type of buyer you identify as most appropriate, you now
know exactly what your company has to offer as opportunity and what it
takes to turn a buyer on. In Chapter 5, you discovered how various types of
buyers determine value. With this knowledge of how buyers approach
valuing businesses, you can predict what they might be willing to pay for
your firm.
Buyer Profile and Value
Identifying the proper buyer is important for several explicit reasons.
First, a person who recognizes the greatest opportunity will be more likely to
pay an optimum value (Value is in the eye of the beholder). You have worked
long and hard developing your business and deserve to be properly
compensated for what you have created.
Second, the future of your company depends on the quality and vision of the
person operating it (Future value is dependent upon operator). A significant
portion of your life has been invested in this business. If you are to pass the
baton to someone else, you probably want to see the business succeed and
prosper.
Third, to obtain optimum value, you most probably will participate in the
financing (Third parties are reluctant to participate in financing the
acquisition of small or family businesses). You are selling in order to move
on with your life. You do not want to be forced back into the business should
the new operator fail.
Fourth, knowing who and what type of acquirer you are seeking eliminates
much of the need to parade possible buyers through your business. Instead,
you can walk the parade route and logically pick your successor (Sell it but
do not let anyone know it’s for sale).
Fifth, understanding just which type of buyer your business is likely to
attract affords you the ability to more accurately judge the business’s value
(Ask twelve people and you will get twelve answers). Only the right buyer
will pay the right price.
40
Sixth, should the present value of your business be insufficient to meet your
needs, you need not expose it to the marketplace (Only the business owner
can weigh the personal gain against the financial rewards of selling).
Appropriate steps can be taken to increase the value of the business before
marketing efforts begin.
Seventh, depending upon circumstances, you may decide not to sell at all.
Perhaps you will decide to:
increase the value, then sell
hire a manager, take on a partner
do a merger or joint venture
establish an employee stock ownership plan (ESOP)
go public
do a private placement
engage a work out specialist
refinance the company
simply liquidate the enterprise
pack up the business and move it to Florida
My experience, when completing the business profile and buyer identification
process, is that forty percent of business owners elect not to sell and choose
one of the options above.
This disciplined approach of reviewing the business to identify the right
buyer has been in use for years by Investment Bankers. In fact, when the
value of your business contains two or three extra zeros, investment bankers
would essentially be performing this same exercise for your board of
directors. This process is described as Strategic Planning or Maximization of
Shareholder’s Value.
While the procedure is relatively straightforward and uncomplicated, you
may wish to consider hiring outside assistance. A rare person it is indeed
who can truly view themselves or their business objectively. A person or firm
best suited to this task will have marketplace or deal-making experience,
understand financial statements and tax implications, plus be savvy enough
to understand your particular business and your personal needs.
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Chapter 8
What Do You Do After You Decide To Sell?
inding the ―Right Buyer‖ becomes a manageable task once the type of
the type of buyer (Strategic, Sophisticated/Corporate, Financial or
Financial or Industry) has been identified and their profile has been
has been developed. Knowing where to look and what you are looking for
simplifies the task considerably. However, finding the ―Right Buyer‖ is no
easy task.
In fact, finding the ―Right Buyer‖ can be time consuming and frustrating.
When your business demands your full time attention, and its sale is
important, professional assistance may be a wise consideration. When
maintaining confidentiality is also important to you, obtaining third party
assistance might be considered a must.
HELP, where to find it?
Help comes in several forms, and depends upon the type of buyer most
appropriate for your company as well as the size of your firm. The audience
for this book are most likely to be owners of smaller to mid-size private or
family businesses. It has been written for you. Company revenues then are
probably under the twenty to thirty million dollar range that Investment
Bankers set as minimum size for companies they serve. Therefore, when we
eliminate Investment Bankers from consideration, we essentially have three
options (perhaps four) left to consider.
Merger and Acquisition (M&A) Specialists
M&A Specialists serve the ―Middle Market‖, that is, businesses with
revenues from ten to one hundred million. These firms can be found in most
major markets across the country. Finding a firm or an individual with
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whom you will be comfortable generally means interviewing several and, of
course, checking their credentials and references.
Many law and accounting firms provide M&A services although accounting
firms are becoming reluctant to become involved with existing clients fearing
possible conflict of interest and breach of ethics. Law firms seem less likely
to hold with this view. The buyer pool from which M&A specialists draw
their buyers consists primarily of Strategic and larger Corporate buyers.
Therefore, if your buyer is a Financial or a smaller Corporate or
Sophisticated buyer, and your discretionary earnings are under $500,000 (a
somewhat arbitrary number) it is unlikely that an M&A Specialist will have
sufficient access to candidates likely to consider your business attractive.
Business Intermediaries
Business Intermediaries serve companies whose sales generally fall under
twenty million with earnings often less than one million. They can draw
buyers from essentially all levels but are more effective where revenues are
in excess of one million and where discretionary earnings exceed $250,000.
Fees charged by both the Intermediary and the M&A Specialist involve an
initial retainer plus commission, or success fee, from which the retainer may
or may not be deducted.
Business Brokers
Business Brokers are most effective representing businesses that are
attractive to and sought by individual Financial buyers. Business revenues
typically are less than one million with Discretionary Earnings generally not
exceeding $100,000. However, most Business Brokers are not familiar with
the Profiling and Buyer Identification approach used by Intermediaries and
M&A specialists. Most understand the need for confidentiality, and feel they
intuitively know who your buyer should be. Most of the time they are right.
You may have noticed a gap in the Discretionary Earnings mentioned above.
Who is it that serves companies where revenues may or may not exceed one
million with Discretionary Earnings less than $250,000 but more than
$100,000? There are not very many who do it very well. Companies that fall
into this never-land suffer most by attempting to apply public company Price
Earning Ratios, and selling processes to the sale of this category business.
M&A Specialists and many Intermediaries do not have the necessary
experience in selling smaller private companies and then fail to delineate
between the appropriateness of Public and Private Company convention
when attempting a sale. The reverse is also true for many business brokers
since many are not familiar with the appropriate protocol of selling a larger
or complex company.
There are however, a few intermediaries/brokers who do possess an ability to
differentiate between public and private company conventions. Typically,
they have their roots in the business broker world and education or
experience which gives them an understanding of public company convention.
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This group is effective dealing both with buyers/sellers in the ―mom and pop‖
world as well as the Corporate and Strategic Buyers from ―the boardroom.‖
Selection of the professional best suited to handling your situation suggests:
a) first obtain an accurate and realistic understanding of why your company
is an attractive opportunity
b) determine to which type of buyer it would be most attractive.
Armed with this preliminary knowledge, you can then identify the
professional equipped to serve you best. With this strategic knowledge you
are also in a better position to measure the quality of their efforts during the
selling process.
Sell it Yourself
Selling your business on your own is a fourth possibility. In fact, a majority
of smaller and mid-size business owners, will attempt the sale of their
business on their own. This same person, however, is quite likely to use the
services of a Real Estate broker when selling their home.
In order to better understand this apparent contradiction, we assembled a
focus group consisting of fifteen business owners who were unaware that this
author sold businesses. They were asked, ―If you were to sell your business,
how would you go about it?‖ After general discussion all agreed that they
weren’t quite sure. However, they were consistent in resisting the use of a
broker—Most would ―do it themselves.‖ The reasons given are summarized
as follows:
“No one understands my business the way I do”
This statement is very true. However, when selling a business it is more
important to understand the business from the outside in than from the
inside out.
A person who designs and builds a watch is usually the worst choice for the
person to sell it. Typically, a designer or builder will focus too much on the
care and precision required to build the watch. Then will point out the
quality of the movements and materials, and dwell on the many features
built into the watch. The buyer seemed interested but did not buy. Why?
The buyer in this case could care less about the features. Buyers really want
to know about benefits that the purchase will bestow upon them. Then, and
only then, will they buy. In our example of the watch, benefits can range
from always being on time, to the prestige associated with owning such a
timepiece, or to the ability to circumnavigate the world.
You must understand your buyer’s needs and motivations and how your
product can satisfy them. To effectively sell anything one must develop an
―outside in‖ perspective. Knowing your business ―inside out‖ will often
prevent you from developing an objective overview.
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“I know the players in this industry better than anyone else.”
This is probably very true, but in what respect is that really important? As
mentioned previously, Industry buyers are typically the worst buyers. In
fact, unless they harbor a strategic reason for purchase, they should be
considered buyers of last resort.
A few years ago we compared the results from a PINE (Printing Industries of
New England) survey encompassing printing company sale prices with our
own data base of 55 printing company sales. Essentially all the companies in
the PINE survey were purchased by people from within this industry. All but
one of our buyers came from outside the printing industry. The prices we
obtained for our sellers exceeded the PINE survey results by almost 50%!
“Brokers charge too much money.”
It is widely recognized that buyers pay what they feel an item is worth, and
not a dime more. Sellers will only accept offers that meet their expectations.
In order for Brokers or Intermediaries to exist they must add value to the
equation, otherwise sales cannot be made.
One way in which brokers add value to business sales, is to identify the right
buyers and to position the offering so that buyers will identify the optimum
opportunities and value (circumnavigate the world).
“A Broker will not be able to maintain confidentiality.”
This one really floored me! However, when you recognize that the term
Broker means Real Estate Broker to most people their comment is more
understandable. In real estate scenarios, the more exposure obtained, the
higher is the probability of a property selling. Studies indicate that a
majority of real estate sales are derived from posting signs followed by
pictures of the property in an advertisement. According to the National
Association of Realtors (NAR), 45% of sales come from signs, and 9% from
classified ads.
Real estate type classified ad descriptions of properties generally reveal more
information than most business owners would want revealed. Example:
Business for Sale, Town (yours), Type business (yours), next to Post Office (just as you are), grossing (your volume), nets owner (your earnings), Reason for sale (your personal reason), for more information call Sue at ACE REALTY 345-6789
Fortunately those who specialize in the sale of businesses (of all sizes)
understand that their job is to ―sell it quickly but don’t let anyone know it’s
for sale‖.
Unfortunately the men and women in our focus group were reluctant to use a
Business Broker or Intermediary, mostly because of their automatic reflex
association with real estate broker methodologies.
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When Business Owners Attempt to Sell on Their Own
When the group was asked how they would specifically go about selling if
they weren’t going to use a broker, the pattern of response was as follows.
―I have a drawer full of letters from people who would like to buy
my business. I would contact them‖
―I would make a list of my competitors, suppliers and perhaps
major customers; then contact them to determine interest.‖
―Place a classified ad in my industries trade journal.‖
―I’d let route sales people and other key suppliers know. Word
would get out that I was for sale that way.‖
―Put an ad in the Wall Street Journal, with a blind reply of course.‖
―I think my accountant and attorney could help me find a buyer.‖
―Gee, I don’t know. That [selling the business] could present a
problem.‖
―No one would want my business.‖
―My trade association provides brokerage services for its members,
I’d probably let them sell it.‖
―I provide a very specialized service. I don’t think my business can
be sold.‖
―Run a classified ad, I guess.‖
The session was scheduled to run for three hours. Interest in the topic was
very high and discussion was reluctantly concluded after five hours.
This session was very revealing and prompted a survey of two groups of
business owners (approximately the same number in each group).
In the first group were business owners who had decided to sell their
business on their own, and with whom we had been in contact during the last
five years. The second group were business owners who had acquired their
businesses from us during this same five year period.
For Sale by Owner Results
Survey results shocked us! Granted, our region of the country had
experienced a severe economic down-turn during this five year period - but
we still were not prepared for what we found.
70% closed doors and went out of business
28% had given up thoughts of ever selling
2% actually sold
It is possible that our findings were a statistical fluke. Our data base
involved about 125 businesses, and maybe the survey base was too small to
be statistically significant. These results may have reflected an adverse
selection, in that some of the business people (who confided to us they were
considering sale but chose not to use a ―broker‖) knew they had nothing to
sell. We may never know for sure.
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On a Happier Note
The survey results for the new business owner group was a shocker also!
All were still in business
All but one had increased revenues significantly since they took
over
40% had doubled sales since takeover
The one owner not increasing sales had just concluded a messy and emotional
divorce. Admittedly, once again, conclusions based upon relatively small
survey numbers may produce conclusions that are statistically indefensible.
On the other hand, one might conclude that this ―profiling‖ thing just might
have some merit after all.
To access the elusive equity locked in your business you need
every advantage you can garner
47
Chapter 9
Is It An Offer You Can’t Refuse?
ou have been approached by someone who professes to have interest in
have interest in acquiring your business. What do you do?
Making the assumption that you have decided you would like to sell,
like to sell, the process is quite straight forward but unique.
First, who are these purchasers? What is their motivation? You have to
know ―where they are coming from,‖ before you can determine what you
might want to do. You need information, lots of information.
Expert negotiators obtain as much information as possible before talks begin.
Gleaning even the most trivial bits of information can be difficult once
negotiations are underway.
For example: Before negotiations begin you might inquire as to the suitor’s
marital status. You ask. ―Are you married?‖ The suitor responds, with
obvious pride, ―Yes, for twenty one years. We have three wonderful children.
The oldest . . .‖
Questions are answered and information freely provided during the
―courting‖ period and your questions are viewed as signs of genuine interest
on your part. When these same questions are asked after negotiations have
begun the response might be, ―Why do you want to know that?‖ Once into
negotiations even innocent questions can be suspected as prompted by
ulterior motives. The suitor may wonder . . . Will they want my wife’s
personal guarantee? Do they want her personal assets pledged as security?
Ideally, you want to know everything about the buyer, before they know you
are for sale. When this is not possible, then obtain as much information as
you can before negotiations begin.
Why your business? What are their plans? Their perceptions? You may be
flattered by their interest, but is their interest well founded? You need to
know about them in order to determine several key elements.
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Type of Buyer
Are they: Strategic, Corporate/Sophisticated, Financial or Industry Buyers?
If you have ascertained that only the Strategic or Corporate buyer will likely
pay your price, and the suitor is an Industry or Financial Buyer, then you
have no reason to expose the fact that you are for sale.
The Fit
Will they recognize that ―all the right things are wrong‖? Will they see
opportunity in what you have created for them? Is their vision one of
potential for what they might do with what exists? Remember, buyers will
buy because of potential but will not pay you for it.
Is their background and experience considered a plus for your company? Do
they have what it will take to bring your business to the next level? Are they
the type of people you would feel comfortable lending money? Do they have a
reputation for fair dealing? Would your customers and employees be
comfortable dealing with them?
Resources
Dreams and enthusiasm are great, but do they have the money? Will they
have additional resources needed to capitalize upon the opportunity your
business represents?
The process begins once both sides have determined that perhaps something
could be structured. It is here that the process becomes unique. Your
company is a private company and therefore public company customs are
inappropriate.
Were you a public company your financial information would be available for
anyone to scrutinize at will. Your channels of distribution, customer base
and perhaps plans for the future would also be well known. Comparative
Price Earning Ratios for your industry would be readily available. Terms of
sale would be expected to be cash. The operating history and style of the
suitor (as another public company) would be well known. The final decision
would be made by your Board of Directors, rather than you personally. You
would not be ―the company.‖
Your profits would be well documented. In fact, your suitor has probably
already reviewed and analyzed your financial data. Electronic data bases
containing this information are readily accessible to anyone with a computer
and a modem. These data bases are also available at many libraries. There
is nothing very private about a public company’s financial status. In fact,
this information is often part of the evening news.
As your suitor is also a public company you have equal access to information
regarding its financial condition. The ―books are open‖ (to a degree) for both
of you, and there is little remaining about who’s who and what’s what.
49
It is natural, therefore, for your suitor, as a private individual or company, to
request the last few years of your financial data in order to understand your
company more completely. Wrong, Wrong and Wrong!
Wrong #1 Financial statements are not operating manuals. They will not
tell the whole story nor will they highlight the opportunities fully. Actually,
financial statements and tax returns are more mystery novels than anything
else. They will generate more questions than they will provide answers.
Wrong #2 Private businesses do not share their financial statements and
tax returns with just anyone who asks for them. Even Dun and Bradstreet
has a difficult time obtaining real financial data from privately held firms.
Wrong #3 You become aware very quickly that a lot of well spoken ―three
piece suits,‖ often without two nickels to rub together, are looking to buy
companies. They, of course, have backers or financial connections that will
provide the required funds. Others plan to borrow money from their ―friendly
banker‖ in order to buy a company. Both types will be wasting your time and
their own.
What are they willing to offer? Do they have the money? How do you find
out? What do you do next? The answers depend on a number of factors
including; the size and type of your company and the type of buyer you have
attracted. The following chapters address several combinations of these
factors.
Ideally, you will know everything about
your buyer before they know you are for sale.
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Every morning I get up and
look through the Forbes list of the richest people in America.
If I’m not there, I go to work.
Robert Orben
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Chapter 10
Dealing with the Financial Buyer
financial buyer may be defined as the type of buyer who views owning
views owning a business as substitute for a traditional job. The type of
job. The type of business envisioned usually is a ―Main Street or Mom
Street or Mom and Pop‖ business. Our experience is that the majority of
these opportunity seekers are hard working, family types with excellent
credit ratings. What they lack in the way of financial sophistication, they
make up with common sense.
This combination of business and buyer is by far the most common. According
to the SBA, 55% of businesses gross $500,000 or less, and 74% of all
businesses gross less than one million. These businesses are the small
businesses that form the backbone of the US economy. They consist of your
local Printer, Restaurant, Coffee Shop, Hardware, Florist or Gas Station, to
name just a few. They employ only a handful of people, and their owners
work hard to serve their customers well. They occupy the principle rung on
the ladder of the American Dream, -- a business of one’s own. Most
individuals envision businesses at this level when considering business
ownership.
It is about this segment of American business (small business) that precious
little is published and/or understood. Perhaps the adage, ―It’s none of your
business‖, or ―Mind your own business‖, is part of the reason so little is
understood (especially with regard to transferring ownership).
In chapter 9, you have attracted a suitor. Your initial conversation went well
and they now want to see your numbers. What do you do?
A
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The Envisioned Process (Conventional)
The buying process envisioned is based upon a lifetime’s experience of
purchases. Purchases of everything but a business, that is. The sequence is
expected to proceed as follows:
Investigate the business
Make the decision to buy
Negotiate price and terms
You can’t refuse what seems to be a reasonable request so you provide them
with your tax returns for the last five years. What assurance do you have
that they can interpret your returns or your financial statements? Will they
fully understand and see the opportunity your business represents?
Oh well! They appeared to be nice people. You could not refuse what seemed
to be a reasonable request. In my experience, the odds of a sale being
consummated are less than 1 in 20 under this scenario!
Why Conventional Methods Do Not Work.
The financial buyer is generally a first time business buyer also. Motivation
to buy usually centers on issues of control and the ability to express one’s self
through self employment. While first time buyers may appear calm and
assured, they are extremely nervous and suspicious.
As is the case with most Americans, they are not financially sophisticated.
Most do not prepare their own tax returns but rather rely on others to do so,
perhaps an accountant or H&R Block. Many are unrealistic and/or naive
regarding the money required to buy a business. Many believe they can
simply borrow the purchase price from a bank (just like buying a house,
right?).
Little is really known about each other at this stage of the game, just the
opposite of a Public company transaction where everyone knows essentially
everything of importance before initiating the acquisition process.
Meanwhile, ―Back at the ranch‖, here on Main Street everyone is walking in
the dark as the courting game begins. Information is required by both sides,
yet confidentiality must be maintained. In addressing this situation a
process has evolved, independently and across the country, that is fair and
safe (for both sides) within which information can be confidentially
exchanged. We will hear more on this later.
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Why Not Give Buyers Financial Information At This Point?
Tax returns do not tell the entire story.
The buyer’s next stop is the person who prepared their personal tax returns,
unless your bottom line has scared them off immediately. You and I both
know that small businesses do not make money, but owners do. Tax returns
are usually more like a mystery in a novel, begging to be solved.
Forces premature purchase decision.
When your buyer meets with their financial advisor you can count on the first
question being, ―Should I buy this business?‖ If the advisor were clergy and
the question was, ―Should I marry this person?‖ the answer would be the
same. ―If you yourself are not sure, then you apparently don’t know what you
are doing. Therefore, I can give the only correct answer, for you—NO!
Confuses motivation.
Buyers explained in this chapter are not approaching their purchase from
purely financial perspectives. Buying a ―Main Street‖ business is more of a
life-style decision than a financial one. Does your buyer understand why
your business needs them? What skills, talents, interests, and resources can
they bring to your business? A sale is unlikely when the decision to purchase
is based purely upon historic financial information. Financial advisors will
critique the offering from a financial perspective only.
Results
Conversations continue. More information is requested, and more
information is provided. Everything seems to be progressing as planned.
You have now provided them with customer lists, lists of vendors, a complete
listing of your equipment, the employee roster, and perhaps other sensitive
information. The buyers contact your suppliers and best customers as part of
their investigation. Their contacts generate questions from your sources as
to why you are selling. One of your key employees gives sudden notice. Your
banker calls on you in a surprise visit. Your best customer cancels a job you
have been doing for years and gives it to your competitor. What is going on?
In this tumultuous lurch, the buyer calls and then faxes an offer to you.
Upon review the offer is found totally unacceptable. Now what to do? You
can counter their offer or you can reject it. In either case you still have to
deal with the mess caused by unmanaged disclosure. Thankfully this is a
story in a book, and not real life. We can start over. Let’s start again and try
it another way.
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The Safe and Effective Process
Let’s begin where the buyers have just asked you for financial information.
Your reply this time is that you certainly are willing to make that
information, and much more available at the proper time. For now, however,
perhaps they will provide more about themselves and describe why they are
interested in this type of business.
Where time or circumstances prevent appropriate discussion, suggest a later
time free of these restrictions. This will allow you to prepare questions, and
to review the profile of the ideal acquiror.
Does your candidate fit the profile? If yes, explain the mutual benefit of their
making you an offer based upon representations you are prepared to make.
Stress that after agreement on price and terms has been reached, any and all
information requested will be made available. The offer will not be binding
upon either party until both have had the opportunity to confirm the
provided information and validate the decision to buy and sell. In other
words neither side is bound contractually to buy or sell until a complete ―due
diligence‖ or ―discovery‖ is completed. Representations (sellers) typically
include:
Annual sales volume
terms and availability of a lease
value of inventory (at cost) to be included in the sale price
a sense of reconstructed or discretionary earnings available for debt
service, actual depreciation reserves, and their compensation
Your buyer must understand that you will expect information from them in
return for the data you will be supplying. Essentially, this is the same
information they might expect a banker to request:
Personal financial statements
Resume or employment history
Current credit report
Several references
Actually, requesting them to share their business plan with you can provide
you with an excellent summary view of how they think and how they would
run your company.
They agree to proceed as you have suggested. Your next meeting goes quite
well. You determine that their background and experience will serve them
well in running your business. They have asked good questions and seem to
understand your answers fully. Your comfort level is high as they appear to
be people of good character and work ethic. With the necessary information
shared and exchanged, the session is concluded. The buyers promise to get
back to you with a proposal.
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Later, you receive their offer, you find it acceptable, and do accept it. Or you
might counter with a request for a larger down payment or shorter terms,
etc., or you may reject their proposal entirely.
At this point, beware. Agreement on both sides does not constitute a ―done
deal.‖ The process has just begun! Business brokers’ experience predicts
that chances of completing a transaction with an inexperienced buyer and
seller are one in three. No statistics are available as to the success rate when
buyer and seller are ―doing it themselves.‖
The Buying Process
The procedure of buying/selling a small business is unique. As mentioned
previously, this progressive check and balance method provides safety for
both parties while they obtain sufficient information upon which to make
intelligent decisions.
Establish price and terms
Investigate
Decision to buy/sell verified
For business continuity reasons, confidentiality must be maintained.
customers lists, sources of supply, and other sensitive information must be
revealed in a controlled manner to maintain the long term integrity of the
company.
Here’s a quick overview of the process. Both sides make representations to
the other (usually verbal) i.e.:
Owner: Sales, profitability, outlook etc.
Buyer: Interest, ability to pay and operate etc.
Buyer makes an offer based on representations of seller
Owner counters, rejects or accepts the offer.
Price and terms are eventually agreed upon however, the decision to buy or
sell is still to be verified by both sides. The agreement typically is not
binding upon either party until representations by both have been verified to
everyone’s satisfaction.
Investigation (Due diligence) of the business by the suitor and of the buyer
by the seller, is conducted in depth. Financial and other confidential
information is exchanged.
Decision to buy/sell verified. Agreements become binding, transfer of
business is scheduled, and closing documents are prepared. Details of
transfer: lease transfer, bulk sale compliance, license transfers, UCC lien
searches, bills of sale, notes etc., are attended.
Closing or transfer documents are executed, money is exchanged for keys.
New owner and you return to the business. Introductions to employees are
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made, transition training begins. Congratulations You Have Just Sold
Your Business.
Summary
When the buyer isn’t willing to meet your price and terms, or when you deem
the buyer unsuitable, no financial statements, tax returns and other
confidential information need be disclosed. Vendors have not been contacted,
employees not interviewed, nor sources of supply and customer lists revealed
unnecessarily. Customer, employee and vendor relations have not been
negatively impacted. Confidentiality has been maintained. Money and
energy has not been expended needlessly.
Remember, buying or selling a private business is different from buying or
selling anything else in the world. The primary difference is the
unavailability of third party financing for the acquisition of a small business.
Your business is perhaps the only asset you posses that cannot be sold for
cash. Very few Main Street businesses sell for all cash. Owners insisting on a
cash deal seldom sell their business. Those that are sold on a cash basis are
usually sold for deep discounts.
The future success and value of a business depends in large measure upon
the person operating the business. You are the best judge of a candidate’s
ability to continue and improve your business. Not only are you the seller of
the business but you probably will provide the financing on a significant
portion of the sale price.
It is important, therefore, to you and your suitor, that an offer not be
construed as binding until parties have had the opportunity to check out each
other and that there is mutual satisfaction with the deal.
Chances of long term success can be greatly improved if you prepare:
Information being exchanged is clear and accurate
The opportunity is clearly identified
The FIT between the buyer and the business is ascertained
No surprises surface, such as increased rent or significant
dependence upon a single customer
The first buyer very often
is going to be the best buyer therefore,
Be Prepared.
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Chapter 11
Main Street Business, Sophisticated Buyer
―Sophisticated Buyer‖ is defined as a person(s) well schooled in
schooled in banking, finance or accounting and/or those buyers who
buyers who rely heavily on their professional advisors when
when considering a decision to buy. Typically the Sophisticated Buyer will
have a ―corporate‖ background, and come out of a middle or upper
management position with a large corporation.
With big companies ―downsizing,‖ Main Street businesses are being subjected
to the scrutiny of Sophisticated buyers more than ever before.
Several factors seem to have combined to produce this phenomenon.
Corporate America is downsizing which reduces the number of
―middle management‖ positions available.
Baby Boomers are reaching the peak of careers and have no upward
place to go as the job market shrinks.
A sluggish economy has intensified the loss of employment
opportunities.
Poor economy intensifies buyer’s fears causing excessive use of
professionals in the buying decision.
A Sophisticated Buyer has a difficult time personally, when attempting to
buy a Main Street business. While Main Street buyers employ a large
measure of common sense and intuition in their decision making process, the
Sophisticated Buyer will generally rely more heavily on ―the numbers‖ to
provide the information they will require.
A
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Why Many Sophisticated Buyers
Avoid “Main Street” Businesses
Main Street businesses do not keep records in sufficient detail to satisfy a
Sophisticated Buyer. Small business owners typically avoid ―extra paper
work.‖ We’re not talking General Motors here. The company is small,
uncomplicated and records are maintained for the benefit of its owner, not
stockholders. The manner and methods by which records are kept are
usually determined by the financial sophistication of the owner and not an
accountant or comptroller. Therefore, key information that a Sophisticated
Buyer or Advisors will anticipate receiving in order to ―understand the
business‖ is generally not available.
Examples of the type of information typically sought and unavailable are:
Balance Sheets—most proprietorship and partnerships do not prepare
balance sheets. They are not required by the IRS. A simple Schedule C as
part of the filing process is all that is required. If the business has borrowed
money or has established a line of credit, then perhaps a balance sheet will
be available. In most cases Main Street businesses have not borrowed from a
bank. If the business is incorporated then a balance sheet of sorts will be
filed as part of the Federal Corporate 1120 tax return.
Financial Statements—tax returns generally are the only source of income
and expense data available for essentially the same reasons mentioned
above. When financial statements are available they are usually
compilations. Occasionally you will see a review. Audited statements are
rarely completed because of their high cost.
Interim Statements are not usually prepared. This fact alone can cause a
Sophisticated Buyer and Advisors to have fits. It is not uncommon for
financial data to be more than a year out of date before the current financial
data becomes available. For example, the company’s year end is December
31st, extensions are filed, and it’s August before the prior years return is
completed. In the meantime, the most recent tax return dates back to the
previous December and is now twenty months old.
Sales by product or segment is usually very difficult to ascertain. Even in
retail situations, where cash registers could gather this information with
very little effort, the information is not routinely gathered. In other
situations information may be available, but is not used as a management
tool, and therefore not compiled in a meaningful manner.
Gross profit by product or segment, is really important. However, this
information is usually carried in the owner’s head. Formal programs,
systems or policies usually do not exist for measuring contributions to gross
profit by item or segment.
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Industry information is usually difficult to obtain unless the industry or
type of business is of a significant size for Robert Morris Associates, Dun and
Bradstreet or other financial information gathering firms to have amassed
meaningful data. Trade associations become the primary source for the
operating and ratio information sought by Sophisticated Buyers. However,
this data is not always available to those from outside the industry.
You can easily lose a good deal with a Sophisticated Buyer when information
they deem important is unavailable, or provided slowly in bits and pieces.
The lack of organized and comprehensive data puts you and your company in
a bad light. Lack of information increases a buyer’s natural tendency
towards skepticism and suspicion.
Fear of the unknown and judging incorrectly based on limited information or,
jumping to conclusions, will combine and kill what should have been a good
deal for both of you.
Attracting Sophisticated Buyers to a
“Main Street” Business
Unlike Financial Buyers, Sophisticated buyers are more likely to have
visions of ―creating empires.‖ They prefer to ―manage‖ rather than ―do.‖
They do not see themselves ―making the donuts.‖ They want to ―direct‖ the
growth of a firm. These statements summarize an attitude in many who
come to us seeking a ―Light Manufacturing or Distribution‖ business.
They are very talented, and could likely do a fine job operating companies
they initially seek. However, they seldom have adequate money (usually
millions) to acquire the manufacturer or distributor of their dreams.
These talented, high net worth buyers can be attracted to a main street
business if the opportunities are present for them to create their empire.
Opportunities such as the ability to:
Develop multiple locations
Expand concept regionally or nationally
Grow company via management or financial savvy
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Examples of Main Street businesses many sophisticated buyers have been
surprised to find attractive:
Quick Printing Dry Cleaning
Silk-screening Employment Agencies
Donut Shops Office furniture refinishing
Medical Practices Commercial Printer
Ambulance Service Lumber Yard
Home Center Restaurants
McDonald’s was purchased by Ray Kroc when it was a one stand hamburger
joint. Ray recognized the opportunity the unique ―joint‖ represented and
created his empire.
Positioning Your Business For The Sophisticated Buyer
To be attractive to the Sophisticated buyer you must present your business as
an exciting management challenge rather than a job. In order to enhance the
probability of consummating a sale, time and effort must be devoted to create
and organize meaningful data into a comprehensive information package or
prospectus. The package should minimally include:
History of the company—concise overview
The Business—description of the business
Market served—who are your customers, (generically, not by name)
Customer concentrations
Operations—hours, staffing, benefits, wages and who does what
Location—copy of lease, summary of terms
Business segments—breakdown of sales by products or service
Profit Margins—by product and/or service
Competition—Who, competitive advantages
The industry - outlook, trends, recent changes etc.
Financial Information - Five years or at least three years of income
statements and balance sheets with corresponding tax returns.
Comparison with industry—compare key operating ratios of your
company with those typical for your industry
Highlight the opportunity—as supported by industry trends and
outlook, ratio analysis, and comparison with current industry
operating data
The above need not be elaborate but must be accurate. No attempt to conceal
material information should be made. If you have profiled your ideal
candidate correctly the areas of weakness in your business will be pictured as
opportunities to the buyer.
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Identifying Sophisticated buyers and understanding the information
they want will, in itself, increase the price you receive for your enterprise.
The selling process is essentially the same as that used with the financial
buyer, except that a prospectus or information package has to be available
when dealing with a sophisticated buyer.
The prospectus should display your opportunity in a concise fashion. The
more verified data available via third party sources, the more believable the
package. ―Information Highways‖ simplify gathering much of the
information through numerous data bases available today.
Sophisticated buyers seem to prefer ―Letters of Intent‖ (LOI) over Offers to
Purchase. LOIs are designed to be non binding and simply outline terms and
conditions of the contemplated sale. There are cases, however, where the
courts have ruled LOIs to be binding.
Once agreement in principle is reached, the discovery or due diligence begins.
When discovery is completed, a formal purchase and sale agreement and
other closing documents can be drawn up.
No task is completed satisfactorily
until the ―paper work‖ is done right.
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Toots Shor’s restaurant is so crowded
nobody goes there anymore.
Yogi Berra
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Chapter 12
Bottom Line or Between the Lines?
hat’s the bottom Line? It would seem reasonable to assume that one
assume that one could approximate a company’s value by simply
by simply looking at the income statement and balance sheet. This
sheet. This is definitely not the case, especially with smaller private
companies.
Your accountant follows certain rules and regulations for his profession when
preparing your statements. These rules generally are referenced as
―Generally Accepted Accounting Principle‖ (GAAP). These rules, and the
consistency they produce, allow users of financial statements to measure and
compare your results with others from within your industry.
When it comes to determining a Fair Price or Value for a private company,
GAAP regulations can and do distort the picture. Therefore, before
attempting to place a value on a private business, certain adjustments to the
Balance Sheet and Profit and Loss statement must be made. After these
adjustments are made, your company may be worth many times its reported
net worth.
Balance Sheet Adjustments
GAAP and IRS rules require reporting of Assets and Liabilities on an initial
cost basis. Tax rules determine the rate of depreciation taken. Both sets of
rules are by nature arbitrary and do not necessarily reflect actual value.
Balance sheet adjustments are made to correct this, bringing the values in
assets to the present fair market value. Use the example on the following
pages, or use the computer program VALUware 6.0, to make the adjustments
to your balance sheet.
W
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Primary Adjustable Balance Sheet Elements
Balance sheet assets are generally classified into three categories:
Current Assets
Fixed Assets
Intangible Assets
Current Assets
Current Assets are those assets that can be converted to cash in a relatively
short period of time. The most common are listed below.
Cash
Cash obviously needs no adjustment. However, one must remember that
most small business sales are asset rather than stock sales and, as such, cash
is typically retained by sellers and not included as a transferable asset.
Accounts Receivable
Estimates for uncollected receivables may be too high or non existent. For
example, assume a $10,000 reserve for un-collectibles is based upon 1% of
gross sales. However a review of the receivables list and historic results
indicates $2,000 is a more realistic figure. This would result in an $8,000
increase in value. A safer way to value receivables is through the ―aging‖
process. Generally buyers will deduct accounts over 90 days as risky or likely
to be un-collectable.
Inventories
LIFO (Last In First Out), FIFO (First In First Out) and FISH (First In Still
Here) are accounting methods (well, two of the three are anyway) addressing
the fluctuating value of inventory. What is the actual current value of your
salable inventory? It is our experience that most inventory values are
understated.
Pre-paids
Insurance is the most common prepaid and, as with cash, generally retained
by the seller.
Fixed Assets
Assets such as land, buildings, equipment, machinery and furnishings are on
the balance sheet at their initial cost less depreciation. Some items may
have been fully depreciated and therefore, theoretically, have no present
value. Land is not allowed to be depreciated and therefore is always stated at
cost. In many cases these assets may be worth more today than when they
were purchased.
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The most accurate method for adjusting these items is to have an appraisal
by a competent professional. It also is the most expensive. For informal
purposes, your estimate of fair market value (what the assets could bring in
an orderly liquidation) can usually provide a fairly accurate number.
However, when hard assets are significant, an appraisal by a respected firm
is recommended
Depreciation
This number is calculated (and accumulated) based upon accounting and IRS
rules. When adjusting the balance sheet to be representative of a starting
balance sheet, depreciation is omitted.
Intangibles Assets
Values in patents and franchises or license agreements may have been
overlooked or the value may be over or understated.
Adjustments to Liabilities
The most common adjustment found here is Loan from Officer or Affiliate.
These items are more appropriately considered as Equity when adjusting the
balance sheet for valuation purposes and therefore subtracted from
liabilities.
Employment Contracts
Although not a balance sheet item, employee contracts are company
liabilities. For example, a consulting contract with a former employee for
$10,000 a year for ten years is a legal obligation of the firm for $100,000. An
agreement of this type typically will find its impact upon the income
statement unless it is contract for future services (upon the retirement of an
executive in several years).
Adjusting the Balance Sheet
(All $s in thousands) Book Adjusted
Assets Value Adjustment Value Notes
Current Assets
Cash 2.5 (2.5) 0 (1)
Accounts receivable 55.1 ( .4) 54.7 (2)
Inventory 42.7 8.0 50.7 (3)
Prepaids 2.8 (2.8) 0 (4)
Total Current Assets 103.1 2.3 105.4
Fixed Assets
Land 40.0 60.0 100.0 (5)
Building 50.0 80.0 130.0 (5)
Machinery/Equipment 119.8 (35.6) 84.2 (6)
Vehicles 18.7 ( 3.7) 15.0 (6)
Furniture/Fixtures 21.8 (16.1) 5.7 (6)
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250.3 84.6 334.9
less Accum. depreciation (196.6) 196.6 0 (7)
Total Fixed Assets 53.7 281.2 334.9
Intangible Assets
Franchise 25.0 5.0 30.0 (6)
less Accum. depreciation ( 15.0) 15.0 0 (7)
Total Intangible Assets 10.0 20.0 30.0
Total Assets 166.8 303.5 470.3
Liabilities
Current Liabilities
Accounts payable 33.1 0 33.1
Accrued expenses 2.5 0 2.5
Accrued taxes .5 0 .5
Notes payable - bank 8.6 0 8.6
Notes payable - officer 12.0 (12.0) 0 (8)
Total Current Liabilities 56.7 (12.0) 44.7
Long Term/Fixed Liabilities Notes payable - bank 27.5 0 27.5
Notes payable - officer 12.0 0 12.0
Deferred Income taxes 2.5 0 2.5
Total Fixed Liabilities 42.0 0 42.0
Total Liabilities 98.7 (12.0) 86.7
Equity 68.1 315.5 383.6
Notes: 1) Cash typically is not included in a sale of a small business
2) Adjusted for questionable receivables
3) Adjusted to actual value of inventory
4) Prepaids not usually an asset that is sold
5) Book value of land and building is adjusted to present fair market
value
6) Adjusted to fair market value
7) Depreciation is deleted as assets are being adjusted to fair market
value
8) Officer note is usually regarded as being equity rather than debt
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It’s Not What You See, But How You See It.
Purchase decisions and the price a buyer pays for a business depends upon
confidence in the future earnings of the enterprise. That view, whether
favorable or unfavorable, is generally shaped by several factors:
Historic ―bottom line‖ results of the company
General outlook for the industry
General outlook and trend of the specific business
State of the local and national economy
The condition of the market being served
The opportunity the enterprise represents
Adjusting the Historic “Bottom Line”
The Income Statement also known as Profit and Loss (P&L) must also be
adjusted. The purpose in this adjusting is to reflect the actual amount of
earnings for a new operator to pay their salary, debt service and to
hypothecate depreciation reserves. This adjusted earnings number has many
names: Free Cash, Free Cash Flow, Seller’s Discretionary Cash, Normalized
Cash Flow, Cash Flow, Normalized Earnings, Available Cash and
Discretionary Earnings to name few more widely used. Discretionary
Earnings and Free Cash Flow seem to be emerging as the labels of wider
choice. The American Society of Appraisers (ASA) recently declared
Discretionary Earnings the winner and the description or title to be used by
its’ members. However, AACPA membership, continues to prefer Free Cash
Flow. Name or title is really unimportant. Understanding the principle
behind the technique is what really counts.
In making these adjustments bear in mind that you are eliminating or
adding expenses a new operator would have or not have. For example: You
have chosen to pay your daughter and spouse at a rate exceeding the
prevailing wage. The extra pay might be added back to profits. If, however,
they are working full time for no compensation, an appropriate wage for their
services must be deducted from profits.
As you well know, private business owners work quite diligently to use tax
loop holes to suppress profits and minimize taxation. Opportunity seekers,
on the other hand, need to rely upon existing earnings in order to:
feed their families
retire acquisition debt
provide working and expansion capital
earn a return on the dollars invested
All of this money must come out of profits, and private company accounting
practices make it difficult to see levels of profit until statements are
―normalized, adjusted or recast.‖ If the money is not there or if it has been
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hidden or disguised so well that it cannot be found by the acquirer, then
either:
1. the company will not be sold or,
2. if sold, will sell at a greatly reduced price.
Therefore, it is of utmost importance that the dollars deployed to reduce
taxation can be readily identified by an acquirer and/or their advisors. This
exercise is referred to as Normalizing or Recasting.
Recasting or Normalizing Income Statements
Two opportunities exist through which a business owner can minimize
profits. One is illegal and the other is not. Messing with the top line (sales or
revenue) by not reporting sales is perhaps the easiest way to minimize
taxation. It is also illegal. The second method is to work ―between the lines‖
or that area found between the top line (income) and the bottom line (profit)
on your financial statements or tax return. This is where one looks to find
dollars that could have been reported as profit but were instead legally
deployed in such a way as to produce a business expense and to reduce
profits.
Before attempting to value or sell a business, past income statements and
balance sheets must be normalized or adjusted to reflect what many refer to
as, the ―true earnings‖ of the company. The financial results for the last three
to five years should be adjusted. Most sophisticated or corporate buyers
prefer five years of financial information.
Objective
Before making adjustments it is best to first define the objective of the
exercise. The objective—to identify those dollars that would have been
available to a new owner for their: debt service, owner compensation and
actual depreciation reserves after all necessary business expenses have been
paid.
Income statement or Profit and Loss (P&L) adjustments fall into three
general categories:
Non Cash
Non Reoccurring
Discretionary expenses
Non Cash Adjustments
Depreciation may be the only item falling into this category. Depending on
your business, all or none of this number will be used as an adjustment. If
your business is an Auto Driving School and the depreciation number
represents depreciation for your vehicles, which must be replaced every three
years, then it is unlikely that a buyer would accept any depreciation add
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back. A buyer would be likely to add back all of the depreciation for a mail
order company. Most businesses will fall in between these two extremes.
A reasonable approach would be to develop a figure representing ―excess
depreciation.‖ Every business must continually invest in new or replacement
assets in order to remain competitive in the market place. What would a
reasonable number be for your business? A review of historical expenditures
on new equipment and fixtures would provide an excellent basis for
adjustment. For example: as a printing business, over the past five years you
have spent $20,000 (or $4,000/year) either upgrading or acquiring new
equipment in order to remain competitive. Depreciation on your tax return
amounts to $37,550. It would be reasonable to adjust the depreciation to
―excess depreciation‖ of $33,550 by subtracting $4,000 from the $37,550. In
accounting terms, this $4,000 amount is referred to as Replacement Reserve.
Non reoccurring expenses
Unusual expenses not likely to reoccur in the general course of business,
especially those not likely to be expenses of the new owner can be added back
to profits. Some examples are: tax penalties for late filing, excessive legal or
accounting expenses brought about in connection with a partnership
dissolution or dispute, consulting fees or retainers paid to obtain a business
value opinion, new signage to comply with the Americans with Disabilities
Act etc. Any expense item a buyer would be likely to accept as one not likely
to reoccur year after year can be added back to profits, or stated another way,
deducted from expenses.
Discretionary expenses
This is the area affording the most opportunity and also the biggest
challenge. In this area a discretionary expense is often hidden or disguised.
Remember, a buyer has to accept the legitimacy of an adjustment for it to be
added back to profits.
Most common adjustments are:
Auto expense—You may have a Mercedes as a company car and your
spouse may be driving the company’s Blazer. If neither vehicle is really
required in operations then the entire amount may be added back. On the
other hand, if the company van doubles as your personal vehicle you may not
be able to add back any of this expense. The adjustment being sought is that
which represents excess auto expense, or the amount over and above that
which a new operator would have to pay.
Travel and Entertainment - Do you really have to go to Aruba every year
to attend the Pizza & Pasta Convention? Did your spouse really have to
attend also? Will a new operator have to attend in order to remain
competitive? If the answer is yes then no add back. If the answer is no, and
a buyer is likely to agree, then add this expense to profits.
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Owner’s Compensation Some controversy surrounds adding this item to
profits. The appropriateness depends upon the type of buyer you are dealing
with. A Financial Buyer is most likely to accept adding the entire amount to
earnings. The Corporate and Sophisticated Buyer will add only excess owner
compensation. In the later case a wage usual to your industry is determined
and subtracted from actual officer compensation to determine the amount of
excess earnings.
Interest Expense Most business sales are ―Asset Sales‖ and as such the
business is sold free and clear of all debt. The new owner may or may not
have debt, and therefore, your historic interest expense can be added to
profits. Interest on debt that will be assumed as part of the sale structure
should not be included.
Insurance Discretionary insurance expenditures such as officer life
insurance, insurance on private vehicles and insurance on the real property if
the business alone is to be sold can be added to profits.
Other Discretionary Expenses If one uses the creative approaches used
to establish business expenses as a guide, it would appear that many
business owners have taken Creative Writing IV, and scored very well.
Product purchased by the company for personal consumption by the owner’s
family are usually expense not accepted by a buyer. Association
memberships may not be accepted as adjustments because the buyer may
perceive the expense as necessary for business purposes. The key to
acceptance is the ability to provide a paper-trail detailing the expenses.
When an expense cannot be proven beyond doubt, then no add back.
Caution We have heard of many very abstract expenses taken over the
years. How about the cat food and veterinary expenses for a house bound cat
included in business expenses as a security expense? Clever? - yes. Legal? -
NO! Expenses found between the lines must also be within the law if they are
to be added to profits.
Negative Adjustments
Previously, we mentioned increased labor expense resulting from unpaid or
underpaid family members. The amount a new owner would have to pay,
plus taxes and benefit package expenses, should be deducted from income.
Adjustments in rent are usual when one owns and retains the real estate
after sale. Often landlords use a change of ownership as their opportunity to
increase rents. The rent increase should be deducted from profits.
The adjustments to your financial statements represents an important step
in determining the value of your company. An example of Income Statement
adjustments is shown below.
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Example of Income Statement Adjustments
(All $s in thousands) Actual Adjustment Recast Notes
Sales 821.0 0 821.0
Other Income 9.9 (9.9) 0 (1)
Net Income 830.9 (9.9) 821.0
Cost of Sales
Inventory (begin) 53.2 0 53.2
Purchases 153.0 0 153.0
Direct Labor 255.1 (17.5) 237.6 (2)
Outside Services 81.2 0 81.2
Supplies 28.5 0 28.5
571.0 (17.5) 553.5
Less Inventory (ending) 55.1 (.4) 54.7 (3)
Total Cost of Sales 515.9 (17.1) 498.8
Gross Profit 315.0 7.2 322.2
Expenses:
Advertising 2.1 0 2.1
Travel/entertainment 7.2 (5.1) 2.1 (4)
Officer’s salary 155.0 (155.0) 0 (5)
Office wages 67.9 (12.5) 55.4 (6)
Interest 1.5 (1.5) 0 (7)
Telephone 7.2 0 7.2
Professional fees 1.5 0 1.5
Dues/subscriptions .8 0 .8
Office expense 4.8 0 4.8
Heat, light, power 47.5 0 47.5
Insurance 44.4 (3.2) 41.2 (8)
Depreciation 5.2 (5.2) 0 (9)
Taxes 37.5 (17.5) 20.0 (10)
Repair/maintenance 2.8 0 2.8
Total 385.4 200.0 185.4
Profit/(Loss) (70.4) 136.8
Notes
1) This is interest on cash not being transferred
2) Excess wages paid to daughter
3) Adjustment to inventory
4) Discretionary travel and entertainment
5) Officer compensation
6) Excess wages paid to spouse
7) Business will be transferred debt free
8) Officer’s life insurance
9) Non cash expense
10) Taxes on officer and excess compensation to spouse and daughter
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Non Financial Element that Affect Value
If book values and earnings were the only elements determining a company’s
worth, then any first year accounting student could provide valuations for
mergers and acquisitions activities.
Remember, it is the expectation of future profits that determines the value of
a company. If future prospects for profits is in question, value will diminish
or even evaporate.
Example:
We were engaged by a company that had been producing a well known
product for more than 65 years. The second generation owners were
approaching retirement and were considering the sale of the family business.
The company showed pre-tax earnings of $275,000. The fair market value of
its transferable assets was estimated to be $250,000. The company enjoyed:
a broad customer base with no one customer accounting for more
than 1% of revenues
consistent and increasing profitability
respected brand name
state of the art equipment housed in a new facility
virtually no competition
stable and well trained labor force
no significant debt
very favorable long term lease
Unfortunately their product was declared a hazardous waste that presented
serious danger to all who might use it. The prospects of environmental and
personal liability made it improbable that the company would be sold. The
company was therefore liquidated. Non financial factors can have a dramatic
impact on the value of any business. The most common follow.
Outlook for the Industry
What is the outlook for your industry? Are revenues expected to increase,
remain level or decline over the next few years? What changes are occurring
that will impact the industry? If your business is typesetting, the
proliferation of electronic pre-press technology will undoubtedly have a
chilling effect on most acquisition candidates. On the other hand, a
manufacturer of a health care or environmental products company, where the
expectation is for continued growth and demand, could expect a premium
price upon sale. If your buyer perceives a negative trend, then a lower value
will be given to your opportunity.
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Outlook for the Business
Are revenues or sales trending up or down? What is causing sales to increase
or decrease? Is obsolete equipment hurting your ability to compete
effectively? Are major or other competitors entering your market? The more
positive the outlook, the higher the value.
Outlook for the Market Served
Are all of your customers going bankrupt? Have major employers left the
area? Your business’s success depends upon the vitality of your customers. If
you are the owner of a printing firm whose customers are primarily computer
companies (for whom you print operating manuals), what impact would a
downturn in the computer industry have on your printing business? If your
coffee shop is located just outside the gate of a large boat manufacturing
plant, how did the luxury tax imposed on boats impact your business?
Obviously the health and welfare of your customers are important to your
business’s value.
Example
Lengthy negotiations for a mid-sized manufacturing company we
represented were finally completed. Attorneys performed their magic, and
both buyer and seller were enthusiastic for the future prospects of the
business. The transfer was to occur on Thursday, but then rescheduled to
Monday, due to a participant’s travel delay caused by a hurricane..
The banker called one day after the scheduled closing to say that they could
not do the deal! Why? What’s wrong? Apparently they had just learned that
this company’s major customer (15% of revenues and 3% of profits) was found
to have poor credit, and was struggling to remain viable. Threatened with
this information, they had no alternative but to cancel their commitment to
finance this deal.
Fortunately, in this instance, the banker’s information was proven faulty and
the transfer completed. The lesson learned from this example is that present
and future prospects of your customer’s businesses can have a dramatic
impact upon the value of yours.
Regional or Local Outlook
Consider that another major employer has just announced they will be
closing their plant in your town. How will this affect the economic health of
your market area? Is it expected to remain vibrant, or is the economy
expected to decline?
One does not have to be a fancy market researcher to recognize areas with
weak economies; and buyers are quick to retreat from business offerings
located in distressed areas. When the overall economy is bad, buyers and
their advisors are extremely cautious about buying any business. Sellers
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become reluctant to sell during poor economic times and will often choose to
wait for improving conditions before attempting a sale.
The Opportunity the Enterprise Represents
Last, but perhaps the most important of all, is the opportunity represented
by the offering. Motivation to buy is fueled by a buyer’s recognition of the
opportunities your business represents to them. Ideally ―all the right things
will be wrong‖ with the business Opportunity to a buyer is, what can be done
with the company. Opportunities ratified and substantiated by third party
sources add credibility to forecasts and projections creating an aura of
optimism that increases a buyer’s perception of value.
Buyer and advisors are not impressed with ―If only‖ stories that lack data to
support the opportunity claimed. Projections and forecasts must be based in
reality and upon factual data.
―All this company needs is someone with money,‖ and of course, that person
will make a fortune. Yeah, Right! That ―Jolly Roger‖ does not get saluted!
The world is full of people in search of ―sugar daddies.‖ Those who have
accumulated cash are seldom impressed by this simplistic remedial answer.
Unsupported claims, especially those ―all you need is money‖ types, do not
build credibility for you as a savvy business person, nor your business as an
attractive opportunity.
Buyers are always reluctant to make buy decisions when opportunity is
unsupported by credible data. Data without third part verification is often
given only minimal consideration, if at all. To have influence on the value of
your company, projections or forecasts must be made believable through third
party support. Third party participation is discussed in the next chapter.
Reason for Sale
The opportunity your business represents is usually supported by your
personal reason for wanting to sell. Buyers’ first questions to Business
Brokers and Intermediaries are: ―Where is the business?‖ Followed by ―Why
is it for sale?‖ They are not impressed by reasons centering on a lack of
money. What they seek are reasons for sale that, by inference, suggest
opportunity. Examples: Death, Disease, and Divorce appear to be three most
popular reasons for sale, followed by retirement of a long time owner. All
suggest opportunity. Few would wish any of the three D’s on anyone, and
most would someday like to retire.
Warning! Are you tired and losing enthusiasm for your business? This
scenario is a buyer’s dream. Many buyers dream of finding a tired, and
ideally, elderly owner who wants a younger person to take over their
profitable business. However, very few businesses fitting this description
ever come to market. Reason? -- Typically, a business wanes in direct
proportion to an owner’s interest in the business. By the time most
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businesses fit the buyer’s ideal description (excepting the profitable part)
there is simply no business left to sell!
Summary
This chapter shows how recasting and other factors can either add or detract
from the price you might receive for your business.
Recasting is not as difficult as it may sound. Producing credible projections
requires a bit more work. However, as the value of a business depends on a
perception of future profitability, the effort is well worthwhile and can pay
handsome dividends.
Example: In a recent sale financial statements indicated the firm to be
insolvent, to the tune of $600,000. During the past five years not a dime had
been earned! Why would anyone want to buy this company?
In our example, the 50 year old company manufactured and distributed a line
of ―high end‖ building materials. It was purchased five years earlier by a
CPA at a bargain price. Although the highly skilled CPA established
comprehensive systems and controls, an effective sales and marketing effort
was never instituted.
The buyer possessed the right combination of experience and background
(selling different products into similar markets) allowing him to recognize
that ―all the right things were wrong.‖ The basis of projected future profits
could be verified and supported by third party sources.
This story illustrates a sale based solely upon opportunity supported by
verifiable projection of future profitability as recognized by the right buyer..
The decision to buy, and the price paid,
depend upon the buyer’s confidence in
the future earnings of an enterprise.
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One of the symptoms of
an approaching nervous breakdown is
the belief that one’s work is terribly important.
Bertrand Russell (1872-1970)
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Chapter 13
How to Increase Value Without Increasing Profits
ou ask, how can you increase the value of a business without
without increasing the company’s bottom line profits? Before you
Before you began reading this book you might not have had a clue.
had a clue. Hopefully, by now you have a pretty good idea of how it’s done.
Let’s have a little fun. Ask your accountant or your brother in-law, the
financial whiz, and watch them struggle with an answer, other than, of
course—―I don’t know.‖
The most important element of increasing the value of your company is to
attract the best buyer. Only this buyer will pay the best price. Sounds
simple, but yet what makes a buyer best? The best possible buyer is the one
who recognizes the highest degree of either opportunity or synergy. Also, the
very best buyer is the buyer who is not spending their own money. This, of
course, describes the Strategic Acquirer or, to a lesser degree the
Sophisticated or Corporate Buyer as described in Chapter Five.
Most small businesses will never be attractive Strategic Acquisitions, but
essentially all can be made into attractive candidates for the Sophisticated or
Corporate Buyer. Understanding the criteria of the different buyer types will
allow you to shape and position your business so as to be attractive to the
best possible acquirer.
To increase the value of your business without increasing profits the
following factors should be addressed.
Transferability of skills
Bankability and records
Information beyond the financial statements:
Customer concentrations
Y
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Industry concentrations
Margin maintenance
Identification of buyer who fits the opportunity
Credible projections
Stability of tenancy
Proper preparation
Professional assistance
Reducing the perception of risk
Transferability of Skills
To make your firm more attractive to the best candidates, it is imperative
that you reduce whatever dependency your company presently has upon you.
Transferability of an owner’s skills is perhaps the single largest determining
factor in increasing value.
When you are the major element in your firm’s operation, your company may
only be attractive to buyers seeking a job (Financial Buyer). Financial
Buyers pay a fair price, but not the premium prices paid by the Sophisticated
or Corporate Buyers. The best buyers are not seeking a job but rather a firm
to manage and develop. Directing the growth, not doing the work, is the
more specific objective of Sophisticated and Corporate buyers. Any company
can be made attractive to these buyers when you, a) develop a team, b)
develop a firm rather than a business, c) create a uniqueness or method of
successful business operation that might be cloned or replicated elsewhere.
Example:
Several years ago we were asked to provide an Opinion of Value for a
specialty retailer in our city. Our report included a range of values supported
by the types of buyers that could be attracted to the opportunity. Values
ranged from a low of $650,000, if sold to an industry buyer, to a high of
$3,000,000 if a Strategic Acquirer could be attracted.
Our study ultimately excluded prospects for attracting the Strategic
Acquirer, and that the most aggressive price the retailer could expect to
receive for the company (at that point in time) would be in the area of 1
million, with perhaps a $400,000 down payment. The report then
recommended a plan to attract a Strategic buyer. Several recommendations
made were:
1. Reduce dependency upon founder by delegating responsibilities and
creating departments
2. Improve financial and operational record keeping
3. Implement margin controls
4. Close non performing outlet
5. Prove customer acceptance of their unique retailing concept by
opening a store in a different market
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Management decided to forgo immediate sale and instead, implement our
recommendations to attract Strategic Buyers.
Two and one half years later, after implementation of the recommendations,
the retailer was able to attract an Investor Group. The buyers, recognized
the opportunity to open additional outlets, perhaps nationwide. Projected
earnings were based upon verifiable data and supported by outside resources.
Financial and operational data was clear and in concise order. The
opportunity to go public in a few years was an exciting and real possibility.
Pre tax earnings were approximately $250,000, and net worth $1,200,000.
The Group paid Four Million - Cash.
Bankability and Records
Well-maintained financial records in a business translates into your being
perceived as a savvy operator. Understanding what they forecast can
increase the value of your business dramatically as in the above example.
Why can good record keeping increase value? Well, it increases the comfort
levels of buyers and bankers reducing the perception of risk. Comprehensive,
professionally prepared, financial statements are a must if you hope to
attract buyers willing to pay premium prices. What can not be documented
in a legitimate paper trail creates serious doubt, and most often, translates
into discount thinking.
The amount of cash received at transfer is reduced when buyers do not have
access to financing. A lack of financing may also suppress the total value of
your business as well. What impact would a lack of financing have upon the
value of your home?
To enhance the probability of a buyer obtaining financing you have to play by
the rules established by those in charge (the government). The government
wants you to make money and pay taxes.
Your pre tax earnings need not be large but adjustments to earnings must be
clearly identifiable and legal. Borrowing from a lender will be next to
impossible if your records are kept in a shoddy or unprofessional manner.
Keeping accurate and comprehensive records lends a significant degree of
comfort to both buyers and lenders.
Information Beyond the Financial Statements.
Profit and Loss (P&L) Statements do not always reveal the entire story. In
private companies, additional ―clearing‖ work must be done to expose
important financial information to increase buyers comfort-levels. In
addition to income and balance sheet adjustments, you should also be able to
provide information regarding the following subjects.
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Customer Concentrations
What percent of your sales do your top 10 customers represent? Is it 5%, or
perhaps 75%? What percent of your profit is derived from these same
customers. A heavy dependency upon a single customer, or small number of
customers, will decrease value in proportion to the perceived risk.
Many buyers will not ever consider purchasing a company when dependency
on a few customers represents a significant percent of company revenues.
How do you stack up? If your firm is relying upon too few customers, do
something about it. Broaden your customer base. Too many eggs in one
basket is not adding value to your company no matter how profitable their
business.
Example: Several years ago one of my associates purchased a trucking
company we represented. The company was quite profitable and had earned
an excellent reputation during its 75 year history. The company’s largest
customer (essentially the only customer) had been using the company’s
services for the entire 75 years. The relations between company and
customer were excellent.
My friend understood the risk he was taking but chose not to do anything
about it after the purchase. You may have already guessed the end of this
story. He lost the one big customer. The seventy-five year positive
relationship went out the window when the customer was sold during the
LBO mania of the eighties. He chose to liquidate the company rather than
find new customers.
Industry Concentrations
Are you dependent upon a single industry’s health for your company’s
success, or can you serve many industries and groups? Obviously the latter
is better. Again too many eggs in one basket is not good for you or your
company’s value.
In another example, a very profitable printing company we were
representing, was comprised of an excellent management team, and enjoyed
a broad customer base. Unfortunately, essentially all of their customers were
computer or software companies.
Our client printed their manuals and other collateral materials. Company
revenues were approximately 4 million when we were given the assignment
to find them a buyer. Within a few months revenues were tracking at 3
million and before the year was over, down to 2 million. Their customers,
Digital, Wang and others suddenly had fallen upon hard times. Not a happy
story with an even more unhappy ending. Diversity is indeed nature’s single
most effective method of assuring survival. It should be yours as well.
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Margin Maintenance
Managing Cost of Goods sold to produce maximum Gross Profit on sales is
one of management’s singularly most important functions. Both large and
small companies are prone to be lax in this area. This information must be
available if increasing the value of your business is your objective.
Most businesses will have multiple products or services, and subsequently
will have multiple mark-ups and gross profit margins. Information should be
made available that will allow reviews of the various profitability segments
for each product or service.
What is the purpose of this seemingly tedious task?
Detailed information on operations increases the comfort level of a
buyer by making it easier for them to understand operations. When
your company can broken down by segment the operation becomes
easier to understand (your best buyer will usually not be someone from
your industry).
Permits the buyer to investigate and gain confidence that profit
margins can be maintained or improved
Allows you the ability to monitor your operation more effectively for
improved profits (whether the increased profits go to the bottom line or
not is up to you and your accountant).
Only three numbers are required to determine the profitability of any
company. Two represent what will be purchased or inherited. A buyer will
pay to gain access to your Sales Volume or Revenue. The buyer will then
inherit your necessary expenses such as rent, utilities etc. The third item,
Gross Profit, is a management function. You price the product or service.
You are responsible to see that product doesn’t go out either the back or front
door without the cash being in the till. You are the one to make sure you
don’t have unknown ―silent partners‖.
If you are a ―poor manager‖ a gross profit test will allow the buyer to see the
opportunity for increase profitability. It’s interesting that the most ―poorly
managed‖ businesses seem to be ―cash‖ businesses.
Identification of the Buyer to Fit the Opportunity
If making money is truly a secondary motivation for buying a business, why
then would anyone want to buy your business? The answer to this question
is key to your ability to increase value without increasing profits. The right
buyer will recognize that ―all the right things are wrong.‖ What are those
things? What type of person could do something about them? That person is
your ―right buyer.‖ See Chapters 3 and 4. Profile your company, and
compare your results with those of others in your industry.
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Prepare Credible Projections
Chapter 12 discussed forecasting and projections and stressed the need for
third party sources to verify assumptions. The value of any enterprise is
dependent upon the expectation of future profits. The more you can support
an expectation of stability and increasing profits, the more valuable your
business will become.
Sales or Revenues
When sales are projected to increase, unbiased outside information is
required to support this expectation. Buyers will generally ignore projections
that lack documentation. Sources of ratification include:
US Industrial Outlook - This annual study is published by The Department
of Commerce and provides comprehensive information on the outlook for
many different industries. Trends forecast for your industry, and those
industries you serve, form the foundation for any projection.
Census Information - Demographics can paint trends in the market you serve
and should not be overlooked. Is the age group consuming your product or
services increasing or decreasing? ―Baby Boomers,‖ for example, are now at
an age of peak earnings - is this your market?
Trends - What national and social trends impact the future of your business?
Is your business activity consistent with such trends? One strong emerging
trend is the desire by consumers for customized products and services.
Generations accepting standardized mass produced products appears to have
waned and spawned the ―Just for Me‖ movement. The busy schedule of two
working parents and single parents has led to the popularity of ―Buy it
Yourself‖ and have someone else install it. ―Do it Yourself‖ is becoming a less
attractive option for many of today’s consumers.
Compiled studies --Dow Jones & Company and others can provide a wealth
of information. Publications such as American Demographics is one such
source.
Technology Change -- Will emerging technology increase or decrease the
demand for your product or service? Will color copiers and inkjet printers
increase or decrease demand for four color process printing? Trade journals
often are a wealth of information in this regard and should be researched
fully for supporting data.
Gross Profit and Cost of Goods
Perhaps the most important assumption in need of ratification for cash
businesses is the Gross Profit or Gross Profit Margin used in one’s
projections.
Improved gross profit projections will gain credibility when industry data
indicates your gross profit could be higher. A restaurant projecting improved
cost of goods (say down to 40% from 62%) based upon: improved portion and
inventory control, installation of computerized cash registers and an absentee
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owner replaced by an owner operator - will be given credibility if industry
data will support the assumptions.
Sources of Gross Profit information include: Robert Morris Associates,
Financial Research Associates, Dun and Bradstreet Comparative Operating
Ratios, and best of all, your trade association or trade publication(s). Most
will provide comparative ratios and operating data that will be invaluable to
you in adding credibility to your projections.
Expenses
Recording discretionary expenses in such a fashion as to be identifiable will
allow a buyer to add these items back to profits. If you and your accountant
hid the expenses so as to be indistinguishable, value will be decreased. Take
all the deductions you can. Just make sure that they can be easily identifed.
Stability of Tenancy
Most businesses are housed in leased locations. A lease provides a ―license‖
to operate a business in a particular location. Therefore, leases becomes an
extremely important element of value. Without a lease, a business may be of
little value to a buyer, especially a businesses that is location sensitive.
Review your lease. Does it have a provision that will allow assignment or
transfer to another? Ideally a provision stating that ―assignment of the lease
will not be unreasonably refused or withheld‖ will be present. If absent,
negotiate its inclusion, ideally before attempting to sell the business.
Rent/Time - Are future rental amounts clearly stated? To increase value
future rents and duration should be clearly spelled out. The length of a lease
should be a minimum of 5 years. Longer is better and it follows that a low
rent is preferred by everyone, except the landlord. Financing, or a purchase
price note cannot exceed the period of lease. With a two year lease you will
not obtain five year financing. Banks will review the lease before lending
and generally will expect an assignment of the lease as part of their
collateral.
Lease issues and landlords represent the biggest ―deal killer‖ of all. Make
sure you are on good terms with your landlord and that your lease is fair and
transferable. Find out what criteria your landlord will use when assessing
an assignee. Will a new lease be required? Will rents remain the same? Get
requirements in writing. Without this location ―license,‖ your business may
not be regarded as valuable.
Professional Assistance
Buying or selling a business is not a ―do-it-yourself‖ project. You need all the
help you can get to obtain the best results. Of course your professionals must
be experienced and have appropriate expertise in order for you to obtain the
best or optimum results.
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Assemble your team early on. You need marketplace, legal and tax expertise.
Therefore, your team will generally be comprised of a Business Intermediary,
Investment Banker or Business Broker (depending on the size of your firm),
an Attorney and a Tax Expert or Accountant.
Your marketplace representative will add considerable value by locating the
―Right Buyer‖ and positioning your business as an exciting opportunity.
Your attorney will make sure the paperwork is fair and complete. Your
Accountant will guide you through tax implications of the transaction
structure.. You make the decisions. These are your ―bucks‖ on the table.
You must always be in charge
If you relinquish decision making to others, say your attorney or accountant,
you will not sell your business. Remember, buying or selling a business is
not a financial play for either the buyer or seller. Rather the decision to buy
or sell is based upon a complex combination of personal and financial
decisions that can only be made satisfactorily by principals.
Your customary accountant or attorney may not be the most qualified
individuals to assist you in selling your company. Finding appropriate
professionals is never easy. It becomes especially difficult if you want your
intentions kept confidential. Larger law and accounting firms are generally
the best sources of qualified assistance. Very few businesses are sold (in
comparison with real estate) and therefore it is unusual for any but the
largest practices to have had much experience with business transfers.
Review Chapter 8 to refresh your memory as to the types of marketplace
professional most appropriate to your size and type business. The right
team, in itself, can add value to your business.
Perception of Risk
Many diverse factors combine to produce a Perception of Risk or ―Gut Feel.‖
Perception is subjective not quantitative and therefore difficult to measure.
A buyer’s perception of risk is dependent upon personality, background, life
and business experiences, education, training, resources and level of
confidence in their own abilities.
The ―Right Buyer‖ will have the skills, background and experiences that
match the areas of opportunity your business represents The next chapter
provides a tool with which you can measure perception of risk and more
clearly identify your ideal succession candidate.
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Chapter 14
Assessing Risk
ophisticated Buyers will assign Capitalization Rates ("Cap Rate‖), also
Rate‖), also known as Risk/Reward ratios, for assessment of risk
of risk involved, and determine their return on investments. The Cap
investments. The Cap Rate is used by them to develop a value for the
investment contemplated.
What is a Capitalization Rate?
Perhaps the best illustration is your savings account at your local bank. You
receive 5% interest on the money on deposit. Therefore, you must consider a
5% return on your investment appropriate for the risk and effort involved
acceptable (Capitalization Rate). Your $1,000 deposit will earn you $50 by
the end of a year. Therefore, to earn $50 with no risk or effort involved, you
are willing to invest $1,000. The math: $50 divided by .05 equals $1,000.
The inverse of a Capitalization Rate is a Multiple. Example: To obtain the
multiple divide the cap rate into 100 (100 divided by 5% or .05 equal 20) $50
times 20 equals $1,000. If an appropriate Capitalization Rate for your
business were 5% and perceived future earnings $50 then the value of your
business would be $1,000 or 20 times earnings. The average New York Stock
Exchange (NYSE) company’s stock sells for 15 times earnings or a Cap Rate
of 6.7%. What is an appropriate Cap Rate for your business?
General Capitalization Rates
The range of capitalization rates for private businesses rarely parallel those
applied to public companies as investments in private companies are
generally considered riskier than investments in public firms. The chart
below illustrates how varying factors can impact one’s perception of risk.
S
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GENERAL CAPITALIZATION RATES
Perception Business Description Cap Rate
High Venture Capital and
Start up Companies 50% and up
Medium High Existing company,
Mature products, company
and industry
Owner leaving
Easy market entry 35 to 50%
Medium Low Established company
Existing markets
Normal competition
Owner may remain
Fairly easy market entry 20 to 35%
Low Established company
Established markets
Little or no competition
Profitable
Low risk markets
Owner remaining
Difficult market entry 20 to 10%
Risk Free Savings/Money market rate 3 to 10%
Alternative Method of Determining a Capitalization Rate
Another method used to generate Cap Rates is shown below. This method
reviews the subjective environment surrounding the enterprise, and assigns
weights to various elements, based upon the perception of the surveyor. We
find this exercise to be very helpful in determining the profile of a company’s
ideal acquiror. The buyer must see areas with a low score as areas of
opportunity or of little consequence.
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A low score (0 or 1), even if in only one category, will generally prevent
a sale from occurring, unless the acquirer is able to perceive the low
score as opportunity.
FACTORS RATING
1) Risk Rating
0 - continuity of income at risk
3 - steady income likely
6 - growing income assured _____
2) Competitive Rating 0 - highly competitive in an unstable market
3 - normal competitive conditions
6 - little competition in market, high cost of entry
for new competition _____
3) Industry Rating
0 - declining industry
3 - industry growing somewhat faster than inflation
6 - dynamic industry, rapid growth likely _____
4) Company Rating
0 - recent start-up, not established
3 - well established with satisfactory environment
6 - long record of sound operation with an
outstanding reputation _____
5) Company Growth Rating 0 - business has been declining
3 - steady growth, slightly faster than the rate of
inflation
6 - dynamic growth rate _____
6) Desirability Factor 0 - no status, rough or dirty work
3 - respected business in satisfactory environment
6 - challenging business in an attractive environment _____
7) Operating Ratios
0 - All operating ratios below industry norms
3 - Most operating ratios at or slightly above industry
norms
6 - All operating ratios above industry norms _____
8) Liquidity Rating
0 - Consistently overburdened with debt
3 - Liquidity at or slightly better than industry norms
6 - Low debt and liquidity above industry norms _____
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9) Capacity Rating
0 - Immediate expense required for expansion
3 - Moderate growth possible without additional capital
investment
6 - Operating well below capacity _____
10 Management Depth
0 - Owner operated with no supervisory depth
3 - Owner managed with some supervisory depth
6 - Management strata capable of succession in place _____
11) Customer Base
0 - Highly dependent on one or few customers or sales
sectors
3 - Revenues are evenly distributed
6 - No change in any one customer or sector will
effect earnings _____
12) Market Area Rating
0 - Market area declining or negative changes in area
environment
3 - Stable market area
6 - Rapid economic growth predicted _____
13) Marketability Rating
0 - Marginal or negative earnings, requires substantial
operating capital from buyer, sale based upon future
opportunity alone, all cash price
3 - Initial investment commensurate with discretionary
earnings, moderate opportunity for growth
6 - Substantial cash flow, transaction readily financed,
exciting opportunity for growth _____
14) Bankability Rating
0 - Banks and other lending sources unwilling to fund
transfer/growth
3 - Limited financing available
6 - Substantial funding available at competitive rates _____
15) Environmental Rating
0 - Produces a hazardous substance or uses a large amount
of hazardous materials, strict regulation and licensing
3 - Minimal amounts of hazardous materials involved, no
licenses required
6 - No hazardous materials used/produced in the business_____
16) Union Rating 0 - Union Shop
3 - No union, some unionization in the industry
6 - No union, no history of unions in this industry _____
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17) Occupancy Rating
0 - No lease available, tenant at will
3 - Lease (with options) extends for at least eight
years, rent adjustments spelled out in lease
6 - Real estate included in sale, or long lease with
predetermined rents _____
Total _____
Divide total by 17
Equals a Multiple of _____
100 divided by the Multiple = Capitalization Rate _____
Example
Total Score of 51 divided by 17 equals a Multiple of 3
100 divided by 3 equals a 33.3% Capitalization Rate
Our experience is that most private companies will develop a rate somewhere
in the thirty percent range.
Summary
Determining a proper cap rate is as much art as it is science. Much has been
written on capitalization rates but mystery and controversy still surround
this elusive subject. Capitalization Rates, as applied to small business, are a
mystery to those not familiar with financial methods and controversial
among those who are financially savvy.
Much of the controversy would appear to emanate from Internal Revenue
Ruling 59-60 where very low cap rates are used in example but not
prescribed. When this influential document uses rates of 10 and 20 percent
as examples, knowledgeable professionals may find cap rates of 40 and 50
percent indefensible. This can be beneficial or disastrous. Beneficial, if our
buyer chooses a low rate (which produces a high value), or disastrous if
applied to develop a value for tax purposes. Unfortunately, the later occurs
much more frequently than the former.
Choosing a capitalization rate is as much
an art as it is a science.
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The brain is a wonderful organ;
it starts working the moment you get up in the morning and
does not stop until you get to the office.
Robert Frost (1874-1963)
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Chapter 15
Earning Computations, Varying Views
n previous chapters we have discussed four broad categories of buyers,
of buyers, and that each has their own way of looking at earnings. The
earnings. The computations employed by these buyers, using the sample
the sample Income Statement below, produces a range of earnings from a
high of $200,000 to a low of $10,000! How’s that for a range of ―Earnings‖ for
one company?
When one suggests a multiple of ―Earnings‖ to use in computing a firm’s
value, which ―Earnings‖ is appropriate? The fifteen times earnings factor
mentioned earlier, when applied to $200,000 produces a value of $3,000,000.
Sounds good to me! Fifteen times $10,000, is $150,000. Not quite as
attractive, but - why the huge difference? The answer is straight forward.
Taking formulas from one arena (the NYSE’s 15X) and applying it in another
(family and private businesses earnings) is like multiplying apples and
oranges. They simply DO NOT compute!
The hypothetical Income Statement below is shown to assist in illustrating
the differing views of earnings.
Revenue $800,000
Cost of Sales 400,000
Gross Profit 400,000
Necessary Expenses 200,000
Officer Compensation 125,000
Interest 20,000
Depreciation 27,000
Officer Life Insurance 10,000
Personal Auto 5,000
I
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Club Dues 2,000
Travel and Entertainment 1,000
Total Expense 390,000
Pre Tax Profit<Loss> $10,000
Industry Buyer
Industry buyers, and many accountants, will focus on the balance sheet
(assets/liabilities) rather than income statements when assessing purchase
price.
Industry buyers tend to ignore officer compensation, depreciation and all
other discretionary expenses, and would seem more focused on assets when
assessing value. It is unusual to see industry buyers use any valuation
formulas that capitalize income. When credit for profit is given, preference is
to add the most recent years pre tax profit to the value of assets being
acquired ($10,000 in this example).
Financial Buyer
Financial buyers typically focus on income statements to determine value.
This buyer tends to be very practical and pragmatic in approaches to value.
Three major criteria must be fulfilled for the financial buyer to be satisfied.
1. A living wage must be available from the business at time of take
over.
2. The transaction must be financed. A financial buyer is unwilling to
pay cash (many consider it un American to do so).
3. There must be a reasonable return on the down payment.
The financial buyer is sometimes referred to as a ―Life-style‖ buyer, in that
they are seeking business ownership as alternative to getting a job. Usually,
essentially all discretionary expenses and officer compensation is added to
pre tax profit. In our example the calculation would look like this:
Pre Tax Profit $10,000
Plus:
Officer Compensation 125,000
Interest 20,000
Depreciation 27,000
Officer Life Insurance 10,000
Personal Auto 5,000
Club Dues 2,000
Travel and Entertainment 1,000
Discretionary Earnings $200,000
The most recent year is of utmost importance and sometimes is the only year
on which the decision and offer price is based. The outlook for a business
must be positive or transactions will not take place. No credit will be given
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to projections of increasing profitability. What the future holds they assume
belongs to them. If they perform the necessary work, they expect to reap the
benefit, and not compensate you today for their efforts tomorrow.
Sophisticated or Corporate Acquirer
Sophisticated or Corporate buyers, have expectations that are somewhat
more complex than the previous two. Balance Sheet (Assets/Liabilities) and
Income Statements (P&L) are both reviewed with equal importance and
regularity. This group tends to assume that they can learn essentially all
that needs be known through review of your financial statements. They use
more sophisticated methods to assess value and have many different
approaches to discern earnings. We will list the more popular methods they
use when evaluating the smallest company to the largest. As the size of a
company increases, earnings tend to be stated more like Wall Street’s
earnings definition (After Tax Income). These computations are usually
calculated for several years (5 being preferred) and a weighted average is
calculated. The weighted average is then manipulated to produce a value for
the enterprise under review. The more frequently used computations are as
follows:
Adjusted EBIT
(Earnings Before Interest and Taxes plus Depreciation and Adjustments)
This computation is essentially the same as computing the Discretionary
Earnings figure used by the Financial buyer except that:
a) owner or officer compensation is not included, and
b) depreciation will be adjusted to reflect the actual depreciation
reserve requirements of the enterprise.
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The computation:
Pre Tax Profit $10,000
Plus:
Excess Officer Compensation 50,000 (125,000 less 75,000 salary)
Interest 20,000
Excess Depreciation 17,000 (27,000 less 10,000 reserve)
Officer Life Insurance 10,000
Personal Auto 5,000
Club Dues 2,000
Travel and Entertainment 1,000
Adjusted EBIT $115,000
EBIT-D
(Earnings Before Interest and Taxes plus Depreciation)
Pre Tax Profit $10,000
Plus:
Interest 20,000
Depreciation 17,000 (less reserve of $10,000)
EBIT-D $97,000
EBIT-DA – same as above plus Amortization
EBIT
(Earnings Before Interest and Taxes)
Pre Tax Profit $10,000
Plus:
Interest 20,000
EBIT $30,000
Weighted Average Income
Sophisticated buyers seldom use only one year of financial data and prefer
three to five years of financial information in decision making. They will
compute the preferred EBIT for three to five year periods then weight the
results giving a higher weight to the most recent year, and then less to the
next, and so on.
See the example on the next page.
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Example:
Favorite
Year EBIT Weight Extension
1(recent) 96,000 5 480,000
2 85,000 4 340,000
3 110,000 3 330,000
4 87,000 2 174,000
5 90,000 1 90,000
Totals $468,000 15 1,414,000
5Yr. Weighted Average 1,414,000/15 = $94,000
Others will compute a straight average for the same period.
Straight Average 468,000/5 = $93,600
In this example the two computations produce essentially the same answer.
Projections ?
What about your previous hard work and costly investment in capital
equipment acquired to increase revenues and profits in years to come? When
a tangible basis for projecting future profits exists, then projections may be
incorporated into the above calculations. The following example assumes two
years of increased profit can be projected with credibility, based upon existing
conditions. The weight assigned to the projected earnings will reflect the
perception of credibility assigned to the projections. If results are close to a
certainty, the weight of five might be assigned. If only based on
undocumented assumptions, then likely no weight whatsoever will be assigned
to projections.
Weighted Historic and Projected Income
Favorite
Year EBIT Weight Extension
Two years 200,000 3 600,000
Next year 150,000 4 600,000
1(recent) 96,000 5 480,000
2 85,000 4 340,000
3 110,000 3 330,000
4 87,000 2 174,000
5 90,000 1 90,000
Totals $818,000 22 2,614,000
5Yr. Historic plus
Two year Projected Weighted Average 2,614,000/22 = $118,818
Straight Average 818,000/7 = $116,857
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Future Earnings
Purchasers of larger, more stable businesses, and those businesses with a
credible basis for forecasting earnings well into the future, often base their
valuation upon projections alone. Historic information is included as part of
the basis for the projections but future earnings alone are used to compute
the firm’s value.
Discounted Cash Flow (Future Earnings valuation methods) will often
produce the highest values.
Each of the four broad categories of buyers has its
own way of calculating earnings when determining value.
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Chapter 16
Valuation Example
his chapter will provide an overview of how qualitative and
and quantitative elements combine to produce a perception of value. A
perception of value. A Comparative Balance Sheet and Comparative
Comparative Income Statement are provided on the following pages for use
in our example.
The Company
You will notice that this company is relatively new. It was established five
years ago by a young lady just finishing college. The company operated as a
sole proprietorship for two years prior to incorporation. No balance sheet was
produced during her first two years. In the third year, changing accountants,
she incorporated the business.
For anominity, the nature of business has been disguised, however, the
information presented is correct.
The company provides products and services that are increasingly accepted
and sought out by retailers, wholesalers and manufacturers. The company
has sustained very impressive growth.
A Business Plan was created and revised every year, but growth still
exceeded expectations. Modest projections are for continued growth of
$300,000 to $400,000 in revenue during the next several years. More growth
is possible but would require more time than she feels she can give, and more
capital outlay than she can provide.
The young lady is getting tired of working seven days a week, twelve to
eighteen hours per day. She wants the very best for her company, but also
wants a personal life. She has been contacted by a competitor who wants to
buy her out. We are contacted and asked to provide an opinion of value.
T
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As part of our assignment, we profiled the business, gained an understanding
of and the outlook for the market served, reviewed the financial history of the
company, and compiled projections as to future profitability. To gain
comprehensive overview of the opportunity the business represented, we
researched the company’s industry and markets served.
The company was then valued using those methods likely to be used by the
class of buyer(s) most likely to find the enterprise an attractive acquisition:
When reviewing these methods, bear in mind that these formulas assume an
Asset Sale rather than a Stock Sale. Most all small business sales are Asset
Sales and, as such, certain assets are sold free of debt. Cash, receivables and
liabilities are generally retained by the selling firm.
Each of the valuation methods used in this case study are methods more
commonly used by different types of buyers. The key question to be
answered: Which is (are) appropriate to the business? Professional advisors
tend to have ―pet‖ method(s) which they defend vehemently. Will the most
appropriate buyer agree?
Business colleges and universities throughout the country largely teach
Public company techniques, therefore financially sophisticated advisors tend
to apply either Public company or Sophisticated buyer methods, when asked
to offer opinions of value. Although these methods often produce attractive
values, are they appropriate when applied to smaller companies?
Buyer Identification
Industry or Asset based buyers would find the company attractive.
Financial buyers are the most likely buyer presently.
Sophisticated buyers will recognize the optimum value, however, these
buyers will be difficult to attract without proper preparation and positioning.
This example company is extremely dependent upon its founder.
Infrastructure is essentially non existent. Dependency upon one particular
customer must be diminished. Systems and controls must be implemented to
facilitate continued growth.
Strategic or Synergistic buyer methods have been included in this exercise
for purposes of illustration only. This firm is much too small, and lacks the
strategic elements required to be considered by this class of buyer.
Industry or asset based buyers might find the company attractive, but
normally would not be willing to pay Financial or Sophisticated buyer prices.
At this point of this company’s development, a Financial buyer is the most
probable candidate for purchase. However, as the company develops into a
more significant enterprise, attracting a Sophisticated buyer becomes a
definite possibility.
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The owner is pursuing this option for two reasons:
a) They tend to pay optimum prices
b) They are most qualified to manage the company’s future.
Summary of Values
The range in value estimates for private companies can be staggering as this
example illustrates. Small wonder is it that no one really knows what a
private business is worth. In this instance the low-end extremes (Industry
Buyer) should be avoided, and the high end (Strategic Buyer) is unattainable
due primarily to the firm’s small size and lack of a strategic fit.
Industry Buyer $164,400
Financial Buyer 425,000
Sophisticated Buyer 750,000
Strategic Acquirer 1,250,000
Is effort and the time required to attract Sophisticated buyers worth it? Is a
$350,000 difference in estimated value worth the time and effort required to
attract Sophisticated buyers? Will the young lady continue to grow and
operate her company, or is she beginning to lose control?
Operating a business can be analogous to driving a car. One might be
competent driving a Nova at 55 mph but not a Porsche at 120 mph. Small
mistakes forgiven at 55 mph, may be fatal at 120 mph. What is comfortable
and enjoyable at one speed, may be a nightmare at another. Is she able to do
what is required, and if yes, does she want to do it? The point is that more
than dollars alone are involved in a decision of this type
This company is rapidly approaching a point of “grow or go.” If changes are
not made soon, a small simple mistake could cause the company to crash and
burn. Cash flow has become a continuous headache, and crisis management
is the order of the day.
In this example, the young woman recognized her limitations, and has been
able to attract good people to pick up the load. She was willing, and has been
able to delegate responsibility to further develop a firm. Not everyone,
however, is willing to give up control by delegating responsibilities.
This company’s growth continues slightly ahead of projections, and the
objective is to ultimately consummate a sale with a Sophisticated buyer.
Exhibits
The following pages of data will be used by the four buyer types to compute
their estimates of value.
Comparative Balance Sheet (3yrs)
Comparative Income Statements (5yrs) Statement
Comparative Ratio Analysis
9 Month Interim Income
Sales History by Month
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Comparative Balance Sheets
(All $s in thousands)
From Accountants Statements
Years Ago 3 2 1
Assets
Current Assets:
Cash .4 22.9 30.4
Accounts receivable 18.3 68.5 170.8
Inventory 45.0 75.0 120.0
Prepaid expenses 2.2 2.2 2.2
Total Current Assets 65.9 168.6 323.4
Fixed Assets:
FF&E 40.0 50.0 50.0
Motor vehicle 0 0 16.9
Less Depreciation (13.0) (25.5) (47.6)
Total Fixed Assets 27.0 24.5 19.3
Other Assets (Deposits) .8 3.2 2.5
Total Assets 93.7 196.3 345.2
Liabilities
Current Liabilities:
Accounts payable 18.2 26.0 1.1
Capital lease--Current 1.9 2.2 2.8
Current portion--Note 7.7 15.0 18.0
Total Current Liabilities 27.8 43.2 92.0
Long Term Liabilities:
Capital lease 2.2 3.9 1.1
Note 23.0 40.3 65.0
Total L/T Liabilities 25.2 44.2 66.1
Total Liabilities 53.0 87.5 158.1
Shareholder’s Equity 40.7 108.8 187.1
Total Liabilities and Stockholder’s Equity 93.7 196.3 345.2
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Comparative Income Statements
(All $s in thousands)
Years Ago 5 4 3 2 1
Sales 79.9 156.8 334.0 499.3 800.1
Cost of Sales 41.0 80.1 170.3 251.1 402.0
Gross Profit 38.9 76.7 163.7 248.2 398.1
Operating Expenses
Officer compensation 20.0 50.0 75.0
Advertising .5 1.6 2.8 4.1
Auto expense 2.5 2.7 6.0 3.3 6.5
Bad debts 2.8 0 0 0 1.2
Bank charges .4 0 0 .1 .2
Depreciation 4.5 3.5 5.0 12.5 22.1
Dues .3 .1 .4 1.2 1.4
Education 1.1 1.7 2.7
Insurance .6 2.4 5.4 8.8 15.7
Interest .5 .8 1.7 3.5 4.6
Office expense 3.3 2.3 5.6 7.5 10.5
Payroll taxes 5.9 6.9 10.9
Postage 6.0 13.9 29.3
Prof. fees .3 .5 1.2 1.4 2.0
Rent 1.4 1.3 4.4 14.0 14.0
Salaries 20.0 57.7 68.2 104.9
Supplies 1.3 1.7 2.9 10.2 25.9
Telephone 1.0 1.2 3.5 4.1 5.0
Taxes-- other .5 .5 .8
Travel/entertainment .5 .3 1.5 3.5
Utilities 1.2 1.7 1.8 2.5 2.6
Total Expenses 20.6 39.0 130.9 214.5 342.7
Profit/(Loss) 18.6 37.7 32.8 33.7 55.4
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Comparative Analysis of Selected Ratios
Years Ago 3 2 1 Perception
Current Ratio
Total current assets 65.9 168.6 323.4
Total current liabilities 27.8 43.2 92.0
Ratio 2.4 3.9 3.5 Positive
Quick Ratio
Cash & equivalents +
accts & notes receivable 18.7 91.4 201.2
Total current liabilities 27.8 43.2 92.0
Ratio .7 2.1 2.2 Positive
Sales/Receivables
Net sales 334.0 499.3 800.1
Accounts receivable 18.3 68.5 170.8
Needs Ratio 18.3 7.3 4.7 Attention
Days Receivable
365 365 365 365
Sales/receivable ratio 18.3 7.3 4.7
Needs
Days 20 50 78 Attention
Sales/Working capital
Net sales 334.0 499.3 800.1
Net working capital 42.9 128.3 258.4
Needs
Ratio 7.8 3.9 3.1 Attention
Debt/Worth
Total liabilities 53.0 87.5 158.1
Tangible net worth 43.8 118.8 212.6
Very
Ratio 1.2 .8 .7 Positive
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Adjusted 9 Month Interim Income Statement
(All $s in thousands)
Income 700,214
Cost of sales 350,512 50.1%
Gross Profit 349,702 40.9%
Operating Expenses Adjustments
Officer compensation 56,250 (56,250)
Advertising 6,587
Auto expense 4,870 (4,870)
Bad debts 250
Bank charges 552
Depreciation 0
Dues 1,547
Education 4,278
Insurance 14,521
Interest 4,625 (4,625)
Office expense 8,250
Payroll taxes 11,257
Postage 3,104
Professional fees 2,150
Rent 10,800
Salaries 98,541
Supplies 22,158
Telephone 4,915
Taxes-- other 815
Travel/entertainment 2,750 (2,750)
Utilities 2,258
Total Expenses 260,478 (68,495)
Pre Tax Profit/(Loss) 89,224 Estimated Y/E $125,500 plus adjustments 68,495
Discretionary Earnings 157,719 (nine months)
Estimated year end Discretionary Earnings $210,600
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Sales History (by month)
(All $s in thousands)
Years Ago 3 2 1 Current Year
January 15.3 37.5 52.3 75.0
February 19.9 38.0 54.6 63.5
March 20.6 36.9 55.9 71.2
April 24.0 38.9 49.9 75.0
May 28.6 39.9 61.0 76.6
June 26.1 40.1 65.0 81.5
July 28.0 42.6 69.8 83.3
August 30.1 44.3 66.9 86.2
September 32.8 39.6 73.5 87.9
October 34.5 50.6 78.6
November 36.1 42.7 84.0
December 38.0 48.2 88.6
Totals 334.0 499.3 800.1 700.2
Estimated Current Year End 1,000.0
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When the cat and mouse agree, the grocer is ruined
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Chapter 17
Industry Buyer Valuation Methods
s mentioned earlier, Industry buyers focus primarily upon value in
value in assets when assessing a company’s value. Earnings are
Earnings are considered a bonus by most Industry buyers, and are not
and are not willingly included in their preferred valuation methods. When a
prospective buyer announces that ―We don’t pay for goodwill.‖ you can be
fairly certain that you are dealing with an Industry or Asset buyer.
It is also common for Industry buyers to reject the purchase of certain assets.
For example, certain equipment might be considered redundant or obsolete,
and therefore, not compatible with the planned operation.
The methods most commonly used by this type buyer to determine value are:
Book Value
Adjusted Book Value
Liquidation Value
The following pages illustrate these methods, and provide two estimated
values for each method. The first value stated will be the value the buyer
will likely pay for the company. The second represents the net cash
advantage, or disadvantage, after factoring in assets and liabilities retained
by the selling firm. In this example, the difference between assets retained
and liabilities retained was positive. Many times the difference will produce
a negative result that must be considered before a decision to sell is made.
A
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BOOK VALUE METHOD
This method addresses the question ―What am I buying?‖ by simply focusing
upon the stated or book value of the assets to be acquired. Certain assets and
usually all the liabilities will be retained by the seller. In this example the
value of the company is regarded as being the net book value of the assets
being acquired.
CURRENT BALANCE SHEET
(All $s in thousands)
From Corporate 1120
Book Transferable Assets
Assets Value Assets Retained
Current Assets:
Cash 30.4 0 30.4
Accounts Receivable 170.8 0 170.8
Inventory 120.0 120.0 0
Prepaid Expense 2.2 0 2.2
Total Current Assets 323.4 120.0 203.4
Fixed Assets:
FF&E 50.0 50.0 0
Motor Vehicle 16.9 16.9 0
Less Depreciation (22.1) (22.1) 0
Total Fixed Assets 44.8 44.8 0
Other Assets (Deposits) 2.5 0 2.5
Total Assets 370.7 164.8 205.9
BOOK VALUE METHOD $164,840
Residual Value
Consideration must also be given to the ―residual value‖ of the assets and
liabilities being retained by the business owner after the sale. In this
instance the value is positive. Residual value should be computed and
addressed regardless of the valuation method employed. This value is
independent of the sale price.
Retained Assets 205,858
Less Liabilities (158,055)
Residual value 47,803
Net Value from sale $212,643
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ADJUSTED BOOK VALUE METHOD
This method is similar to the previous method in that the focus is on balance
sheet assets. The difference here is that the assets being acquired are
adjusted to fair market value (FMV). Others will refer to the correction as
adjusting for ―functional and/or economic depreciation‖.
CURRENT BALANCE SHEET
(All $s in thousands)
From Corporate 1120
Book Transferable
Assets Value Adjustments Assets (FMV)
Current Assets:
Cash 30.4 (30.4) 0
Accounts Receivable 170.8 (170.8) 0
Inventory 120.0 (10.0) 110.0
Prepaid Expense 2.2 (2.2) 0
Total Current Assets 323.4 (193.4) 110.0
Fixed Assets:
FF&E 50.0 (17.8) 32.2
Motor Vehicle 16.9 (1.9) 15.0
Less Depreciation (22.1) 22.1 0
Total Fixed Assets 44.8 2.4 47.2
Other Assets (Deposits) 2.5 (2.5) 0
Supplies (off balance sheet) 0 12.3 12.3
Total Other Assets 2.5 (9.8) 12.3
Total Assets 370.7 (201.2) 169.5
ADJUSTED BOOK VALUE METHOD $169,540
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LIQUIDATION VALUE METHOD
This method produces the minimum value for an enterprise. Balance sheet
values are converted to Orderly Liquidation Values and assume that assets
could be sold under conditions other than forced or auction sale. The
Liquidation Factors used are examples and cannot be relied upon as more
than example factors.
CURRENT BALANCE SHEET
(All $s in thousands)
From Corporate 1120
Liquidation
Liquidation Value of
Transferable Assets FMV Factor Assets
Inventory 110.0 .80 88.0
FF&E 32.2 .75 24.2
Motor Vehicle 15.0 1.00 15.0
Other (Supplies) 12.3 .40 4.9
Totals 169.5 132.1
Liquidation Value $132,088
Plus Retained Assets Factor
Cash 30.4 1.00 30.4
Accounts Receivable 170.8 .85 145.2
Prepaid Expense (insurance) 2.2 .80 1.8
Other Assets (deposits) 2.5 1.00 2.5
Total 205.9 179.9
Less Liabilities 158.1 1.00 (158.1)
Total 21.8
Net liquidation Value $151,368
110
SUMMARY OF INDUSTRY BUYER METHODS
Although these values are labeled ―industry‖ methods they also apply to
buyers who focus primarily upon assets when determining value.
Buyers typically use more than one approach when estimating price. The
values produced are therefore weighted giving the highest weight to methods
according to their probable importance with buyers.
Methods Value Weight Extension
Book Value 164,840 .30 49,452
Adjusted Book Value 169,540 .60 101,724
Liquidation Value 132,088 .10 13,209
Estimated Industry Buyer or Asset Value $164,385
Industry Buyers generally pay the lowest prices
and therefore should be considered buyers of
last resort.
111
Two farmers each claimed to own a certain cow.
While one pulled on its head and
the other pulled on its tail,
the cow was milked by the lawyer.
Jewish parable
112
Chapter 18
Financial Buyer Methods
inancial buyers comprise the largest group of possible buyers for small
buyers for small and mid-size private family businesses. Our
Our experience has shown that as a group, these buyers are hard
are hard working, fair, honest people with excellent credit ratings. Their
view on value is relatively uncomplicated. Valuation methods they employ
are as much intuitive as they are financial.
The most common methods used by this group of buyers are:
Basic
Earnings
Debt Capacity
Cost to Replace
Comparable Sales
Again, essentially all purchases made by this group are ―Asset‖ purchases
rather than ―Stock‖ transactions. Additionally, Financial buyers usually
have limited cash to invest in an enterprise. Cash they do posses, might
represent a lifetime of saving and investing. Many will mortgage their
homes to obtain funds required to buy the ―Right Business." Typically, this
buyer has less than $200,000 for a down payment, with the overwhelming
majority having less than $100,000 for investment (exclusive of what may or
may not be borrowed on company assets).
This factor will generally limit Financial buyers to businesses with sale
prices under $500,000 (exclusive of real estate), unless significant outside
financing is available.
Examples of the methods used by Financial buyers follow.
F
113
To begin the valuation process we first must determine the amount of cash
available for acquisition. The computations below estimate the calculation of
Financial buyers.
Discretionary Earnings Computation
This exercise adjusts the Income Statement or Tax Return to determine
Discretionary Earnings over a period of time. To calculate Discretionary
Earnings non-cash, non-re-occurring, discretionary expenses and, the owner’s
compensation are added to the company’s pre-tax earnings.
The result represents earnings available to a new owner for their
compensation, debt service and replacement reserves (Discretionary
Earnings).
(All $s in 000)
Years Ago 3 2 1
Revenues 334.0 499.3 800.1
Cost of Sales 170.3 251.1 402.0
Expenses 130.9 214.5 342.7
Profit/(Loss) 32.8 33.7 55.4
Adjustments:
Officer Compensation 20.0 50.0 75.0
Auto Expense 6.0 3.3 6.5
Depreciation 5.0 12.5 22.1
Insurance 1.3 1.2 1.7
Interest 1.7 3.5 4.6
Travel/Entertainment 0 1.5 3.5
Total Adjustments 34.0 72.0 113.4
Discretionary Earnings 66.8 105.7 168.8
The next step would be to determine the value of the assets being acquired.
The result of this exercise is essentially the same as Adjusted Book Value.
Summary of Assets being Purchased
Supplies 12,250
Motor Vehicle 15,000
Furniture & Equipment 32,250
Inventory 110,000
Fair Market Value of
Assets to be Transferred $169,500
114
Having calculated discretionary earnings for the past and estimated current
years, which number is the Financial buyer likely use?
Weighted Income Computations
Buyers and their advisors use various methods to arrive at an amount of cash
available to them based on historical results and their subjective view of the
opportunity presented. The exhibit below illustrates the most probable views
and estimates the amount of Discretionary Earnings a Financial buyer would
be reasonably expected to discern.
Typical Financial buyers do not include projections or future earnings in
their computations of cash available for acquisition. In this instance the 9
month interim financial statements ratify expectations of increased
profitability. Year end Discretionary earnings are predicted to approximate
$210,600. (see Interim Income Statement on page 106)
Discretionary (000)
Year Earnings Weight Extension
Estimated Current Year 210,600 3 631.8
Last Year 168,807 2 337.6
2 Years Ago 105,710 1 105.7
3 Years Ago 66,800 0 0
Totals 6 1,075..1
(All $s in thousands)
Most Recent Year $168.8
Three Year Straight Average $113.8
Weighted Average $179.2
Projected Current Year $210.6
Estimate of Discretionary Earnings likely to be perceived as available by a Financial buyer $200.0
115
Basic Method
This method is perhaps the most commonly used, and is a favorite ―rule of
thumb‖ employed by many accountants. It is often used to quickly gauge the
reality in an offering price. Two important questions are answered by this
formula. ―What am I buying?‖ and ―What is the company making?‖ This
formula is more intuitive than financial.
The two variations in this method differ only as they address a buyer’s
perception of ―Barrier to entry.‖ The first method gives credit for one year’s
earnings. The second gives additional credit for earnings assuming that
buyers recognize and, are willing to pay for the additional time it would take
to reach current levels of profitability from start-up. Buyer optimism will
usually limit this credit to 24 months even though it may have taken you
twenty four years to achieve.
First Method
Fair Market Value of Assets 169,540
1 Year Discretionary Earnings 200,000
First Value $369,540
Second Method
Fair Market Value of Assets 169,540
Monthly Discretionary Earnings 16,667
Multiplied by # of months estimated X
to reach current level of profitability 18
300,000
Second Value $469,540
Average both to obtain basic method value.
Basic Method Value $419,540
116
Discretionary Earnings Method
This method can usually be considered to produce realistic values for at least
two reasons,
1. It addresses numerically what the buyer is seeking intuitively
2. The transaction is automatically structured so that ―the numbers‖
work, setting aside amounts for debt service and living wage (75%
Living Wage and 25% Debt Service)
When the percent assigned to Living Wage is reduced by increased
Debt Service, two things happen:
a) The price will decrease
b) The likelihood of a transaction occurring diminishes
As the ratio drops below 75/25 buyers loose the perception they will be
working for themselves, and begin to feel they will be working for you.
Remember -- Financial buyers are seeking three things:
1. A living wage providing a certain lifestyle
2. Terms -- These buyers do not want, nor are they able to pay
an all cash price
3. Looks for a reasonable return on invested capital.
This valuation method addresses all three concerns
The Computation:
Discretionary Earnings $200,000
Less 25% reserved for Debt Service X .75
Buyer’s Wage assumed to equal
the down payment 150,000
Less return on investment (10%) (15,000)
Buyer’s net cash advantage 135,000
Divided by .333 (typical down payment) /.333
Discretionary Earnings Value $405,405
117
Debt Capacity
This method is based upon the Company's ability to pay the purchase price
out of cash flow. An amount appropriate for the owner/manager's
compensation (and commensurate with the required down payment) is
deducted from Discretionary Earnings. This leaves an amount available for
Debt Service. From this point it is a simple matter to determine how much
debt the Company can afford from existing Discretionary Earnings.
The value will increase as you decrease the interest rate and/or extend the
payment period. Both of these actions require you to attract the "Right
Buyer". Ten percent is the rate of interest most commonly used, and it is
unlikely for a period to exceed the remaining duration of the lease.
Discretionary Earnings 200,000
Less appropriate Owner/Manager salary 75,000
Replacement Resrves 15,000
Cash available for debt service 110,000
Assumptions:
Interest rate 10.0%
Monthly payment 9,167
Term of Note Values
3 years 284,103
5 years (most probable) 431,473
7 years 552,238
Debt Capacity Value $431,473
118
Comparable Method
Data used in this method is rarely available to buyers or to business owners
of private companies. Our experience with several hundred actual
transactions produced the ratios shown below. These ratios are applied to
the subject business for developing a probable down payment and purchase
price.
Calculate a Down Payment using Comparable Sales Data
Down
Subject Payment
Business Ratios Values Weight Extension
Vol/Sales 800,100 .15 120,015 0 0
DE/Sales 200,000 1.02 204,000 2 408,000
Assets/Sales 169,540 .71 120,373 1 120,373
3 528,373
Probable Down Payment $176,124
Calculate a Purchase Price using Comparable Sales Data
Purchase
Subject Price
Business Ratios Values Weight Extension
Vol/Sales 800,100 .35 280,035 0 0
DE/Sales 200,000 2.37 474,000 2 948,000
Assets/Sales 169,540 1.64 278,046 1 278,046
3 1,226,046
Probable Purchase Price $408,682
119
COST TO REPLACE
Nearly all buyers will consider the cost of creating a similar business
from scratch. This exhibit addresses establishing a similar business
using a buyer's usual optimistic perspective.
Working Capital $30,000
Accounts Receivable 0
Supplies 12,500
Motor Vehicle 15,000
Furniture and Equipment 50,000
Deposits 2,500
Leasehold Improvements 2,250
Inventory 120,000
Cost to Replace Value $232,250
120
MULTIPLE OR WEIGHTED VALUE METHOD
The weighted average of various formulas is often used by buyers or their
advisors who will generally consider more than one approach to
determine value.
All Values indicated are stated as gross figures. They do not include
cash, accounts receivable or other assets not being transferred.
Importantly, they do not address outstanding debt, liabilities, or any
financial obligations existing.
It is important to further note that institutional sources of financing are
generally unavailable for purchasing small private or family businesses.
Therefore, the values developed assume financing being provided by the
seller.
Method Value Weight Extension
Basic 419,540 .25 104,885
Discretionary Earnings 405,405 .25 101,351
Debt Capacity 431,473 .25 107,868
Comparable 408,682 .25 102,170
Cost to Replace 232,250 0 0
Resultant Value $416,274
Range of value from $405,405
to 431,473
Target Value $425,000
121
Whatever their other contributions to our society,
lawyers could be an important source of protein.
Guindon cartoon caption
122
Chapter 19
Methods Used by Corporate and Sophisticated Buyers
orporate and Sophisticated Buyers can be separated into three broad
three broad segments. Most small businesses will be able to attract
to attract only the first of the three listed below.
Summary of Classifications
High Net-Worth Individual(s)
High net-worth individuals with ―Corporate‖ backgrounds (and small
corporations) typically require a company to have minimum revenues of two
million. They usually possess cash or equity for a down payment of $100,000
to perhaps $300,000.
These individuals tend to become very frustrated when they discover their
cash inadequate to purchase most companies fitting their criteria. As a
result, many are banding together and pooling their resources to afford
suitable firms. Others are turning to franchises as an alternative to
purchasing an ongoing business.
Small Investment Groups
Small Investment groups (and mid-size Corporations) will consider target
firms if revenues are between five and twenty million. Smaller firms will be
considered if they are synergistic with companies already in their portfolio.
Large Investment Groups
Larger groups (and large corporations) usually will not consider companies
with pre tax earnings under one million dollars or revenues under twenty
million. ―Add on Companies‖ (that is target companies in the same business
C
123
as portfolio companies) can be considered when revenues are as low as five
million dollars.
Stock transactions occur infrequently with smaller acquisitions and seem to
be the acquisition method of choice with the largest companies. Asset sales
however, are most common with small to mid-size firms. These transfers
may resemble stock sales in that selected liabilities and Accounts Receivable
usually become elements of the transaction.
Favorite Methods
Capitalization and Present Value methods are the valuation methods of
choice with all of these groups. All are familiar with valuation methods that
will factor future earnings when computing value. Most commonly used
methods include:
Excess earnings
Discounted cash flow
Discounted present earnings
Various capitalizations of income
Various EBIT computations
A review of historical earnings begins the valuation process. Sophisticated
buyer income computations are essentially the same as those of Financial
buyers. The major difference between the two is that Sophisticated buyers
will deduct a salary for an owner/manager.
Adjusted EBIT Computation
(All $s in 000)
Years Ago 3 2 1
Revenues 334.0 499.3 800.1
Profit/(Loss) 32.8 33.7 55.4
Adjustments 34.0 72.0 113.5
Discretionary
Earnings 66.8 105.7 168.9
less Owner or
Manager’s salary (50.0) (75.0) (75.0)
EBIT-DA 16.8 30.7 93.9
The usual next step is to assess risk.
This segment begins with a completed Business Risk Analysis worksheet
indicating 28% as an appropriate rate of capitalization for our example
company.
124
BUSINESS RISK ANALYSIS
This worksheet converts the subjective view of risk, stability and other
factors into a numeral that should represent an appropriate capitalization
rate (risk/reward ratio).
Standards Score
1) Risk Rating
0 - continuity of income at risk
3 - steady income likely
6 - growing income assured _4.0
2) Competitive Rating
0 - highly competitive in an unstable market
3 - normal competitive conditions
6 - little competition in market, high cost of entry
for new competition 3.0
3) Industry Rating 0 - declining industry
3 - industry growing somewhat faster than inflation
6 - dynamic industry, rapid growth likely 4.5
4) Company Rating
0 - recent start-up, not established
3 - well established with satisfactory environment
6 - long record of sound operation with an
outstanding reputation 3.0
5) Company Growth Rating
0 - business has been declining
3 - steady growth, slightly faster than the rate of
inflation
6 - dynamic growth rate 6.0
6) Desirability Factor
0 - no status, rough or dirty work
3 - respected business in satisfactory environment
6 - challenging business in an attractive environment 4.0
125
7) Operating Ratios
0 - All operating ratios below industry norms
3 - Most operating ratios at or slightly above industry
norms
6 - All operating ratios above industry norms 4.0
8) Liquidity Rating
0 - Consistently overburdened with debt
3 - Liquidity at or slightly better than industry norms
6 - Low debt and liquidity above industry norms 5.0
9) Capacity Rating
0 - Immediate expense required for expansion
3 - Moderate growth possible without additional capital
investment
6 - Operating well below capacity 3.0
10 Management Depth
0 - Owner operated with no supervisory depth
3 - Owner managed with some supervisory depth
6 - Management strata capable of succession in place 1.0
11) Customer Base
0 - Highly dependent on one or few customers or sales
sectors
3 - Revenues are evenly distributed
6 - No change in any one customer or sector will
effect earnings 1.0
12) Market Area Rating
0 - Market area declining or negative changes in area
environment
3 - Stable market area
6 - Rapid economic growth predicted 3.0
13) Marketability Rating
0 - Marginal or negative earnings, requires substantial
operating capital from buyer, sale based upon future
opportunity alone, all cash price
3 - Initial investment commensurate with discretionary
earnings, moderate opportunity for growth
6 - Substantial cash flow, transaction readily financed,
exciting opportunity for growth 5.0
14) Bankability Rating
0 - Banks and other lending sources unwilling to fund
transfer/growth
3 - Limited financing available
6 - Substantial funding available at competitive rates 2.0
15) Environmental Rating
0 - Produces a hazardous substance or uses a large amount
126
of hazardous materials, strict regulation and licensing
3 - Minimal amounts of hazardous materials involved, no
licenses required
6 - No hazardous materials used/produced in the business 6.0
16) Union Rating 0 - Union Shop
3 - No union, some unionization in the industry
6 - No union, no history of unions in this industry 3.0
17) Occupancy Rating
0 - No lease available, tenant at will
3 - Lease (with options) extends for at least eight
years, rent adjustments spelled out in lease
6 - Real estate included in sale, or long lease with
predetermined rents 3.0
Total 60.5
Divide total by 17
Equals a Multiple of 3.6
100 divided by the Multiple = Capitalization Rate 28%
Sophisticated Buyer’s Probable View of Future Earnings
Business value depends on the confidence buyers have in future profits of the
enterprise. The more financial projections can be verified, the more likely are
they to be relied upon when assessing value.
The information below is an estimate of what buyers might believe to be
future profitability, based on the opportunity presented.
Projections (All $s in thousands)
Estimated 1 Year 2 Years 3 Years 4 years 5 Years
Current Yr. Forward Forward Forward Forward Forward
Sales 1,000 1,500 2,000 2,500 3,000 3,500
Cost of Sales 502 753 1,004 1,255 1,506 1,757
Net Expenses 287 425 550 655 750 850
Profit/(Loss) 211 322 446 590 744 893
Less Salary 75 75 75 75 75 75
Adjusted EBIT 136 247 371 515 669 818
127
Projection Ratios
Cost of Sales 50.2%
Net Expenses 28.7% 28.3% 27.5% 26.2% 25.0% 24.3%
Profit 21.1% 21.5% 22.3% 23.6% 24.8% 25.5%
Income Computations
Arrayed below are the income computations most frequently used by
Sophisticated buyers. You will notice that these computations differ from
those of the Financial buyers in two ways:
1. Forecasts of future profitability are employed
2. Deductions from Discretionary Earnings for an owner’s salary or a
manager’s wage
The Computations (All $s in thousands)
Adjusted
Year EBIT Weight Extension Weight Extension
3 yrs forward 515 1 515
2 yrs forward 371 2 742
1 yr forward 247 3 741
Current yr (E) 136 3 408 3 408
Last yr 94 2 188 2 188
2 yrs ago 31 1 31 1 31
3 yrs ago (Omit)
Totals 6 627 12 2,625
Most recent Yr 94
3 Year Average 87
Weighted Average 104
Weighted Historic
and Future Average 219
Projected
Current Year. 136
Projected
First Year 247
The valuation examples that begin on the next page will employ several
different estimates of earnings in computation.
128
Excess Earnings
The excess earnings method blends values in assets and earnings to
determine the value of a business.
This approach assigns a portion of adjusted EBIT as a return on
shareholder’s equity. The remainder is referred to as excess earnings, and
regarded as having been generated by the company’s intangible assets --
largely goodwill.
Excess earnings are then capitalized, and this value is then added to
shareholder’s equity. The result is the total value for all tangible and
intangible components of the business.
The Calculation
Current Year Estimated Adjusted EBIT $136,000
Shareholder’s equity 212,643
X Investment rate (1) X 13%
Return on shareholder’s equity (27,906)
Excess earnings 108,094
Capitalize Excess Earnings 108,094
28% = 384,688
Add shareholder’s equity 212,643
Excess Earnings Value $597,331
(1) The investment rate represents a composite of the following rates of
return.
Inventory 120,000 .15
Fixed Assets 44,840 .20
Accounts receivable 170,822 .10
Composite rate .13
129
Present Value Computations
Present value computations provide an answer to the question ―what amount
must be invested today to produce one dollar at the end of a certain period?‖.
Example: 87 cents (.87) invested at 15% will be worth $1.00 at the end of one
year. Therefore a dollar received one year in the future would have a present
value today of 87 cents, assuming you use a Capitalization rate, Rate of
Return or Discount Rate of 15%. At a Discount Rate of 20% the present value
of one dollar would be 83.3 cents today, 24% rate translates to 80.6 cents, and
so on.
Sample of Present Value Factors
Rates of Return
Period 15% 20% 24% 32%
1 .870 .833 .806 .758
2 .756 .694 .650 .574
3 .658 .579 .524 .435
4 .572 .482 .423 .329
5 .497 .402 .341 .250
You will find Tables of Present Value Factors in the Appendix section of this
book.
Example of the calculation:
What is the present value of earnings expected to be $100,000 per year for
the next five years using a Discount Rate of 32%?
Year 1 2 3 4 5 Totals
Expected
Earnings 100,000 100,000 100,000 100,000 100,000 $500,000
PV Factor X .758 .574 .435 .329 .250
Present
Value 75,800 57,400 43,500 32,900 25,000 $234,600
Present Value of $500,000 to be received over five years = $234,600
Present Value or Discounted valuation methods are often used by
Sophisticated buyers as the following methods will illustrate.
130
Discounted Present Earnings
This valuation method uses existing earnings, adjusts future year earnings
for inflation (3%), and then reduces these forecasts to present value. The
sum of Discounted Earnings represents the Present value of expected
earnings. In this example earnings for the projected current year have been
used based upon an assumption that a buyer might lack knowledge on which
to make credible projections.
Adjusted Present
End EBIT or Value Present
Year EBIT-DA Factor Value
28%
1 136,000 .78125 106,250
2 140,080 .61035 85,498
3 144,282 .47684 68,800
4 148,611 .37253 55,362
5 153,069 .29104 44,549
Total $360,459
Plus value of assets 169,540
Discounted Present
Earnings Value $530,000
Variations of this method
It is not uncommon for periods to extend ten years or longer into the future
when applying this and other ―Discounted‖ methods in large transactions.
Variations in use with this formula add the present value of assets at the end
of the period to the discounted earnings while others will ignore asset values
altogether.
The Discounted method on the next page uses projected instead of present
earnings. You will notice how a credible basis for projecting increasing
profitability has more than doubled the estimated value of the company.
131
Discounted Projected Earnings
This is a variation of the previous method and differs only in that projected
earnings are used in the computation of value.
Adjusted Present
End EBIT or Value Present
Year EBIT-DA Factor Value
28%
1 247,000 .78125 192,907
2 371,000 .61035 226,440
3 515,000 .47684 245,573
4 669,000 .37253 249,223
5 818,000 .29104 238,071
Total $1,152,274
Plus value of assets 169,540
Discounted Projected Earnings Value $1,321,814
This exhibit provides an excellent illustration of how one’s expectation for a
company’s future profitability impacts its value.
The value of a company is dependent upon
expectations of future profits.
132
Capitalization methods are a trademark of Sophisticated buyers and their
advisors. The examples below capitalize earnings. Essential differences
between approaches has to do with perception of quality and continuation of
earnings. Perceived earnings are capitalized at a desired rates of return, and
capitalization rates. These examples use various EBIT-DA (Discretionary
Earnings less operator’s salary) in computation.
Capitalization of Income
Cap. Adjusted
Earnings Rate Value Weight Value
Method #1
Projected
Current Yr.
EBIT-DA 136,000 .28 484,000 .2 96,800
Method #2
Weighted 3 Yr.
Adj. EBIT 104,417 .28 371,600 .1 37,160
Method #3
Projected 1st Yr.
Adj. EBIT 247,000 .28 879,029 .7 615,321
Weighted Average 749,281
Probable Capitalization of Income Value $750,000
133
EBIT Valuation Methods
EBIT valuation methods are both widely used and misused by many
Sophisticated buyers since EBIT-D and EBIT methods can be inappropriate
for many small and mid-sized companies where significant amounts of
earnings have been taken as discretionary expenses.
EBIT calculations are simply multiples of selected EBITs. The examples use
expected current year earnings as calculated from the 9 month interim
income statement.
Range of Range of Type EBIT Multiple Value
Adjusted EBIT $136,000
(Earnings Before Interest, Taxes, 2 272,000
Depreciation and Adjustments) 3 408,000
4 544,000
The calculation:
EBIT-DA 136,000 X 3.5 = $476,000
EBIT-D $147,600
(Projected pre-tax earnings 3 442,800
Before Interest and Depreciation) 4 590,400
5 738,000
The calculation:
EBIT-D 147,600 X 4.5 = $664,200
EBIT $129,600
(Projected pre-tax earnings 3 388,800
plus Interest) 4 518,400
5 648,000
6 777,600
7 907,200
The calculation:
EBIT 129,600 X 5.5 = $712,800
Probable EBIT Value $650,000
134
Summary of Sophisticated Buyer Methods
This exhibit illustrates how weighting the various methods produces a
summary value.
Method Value Weight Extension
Excess Earnings 597,331 .20 119,466
Discounted
Present Earnings 530,000 .15 79,500
Discounted
Projected Earnings 1,321,814 .10 132,181
Capitalization of
Income 750,000 .30 225,000
Various EBIT
Methods 650,000 .25 162,500
$718,647
Target Value $750,000
This summary provides an excellent example of the impact that credible
projections have on business value.
Because Sophisticated buyers will consider
future earnings in value computations,
their values can be much higher than
prices Financial buyers will be willing to pay.
135
Progress might have been all right once
but it has gone on too long.
Ogden Nash (1902-1971)
136
Chapter 20
Strategic Acquirer Methods
aluation methods and value rationale of Strategic Acquirers are often
Acquirers are often restricted to the Board Room and not made public.
made public. Synergistic benefits are, by definition, part and parcel of
and parcel of strategic purchases, and values developed are based upon
expectations of future benefits uniquely particular to acquirers. The
synergistic benefit can vary dramatically on a case-by-case basis. Examples
of strategic acquisition logic might include:
access to new technology or expertise
addition of a complimentary product line
elimination of competition
increased market share
penetration of new markets
elimination of supplier dependency
access to channels of distribution
Acquisitions might conceivably be made on a less obvious premise that
improved public perception will increase the acquiring company’s stock price
by two dollars per share. With twenty million shares issued, a price below
forty million dollars could make strategic sense to a Board of Directors. The
fact that the Target company’s revenues are $20 million, and earnings $1
million, may or may not enter into the decision to pay $30 million for the
firm.
To estimate what a Strategic buyer might pay, one can review transaction
activity of Public companies sold within their industry. Information is
readily available at most libraries, from many of the on-line data bases or
from your stockbroker. In addition, annual reports and SEC 10Ks can be
obtained from public companies directly or from your stock broker. These
documents often will contain information useful in determining acquisition
and value rationale used in previous transactions.
V
137
Data to be gleaned from the above sources will include:
Price/Earnings Ratio for a period of years
Price/Present Revenue
Latest 12 month earnings per share
Price/Current Book Value
These values are expressed as price per share (after tax). Therefore, before
comparisons can be made, a target company’s corresponding ratios must be
converted to after-tax per share prices also. Once these ratios have been
made similar, they can then be applied to the subject company to estimate
what a Strategic Acquirer might be willing to pay.
You might question the relevancy of this seemingly convoluted and pedantic
exercise to its applicability in estimating the value of your small business. It
is important that you understand this method because the Internal Revenue
Service stipulates this procedure for appraising a business’s value. IRS
Revenue Ruling 59-60 specifies this method for calculating values for tax
purposes (estate taxes usually). Therefore, financially savvy advisors will
often use this method when estimating value for partnerships, estates,
divorce settlement, market value or other reasons. When your company
cannot attract Strategic buyers, using or relying on this method can be
extremely damaging.
In this example, values predicted using Income ratios ranged from
$2,603,000 to $1,118,000, forecasting an attainable value of $1,250,000.
Book value and Price-to-Revenue values produced estimates of $381,800 and
$288,000 respectively. Book and Revenue values are not considered Strategic
or Synergistic values and, therefore, would be disregarded by most appraisers
and the IRS.
This method and the research it entails can be of great value to you, the
business owner, as it allows you an understanding of motivations and
expectations prevailing in your industry’s ―deal stream." If you determine
that your firm is not a strategic acquisition, you will gain a better
understanding of what might be done to make it one.
Comparison with Public Companies
Although this method is widely publicized, and is one of the methods referred
to in the IRS Revenue ruling 59-60, it is seldom appropriate when applied to
private or family businesses for the following reasons:
Stock in a family business is not publicly traded. No public market
exists for private company stock.
Publicly traded shares represent sale of a fraction of the business,
not controlling interest as in the sale of a private company.
138
Earnings of a private company are intentionally suppressed to limit
taxation. Public company earnings generally are not.
It is difficult to find public companies that are truly comparable
with family firms.
Computation of Earnings
Other earnings computations reviewed earlier employed adjusted incomes.
This method starts with pre-tax profit and adjusts to after tax income.
Example:
Pre-Tax Profit 150,000
Deduct
a) State taxes 10,000
b) Federal taxes 40,000
Total taxes 50,000
Profit after tax 100,000
Multiplied by appropriate
Price Earnings Ratio X 12
Resulting value $1,200,000
Converting Earnings for Public Company Comparison
Public Company valuation schemes focus primarily on after tax earnings.
After adjusting or ―normalizing‖ the company’s income statement, the
resulting EBIT-DA is converted to an after tax figure. This example deducts
32% for State and Federal taxes to calculate after tax earnings. The
company has issued 1,000 shares of stock. and accordingly, earnings
developed are stated in per share prices.
Adjusted After
Year EBIT Tax Weight Ext. Weight Extension
(000) (000) (000) (000)
3 yrs forward 515.0 350.2 1 350.2
2 yrs forward 371.0 252.3 2 504.6
1 yr forward 247.0 168.0 3 503.9
Est. current yr 136.0 92.5 3 277.5 3 277.5
Last year 97.8 66.5 2 133.0 2 133.0
2 yrs ago 32.8 22.3 1 22.3 1 22.3
Totals 12 1,791.4 6 432.8
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Having arrayed historic and projected earnings, deducted 32% for State and
Federal taxes, we now can attempt to estimate an earnings figure likely to be
used by this type acquirer.
Earnings per Share
Most recent year 66.50
Three year straight average 60.43
Three year weighted average 72.13
Weighted historic and future average 149.28
Estimated current year 92.50
Projected first year 168.00
Estimate of after tax earnings likely to be
used by a public company formula buyer $100.00
Comparison with Public Companies
Having calculated an earnings figure, the next step is to identify Public
companies that are similar to the subject company, and to gather data from
which various ratios can be computed. These ratios are then applied to the
subject company to calculate a ―Comparable Value‖. In the example below a
letter has been substituted for the public company’s name.
Ratios that will be used include:
Price/Earnings Share Price
Earnings/Share = P/E ratio
Price/Revenue Share Price
Revenues/Share = P/R ratio
Price/Book Value Share Price
Book Value/Share = P/BV ratio
Public Company Data
Public
Company P/E ratios P/R ratios P/BV ratios
A 16.21 .15 1.30
B 15.60 .18 2.51
C 17.89 .24 5.21
D 17.01 .31 1.08
E 15.49 . .35 1.26
F 11.69 .48 1.08
G 14.60 .81 1.82
Average per share value 15.50 .36 2.04
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Apply Public Company Data
Having researched and gathered appropriate public company data, and
derived applicable ratios we will now apply this data to our example
company.
Price/Earnings Methods
We will compute three possible values using this method.
1. P/E using estimated earnings 100/share
X P/E ratio 15.50
1,550
X 1,000 shares
Price/Estimated Earnings Value $1,550,000
2. P/E using 3 year weighted earnings 72.13/share
X P/E ratio 15.50
1,118
X 1,000 shares
Price/3 year Weighted Average $1,118,000
3. P/E using estimated first year 167.96/share
X P/E ratio 15.50
2,603
X 1,000 shares
Price/First Year Earnings $2,603,000
Price/Book value Method
Book Value 187.1
X 2.04
381.8
X 1,000 shares
Price/Book Value $381,800
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Price/Revenue Method
Revenue 800.0 X .36 = 288.0
X 1,000 shares
Price/Revenue Value $288,000
Summary of Public Company Methods
Resulting estimates are then discounted because private company shares are
difficult to sell (lack of liquidity). Liquidity discounts will range between 20%
and 40%, we will use 30% in our example. You will notice that Book Value
and Revenue Methods were not weighted in the final estimate of value. They
are included as example only as they may be appropriate for inclusion in
some instances.
Discounted
Method Value Value Weight Extension
P/E Methods:
Est. Earnings 1,550,000 1,085,000 .50 542,500
3 yr. Wgt. Avg. 1,118,000 782,600 .20 156,520
1st Yr. Earnings 2,603,000 1,822,100 .30 546,630
Book Value Method 381,800 0
Revenue Method 288,000 0
$1,245,650
Estimated Public Company Method Value $1,250,000
Using Public company price earnings ratios to estimate
a small family or private business’s value
is like adding apples and oranges.
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Chapter 21
Fair Market Value and Fair Cash Value... What’s the Difference?
any estimates developed when forecasting the value of a small
a small business are misleading in two respects: 1) Values may be
Values may be mathematically correct but inappropriate if not likely
inappropriate if not likely to be paid by the ―Right Buyer‖. 2) Prices
developed may be deceptive if third party financing is unavailable or
restricted.
The reason:
1. Much has been written and is reported on Public mergers and
acquisitions. Detail of Public company transactions is readily
available and often reported on the evening news. Small private-
company transaction data is difficult if not impossible to obtain. Lack
of small business information availability leads to use of Public
company data for estimating value in smaller, private companies.
2. The impact of ―lack of financing‖ upon the value of a business is
quite often overlooked. Expectations for a cash deal may be unrealistic
if third party financing is unavailable.
Some of the mystery surrounding small business value might be removed if
more transaction data were available. But then again, if that were so, I
would not feel the need to write this book.
M
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A comparison of large public and small private business transfers reveals the
following:
Public company transfers are usually all cash or equivalents,
(shares or stock).
Private transfers involve an initial investment or down payment plus
a note, usually held by the seller, and secured by the assets of the
business.
Public companies are able to create third party debt in acquisitions
Buyers of small private companies are usually unable to obtain outside
financing to any significant degree without additional security (home).
Comparable sale or market data is available for large public
companies.
Comparable sale or market data generally is not available for small
private company transfers
Private companies usually represent higher risk because of:
small size
importance of owner who is generally departing
lack of infrastructure
buyer using personal rather than corporate funds to buy
financial/operating information less complete
future profits less predictable
These differences have a major impact on the Price/Earnings ratios of private
companies as compared to public company P/E ratios.
You will recall the four major classifications of businesses from Chapter 6:
Wall Street, Middle Market, Upper Main Street, and Main Street. It’s in the
latter three groups where valuation/appraisal or transfer protocol
misunderstandings most often occur. Unfortunately the overwhelming
majority of companies probably fall within those three categories.
Wall Street firms attract other public companies or suitors who will be
expected to acquire for cash. The remainder, however, generally never
attract such suitors, although all hope and too many think they can.
Thus a majority of companies are left to be bought by either individual(s),
investor groups or other small companies, who neither have the means nor
the desire to pay all cash.
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Effect of Conflicting Perspectives
The clash of buyer and seller perspectives (terms vs cash) is fueled and
distorted by media reports of cash buys in the public sector. Unfortunately,
this leads to:
over-priced businesses
seller insistence on all cash
inaccurate appraisals/valuations
businesses that never sell or finally sell at shop worn prices
buyer/seller frustration in finding compatible partners for ―deal-
making‖
The situation is often further compounded by professional advisors whose
background and training is based on public company protocol and convention.
Perhaps the situation can be better illustrated through an appraisal
assignment involving the division of an estate between twin brother and
sister.
Case Study
Their mother’s estate consisted of two primary assets; a home and a small
business. The home was under contract for sale at $250,000. Both parties
felt the business was worth approximately the same, but wanted an
appraisal to verify their assumptions.
We appraised the business applying methods and formulas appropriate for
this type of business. Comparable sales or market data on 95 similar
companies from our proprietary data base of sold companies was used, and
this information was given greater weight in determining value.
The resulting value was $250,000. Other valuation methods, excluding
comparable sales, produced essentially the same value. The home and
business had FAIR MARKET VALUES that were exactly the same, or did
they?
Comparable data indicated that only one of the businesses had sold for cash.
The typical sale had a 40% down-payment with the balance financed by the
sellers. The full purchase price of $250,000 would be received upon sale of
the home. Only $100,000 would likely be received on sale of the business,
with the balance received over a period of years.
FAIR MARKET VALUE (FMV) in the minds of most people means FAIR
CASH VALUE (FCV). This is quite understandable as most sales of cars,
houses, boats etc. equate to cash for the seller upon transfer. Were buyers of
small companies able to obtain third party debt to acquire as the buyers of
the home were, then $250,000 would be the FMV of the business. The value
derived for the business was actually the FAIR MARKET PRICE (FMP), not
Fair Cash Value. For purposes of illustration, we will define FAIR MARKET
PRICE as being normal terms of payment (the American Society of
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Appraisers now includes this language in their definition of FMV). In the
case of most smaller business transfers that means a down payment plus
SELLER financing.
Fair Market Price or Fair Market Value had to be converted to Fair Cash
Value to conform to the definition of the assignment. That is, what price
could be expected for the business in an all cash transaction?
It is often stated that the valuation or appraisal of small businesses is more
an art than a science. That being said, two critical factors must be
addressed:
Perception of risk
Value and ―bankability‖ of the assets
In this instance the business was very well run, had a long history of
profitability, sales were increasing in spite of the regions economic down-
turn, and was operating with absentee management. Conversations with
several banks revealed an unwillingness to lend on the company’s assets,
especially for a new owner. The company had no debt which could be
assumed.
A comprehensive review of the company’s operating environment, its
expectation for future earnings, their historic financial performance, its
industry, the regional economic outlook, competitive environment and other
factors led to developing a capitalization or perception of risk rate of 24%.
Market data suggested that reasonable buyers might be willing to invest
$100,000 assuming that the seller would finance the remaining balance over
a five year period. Calculating the present value for the note and adding the
result to the anticipated down payment should produce a FAIR CASH
VALUE for this business.
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The calculation:
Present Present
Value Value
Factor
Normal down payment $100,000 1.00 100,000
5 yr. Note for balance 150,000
Total Purchase Price $250,000
Capitalization rate of 24%
Adder for lack of financing 26%
Discount Rate or PV factor 50%
Annual payments PV factor PV of payment
1st yr. payment 39,570 .667 26,393
2nd yr. payment 39,570 .444 17,569
3rd yr. payment 39,570 .296 11,792
4th yr. payment 39,570 .198 7,835
5th yr. payment 39,570 .132 5,223
Total Present Value of Note 68,812
Plus Down Payment 100,000
Present or Fair Cash Value $169,000
The Facts as Supported by Actual Sales Data
1. Usual valuation results do not produce a Fair Cash Value when
banks or other third parties are unwilling to finance the sale.
2. Business owners have to participate in financing to obtain the
values produced by usual valuation methods.
3. When sellers insist upon all cash, the value will be considerably
less than Fair Market Value.
4. The chances of sale are greatly reduced with expectations of an all
cash price (only one of 95 in the comparable group actually sold for
cash without outside financing).
Conclusion:
Valuation estimates where third-party financing is unavailable or limited,
must be adjusted downward if a cash price is being sought.
Advisors to small businesses must be constantly aware of the difference
between Fair Market Value and Fair Cash Value. How many business
owners have been advised not to accept terms by well meaning advisors, and
later, when forced into sale, either liquidated or gave their company away.
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Before you decide to sell, you must understand the
difference between a Fair Market Value, and the
Fair Cash Value for your business.
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Ninety-eight percent of the adults in this country
are decent, hard-working, honest Americans.
It’s the other lousy two percent that gets all the publicity.
But then-- we elected them.
Lily Tomlin
149
Chapter 22
Financing and Value Attainment
he amount of cash that you can expect to receive at closing, and
closing, and frankly, the total price you receive for your company
company depends upon the availability of financing. Financing sources
Financing sources are normally you or a financial institution. The price of
your business will plummet dramatically when neither you nor a bank is
willing to lend money for its purchase. This chapter will assist you in
determining:
1. Probable amount of financing available
2. All Cash Value for your firm (Fair Cash Value)
3. Amount of financing you might provide
4. Terms Price for your business (Fair Market Price)
Favorable or easy terms will increase prices over situations where terms are
stringent or burdensome. Third party willingness or unwillingness to lend
will also increase or decrease prices.
Availability of financing, and the terms under which money is provided are
significant contributing factors to the buyer’s perception of risk. Perception
of risk certainly will be higher when no one wants to finance and lower when
everyone ―wants a crack at it." Price received also decreases as the terms of
financing increase in complexity and expense.
Values produced by most business valuation methods assume that financing
is available under normal terms and conditions. This is seldom the situation.
Of the several hundred transactions in which we have been involved, only a
handful have had institutions lending significant portions of purchase prices.
Terms on institutional loans have been stringent and, most often, require
collateral in addition to business assets (usually the buyer’s home).
T
150
Amount of Financing Available
Is a Cash deal available to you or should you offer financing terms? Cash is
always safest, but is all cash possible in your case? Will a buyer be able to
obtain necessary financing required to pay an All Cash Price?
Factors that increase probability of obtaining institutional financing and
your receiving all cash for your business :
Company Size
Profitability
Collateral
Outlook for the Business
Outlook for the Industry
Outlook for the Market Served
Caliber of Record Keeping
Strength of the management team after your departure
Presentation
Company Size
The likelihood of obtaining acquisition financing increases in direct
proportion to a business’s size. Main Street businesses seldom are sold with
banks participating. Upper Main Street enterprises will often be sold with
banks providing some equipment or receivable financing. The sale of Limbo
firms (companies with revenues measured in the small millions) will usually
involve significant bank participation. Working capital and equipment loans
are an integral part of business life for this group. It is rare for buyers to
have the total cash required for both purchase and working capital in this
size business. Wall Street companies are always sold for cash or equivalents
(Stock, Warrants, etc.).
An overwhelming majority of businesses fall into the first two groups, Main
Street and Upper Main Street. The Small Business Administration
estimates that more than seventy-five percent of all businesses fall into these
two size categories. It is for these two groups that this book has been
written.
Profitability
Profits are obviously required if loans are to be repaid. From a banker’s
perspective, profits ideally shall have been increasing consistently over the
recent few years. Succession management is viewed as capable of improving
this positive trend. Variation from this ideal will diminish chances of
obtaining funds.
Lenders are often reluctant to accept adjusted or discretionary earnings when
considering a firm’s ability to pay. They prefer to focus solely upon pre tax
profits. The preference for use of pre tax profits flies in direct opposition to
the practice of most business people to minimize taxation.
151
Collateral
A banker friend of mine says that collateral simply ―makes a good loan
better.‖ He is also quick to point out that banks are really stewards of other
people's money and, therefore, not in a position to take ―unreasonable‖ risk.
Bankers should not be confused with venture capitalists who do take risks
with their own risk dedicated funds.
Small businesses are considered risky simply because they are small.
Therefore, collateral for a loan is examined very closely by lenders. Service
businesses with few assets, or businesses with assets nearing obsolescence,
will have less ability to gain financing than will asset rich firms.
Outlook for the Business
The outlook must be positive. Operating ratios should reveal competent
management. Your successor’s credentials should forecast expectations for
continued operating excellence.
Outlook for the Industry
Some businesses find great difficulty in obtaining financing simply because of
the industry in which they operate. For example, many lenders will not even
consider restaurant loans. The outlook for your industry must be positive.
Outlook for the Markets Served
Customers impact a firm’s ability to borrow. Bankers often will not consider
loans to companies serving customers afflicted with various woes. Bankers
will also consider dependency upon any one customer as a negative.
Record Keeping
Shoe box record keeping and banks do not coexist. Banks want formal
balance sheets and interim statements. They relish dealing with savvy and
astute business persons who obviously exert financial control over the
business. Bankers are more comfortable with statements when prepared by
respected CPA firms. Records should be ―ship shape‖ or the loan boat never
seems to get launched.
Succession Management
Lenders become more comfortable with the deal when you can demonstrate
that you have in fact attracted ―the right buyer.‖ When lenders conclude that
the new operator lacks necessary experience to fill your shoes, they will walk
away from your deal.
Presentation
A loan request literally outlined on the back of an envelope is guaranteed to
produce a negative first impression, an impression that may never be
overcome. BEFORE approaching any lender homework and preparation
152
must be completed. A comprehensive proposal must be available for the first
meeting.
I remember one case where a buyer went to a bank somewhat prepared only
to be turned down 10 days later. Both he and the seller were very
disappointed. We volunteered to assist the buyer in redoing his loan proposal
and, business plan, as several important areas had been neglected in the
original presentation. The revised proposal was submitted to a different
branch of the same bank, and was approved within seven days. Preparation
and presentation are very important to success in obtaining financing.
How Much Might a Bank Lend for the Purchase of Your
Business?
The value of a business is the composite value of tangible and intangible
assets. It is not uncommon for intangible values to exceed tangible values (as
is the case in the valuation example). Lenders will consider the intangible
factors in their loan review process, but require tangible assets as the
collateral for their loans.
Collateral Value
The company illustrated in the valuation example possessed hard assets with
a Book Value of $347,100. A banker would view the collateral value of the
same assets as worth perhaps only $82,500! A familiar example of why this
is so is the value in your personal residence. Let’s say the home has a market
value of $200,000, and that most lenders today will lend 80% of that value.
This produces a collateral value of $160,000. Real estate is generally
considered most solid next to cash collateral. Real estate values are usually
stable. The collateral cannot be moved, lost, stolen or sold (without lender
consent). The same cannot be said for most other assets in a business and,
therefore, the loan to value factor will be less than the percentage used for
real estate.
Usual loan to value factors for business assets
Remember, it is in the banker’s nature to view asset value under liquidation
conditions.
Business real estate -- 70% of appraised value or less if a purpose
built structure.
Leasehold Improvements -- 0% as paint, carpeting, signage and
other leasehold items have little or no value under liquidation or
foreclosure conditions.
Inventory -- 50% of salable inventory at cost.
Accounts receivable:
0 to 60 days 80%
60 to 90 days 60%
over 90 days 0%
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―Most Main-Street‖ and many ―Upper-Main Street‖ businesses are sold with
accounts receivable retained by the seller and, therefore, this asset is not
available as collateral for the buyer.
The data presented above can be loosely used for purposes of estimating the
collateral value in your own assets. Lending criteria change and, therefore,
for more exacting estimates, contact your local banker for current
information.
Will the Business Qualify for a Loan?
Financing a business sale or business expansion may not be as easy as some
TV commercials might lead one to believe. SBA loans are not giveaway
programs, as too many consider them to be. Federal regulations and
historical oversights have made many bankers feel like fish in fish bowls.
Borrowing or lending money today is not easy. Days of easy credit are gone,
and yesterday’s ―personal‖ Banker has all but disappeared. As the
availability of financing has such an important impact upon the value of your
business, you may want to gauge the probability of success before going to
the bank. The following worksheet will assist you in this regard.
Bankability Review
This worksheet is similar to our Business Risk Analysis where a score of zero
to six is applied to various categories as may be appropriate to your situation.
For example, a company with minimal profits would score a 1 under
Profitability
Your Score
A) Profitability _________
0 - History of losses, not yet profitable
3 - Profitable with erratic prior earnings or reasonable historic earnings
with new management.
6 - Very profitable with strong management team in place
B) Collateral ___________
0 - Outdated or obsolete equipment and facilities or minimal fixed assets
3 - Serviceable equipment or other fixed assets with reasonable
marketability
6 - Assets readily converted to cash
C) Operating Ratios ___________
0 - Ratios well below industry norms
3 - Most ratios at or better than industry
154
6 - All ratios well above industry norms
D) Coverage Ratios ___________
0 - Company burdened with debt
3 - Moderate debt
6 - Minimal or no debt
E) Management ___________
0 - Start up business, or no prior experience in this business
3 - Established company & management or purchase with seller providing
training or purchase of a recognized franchise
6 - Well established company with experienced and respected
management
F) Industry ___________
0 - Declining industry or industry with a high failure rate
3 - Stable industry with history of consistent profits and expectations of
moderate growth
6 - Dynamic and profitable industry with future growth and profitability
assured
G) Environmental ___________
0 - Produces or uses a volatile hazardous waste
3 - Moderate but controllable amounts of materials representing possible
environmental risk
6 - No process or material representing environmental risk present
H) Records ___________
0 - Minimal records prepared by management
3 - Financial statements and tax returns prepared by respected CPA or
accountant
6 - Audited statements prepared by major accounting firm
Total 27.5
Divided by 8 equals 3.4
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Probabilities of obtaining institutional financing.
The scores below predict the likelihood of obtaining bank financing.
0 to 1.5 Next to Impossible 1.6 to 2.5 Unlikely
2.6 to 3.5 Maybe 3.6 to 4.5 Possible
4.6 to 6.0 Likely
Do You Want a Bank to Participate?
Our experience shows that most owners of smaller businesses prefer not to
involve banks in acquisition funding. A common reason centers on issues of
control and security. Banks dictate the terms and payment of subordinated
debt (your note or second mortgage). It is not unusual for a lender to insist
that subordinated debt payments be delayed for considerable periods of time.
In the valuation example (Financial buyer), bank financing would
approximate $82,500 and the Seller’s note would be $174,500. Is it worth
being in second position for $82,500, plus the extra red tape and delay
associated with bank loans? Is it worth the risk that the bank’s demands and
restrictions may scare off the buyer? Only you can answer that question.
The objective is to:
Set the Right Price and get the Most Money
156
Here is a supplementary bulletin from the
Office of Fluctuation Control, Bureau of Edible Condiments,
Soluble and Indigestible Fats and Glutinous Derivatives, Washington, D.C.
Correction of Directive 9434566201, issued awhile back, concerning the
fixed price of groundhog meat. In the directive above named, the quotation
on groundhog meat should read ground hog-meat.
Bob and Ray
157
Chapter 23
Transaction Structuring and Value Justification
LL CASH, CASH and SELLER FINANCING (second position) or CASH plus
plus SELLER FINANCING (First position) -- Which situation will best suit
your needs?
Chapter 22, ―Fair Market Value or Fair Cash Value. . . What’s the Difference?‖ points
out why usual valuation estimates should be adjusted to predict an all cash price (the
example restaurant was sold three years later for $175,000 in cash). The following
example converts Fair Market Value to Fair Cash Value, using our valuation case
study as illustration.
What’s the Cash Price?
In order to answer this question, we must first measure a buyer’s increased
perception of risk caused by financing restraints. To accomplish this, we start with
the Target Purchase Price and subtract both the typical down payment (from
comparable sales data) and the probable bank loan (from collateral worksheet). This
estimates hard cash you might receive at closing.
Measure Increase in Perception of risk
Target purchase price $425,000
Subtract:
Usual down payment 162,000
Probable bank loan 82,500
Estimated cash at closing $244,500
A
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Develop an “Adder” for Increased Perception of Risk
Next, calculate the percentage of your purchase price not covered by usual down
payments and bank financing. Divide this percentage by 2 to develop an ―adder‖ to
the capitalization rate as a measure of the perceived increase in risk caused by
restricted financing.
Cash at closing $244,500
Divided by purchase price 425,000 = 57.5%
Percent of the purchase price remaining 42.5%
Divided by 2
Equals percent to be added to the capitalization rate 21%
Convert Usual Seller Note to Present Value
The purchase price of $425,000 less the down payment and bank financing of $244,500
leaves $180,500 to be financed by the business owner. This seller note is converted to
present value and the present value of the note is added to the estimated cash at
closing. The sum predicts the all cash price.
Usual seller note $180,500
Capitalization rate developed for the business 28%
Adder for restricted financing 21%
Discount rate 49%
Present Value Computation
Calculate the annual note payments and multiply by the appropriate present value
factor to produce the present value of the stream of payments.
Present Value Present Value
Annual note payments Factor of Payments
1st year 43,919 .67114 29,476
2nd year 43,919 .45043 19,782
3rd year 43,919 .30230 13,277
4th year 43,919 .20289 8,911
5th year 43,919 .13617 5,980
Present value of usual seller note 77,426
Plus cash at closing 244,500
Estimated All Cash Price 321,926
159
Terms or Cash -- Which do you prefer?
Let’s compare the terms price with the cash value.
Terms vs Cash Difference
Cash at closing $244,500 $322,000 ($77,000)
Future payments 219,595 0 219,595
Total cash received $464,095 $322,000 $142,095
By accepting the terms price you will receive three dollars in the future for every
dollars left on the table at closing if the transaction was for cash. If your confidence in
the buyer and your financial situation allow, you might prefer the terms price.
The same computation for Sophisticated buyers is summarized below. However, a
cash transaction with a Sophisticated buyer tends to be a long shot because the values
produced:
exceed the funds this buyer usually has to expend for an all cash
transaction
the firm’s assets preclude significant bank participation
Corporate buyers would probably have access to the necessary funds, but are unlikely
to be interested contenders at this stage in the company’s growth.
Summary using the Sophisticated buyer’s value in example
Target purchase price $750,000
Probable down payment 300,000
Bank loan 82,500
Total cash at closing $382,500
Percent of price left to be owner financed 49%
Divided by 2 equals ―Cap rate‖ adder 25%
Capitalization rate developed for the business 28%
Discount rate 53%
Present Value Present Value
Annual note payments Factor of Payments
1st year 89,419 .65359 58,443
2nd year 89,419 .42719 38,199
3rd year 89,419 .27921 24,967
4th year 89,419 .18249 16,318
5th year 89,419 .11927 10,655
Present value of usual seller note 148,592
Plus cash at closing 382,500
Estimated All Cash Price 531,092
160
Compare Sophisticated buyer’s terms price to a cash value
Terms vs Cash Difference
Cash at closing $382,500 $531,092 ($148,592)
Future payments 447,095 0 447,095
Total cash recieved $829,595 $531,092 $298,503
You will notice that the three to one ratio developed in the Financial buyer model
repeats here as well. Stated differently -- lend the buyer three dollars or accept one
dollar today.
All Cash Sale Implications
Buyers natural reaction to a request for a cash price is ―What does the business owner
know that I don’t?‖. This reaction alone may raise a buyer’s perception of risk to a
level where you might not be able to give them the business. Perhaps, because that is
exactly what they fear you are trying to do!
The sale of a business for cash presents a unique set of problems.
the number of potential buyers decreases disproportionately as cash
requirements increase -- business remains on the market longer
requests for all cash will frighten away many possible suitors
produce ―low ball‖ offers
taxes may be more severe than necessary
Buyer Expectations
Having developed your price you now want to test your price against the marketplace’s
expectations. As you now know, different buyers have differing expectations and
methods of measuring the fairness of a purchase price. In all cases there must be a
balance between the initial investment and either the buyer’s living wage or the
return on their investment. We summarize the expectations of the Financial and
Sophisticated buyer below.
Financial Buyers
Financial buyers are sometimes referred to as Lifestyle buyers also. They typically
are willing to invest 80% to 120% of Discretionary earningsas a down payment. The
existing level of earnings is expected to service any acquisition debt and leave a
reasonable balance for their living wage. The example below illustrates the
calculation using a down payment of $100,000 on a business with Discretionary
earnings of $100,000.
Example: $100,000 Discretionary earnings
less (25,000) Debt service and depreciation reserves
equals 75,000 Living wage
divided by 100,000 Down payment
equals 75% Ratio of wage to down payment
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Our data-base of completed transactions indicates that Financial buyers consider a
transaction fair when the down payment to living wage ratio is 70% or better. When
the ratio drops below 70% comparable sales data predicts that a transaction is
unlikely to occur.
Sophisticated or Corporate Acquirers
This group will deduct an appropriate manager’s salary, debt service and reserves for
depreciation from Adjusted EBIT. They then calculate their expected return on
investment. The ROI should approximate the Capitalization rate developed as the
measure of risk appropriate for the opportunity (plus or minus 10%).
Example $350,000 Adjusted EBIT
less Salary, debt service and 250,000 depreciation reserves
equals $100,000 $ Return on investment (ROI)
divided by 400,000 Down payment
equals 25% % Return on investment (ROI)
Comparable sales data indicates that transactions typically will not occur when
structured outside of the above parameters by more than 10%.
Value Justification
We will compare the Financial and Sophisticated buyer’s expectations of appropriate
returns on investments. The Financial buyer wants to be as close to ―Cash on Cash‖
as possible (comparable sales suggests 1 to 1). Sophisticated buyers measure
appropriateness based on capitalization logic.
A sale is possible when a win-win situation can be reached. Many factors must be
considered, including the quality of the buyer, cash to the seller, security for notes
and, terms and conditions of the purchase and sale agreement.
Possible Transaction Structurers
(all $s in thousands) Financial Buyer Sophisticated Buyer
Possible Structure Terms Cash Terms Cash
Target Price $425.0 322.0 750.0 531.0
Down payment 162.0 239.5 300.0 448.5
Bank note/assumptions 82.5 82.5 82.5 82.5
5 year Covenant non compete 25.0 30.0
5 year Consulting agreement 25.0 30.0
Seller note 130.5 307.5
Total Purchase Price $425.0 322.0 750.0 531.0
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Annual Debt Service
Seller Bank Seller Bank
Terms of Notes: Note Note Note Note
Interest 8% 10% 8% 10%
Number years 7 7 7 7
Monthly payment 2,034 1,370 4,793 1,370
Debt service
Bank Note 16.4 16.4 16.4 16.4
Covenant non compete 5.0 6.0
Consulting agreement 5.0 6.0
Seller note 24.4 57.5
Total debt service 50.8 16.4 85.9 16.4
Total cash to seller $485.4 322.0 869.1 531.0
Buyer’s View of Fairness
Financial Sophisticated
Buyer Buyer
Discretionary earnings $200.0 200.0 211.0 211.0
Manager’s salary 50.0 50.0
Debt service 50.8 16.4 69.5 16.4
Buyer’s return on cash 16.2 24.0
Buyer’s wage or ROI 133.0 159.6 91.5 144.6
Buyer’s down payment 162.0 239.5 300.0 448.5
Return on down payment 82% 67% 30% 32%
Buyer’s Living Wage
or ROI/DP ratio expectation 70% up 28% (capitalization rate)
The above structures appear to meet the expectations of fairness for both Financial
and Sophisticated buyers.
Identify your best buyer, then
set price and terms that best meet your needs and
meet market-place expectations.
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Chapter 24
How a “Savvy Businessman” Sells His Business
elling one’s business is not an everyday event for entrepreneurs For
entrepreneurs For most it is a once in a life time experience. The
experience. The consequences are generally greater and have longer
have longer lasting impact than any business decisions previously made.
Result from a sale can be either traumatic or rewarding -- financially and
emotionally. Given the stakes, business owners owe it to themselves, their
families and employees, to take steps calculated to maximize success -
success not only in obtaining the highest value but also in the continued
viability of the company after the sale. To achieve this objective, savvy
sellers will approach the selling process with the same planning discipline
that they impose on important day to day operations and strategy decisions.
What follows is an overview of the winning strategies.
Plan ahead. Eventually every business is either sold or closed.
Decide which it will be for your business.
Is selling now timely? Obtain the information you need to make an
informed decision.
Identify the ideal candidate. A company that would be worthless to
one might be worth millions to another.
Position your company. Package the information the acquirer will
need in the decision making process.
Set price and terms for your company that you can defend with
confidence and credibility.
Apply attitudinal and negotiating techniques to enhance your
ability to obtain the best price and terms.
S
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Following this procedure will eliminate many problems before they occur
thus saving extravagant expenditures of time, money and energy.
Plan Ahead
Savvy sellers decide that their business will survive beyond them! They
understand that no matter how strong a grasp they have on the business,
that grasp will turn into a strangle hold if they stay too long, and make
transition plans accordingly.
Transition planning is one way savvy sellers assure the continuation of their
business and maximize profit when selling. They understand that when it
comes to selling, the company is a product. The future outlook for the
business and its historic records will result in its being deemed either a prize,
or a distress item to be acquired only at a bargain price. Explanations and
projections will not eliminate dull historical performance or the apparent lack
of future opportunity.
Here are some of the things you can do:
Decide that you will eventually sell your business. This single step
is crucial and usually addressed too late. The savvy seller knows that
a business must grow or the owner should go. There is no status quo.
You can’t take your foot off the gas and coast in business.
Review the chapter on ―How to increase value without increasing
profits.‖
Develop interests apart from the business.
Invest in vehicles other than just your business. Keogh, IRA, SEP
and other vehicles are available and should be used to lessen financial
dependence on your business.
Create a ―succession plan.‖
Would selling now be timely?
Only you can answer this question. However, in order to do so, you need
information upon which to make informed decisions. You need answers to
several questions. What is the company worth now? What might it be worth
later? What steps can be taken to increase its value?
Look at yourself in the mirror. How do you appear to others who may be
involved in a buy decision? Personal assessment of our own strengths and
weaknesses is extremely difficult, if not impossible to do. Seldom are we able
to distance ourselves sufficiently to be truly objective. Additionally, we
usually lack the ―Market Place Perspective‖ required to understand how and
under what conditions others will view us positively. What to do? As in any
situation of major importance where personal experience may be short, you
should consider engaging a professional.
In this case you need a firm or person actively engaged as a business broker
or intermediary (Marketplace Advisor). They interact daily with bankers,
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buyers and private money sources. They understand the market place, and
the perspective of various investor types and their advisors. The firm you
choose should have market place experience in dealing with buyers, sellers
and bankers. It should be large enough to bring in a team of diverse talents
to help with your project. Make sure it has experience working with private
companies. There is a world of difference between private and public
companies.
To know where you are going you must first know where you are. Your
Marketplace Advisor can provide you with this information. Most will
develop Business Profiles and Buyer Identification reports that include
summaries of probable expectations of buyers likely to be attracted to your
business. This report is created in preparation for eventual sale, and is a tool
used in decision making.
The report will review both the objective data and subjective environment
that surrounds your business as seen through the eyes of those involved in
your decision, (bankers, buyers, investors, etc.). Appropriate accounting,
statistical and subjective approaches are then applied to develop a range of
prices for your business. Values include, but are not limited to present
Market Value and Cash Flow benefits to you (present and future).
An understanding of the marketplace, and what specifically drives your
company’s value, allows you and your advisors to objectively determine a
course of action that represents your best interests. You are now in charge!
Attracting the “Right Buyer”
Value, like beauty, is held ―in the eye of the beholder,‖ and beauty is very
subjective. The savvy seller instinctively understands that the uniqueness of
his firm represents its highest value only to a unique buyer. Your buyer will
have the specific combination of skills, interests, talents and resources that
the company requires to prosper and grow. In other words, the buyer will
―fit‖ the opportunity the company represents. During the Business Profile
and Buyer Identification portion of the first step, a portrait of an ideal
acquirer was developed. You know ―what he will look like." You also know
where to find him. You understand how he thinks and why he will pay the
highest price. As they say in tennis, ―Advantage, Savvy Seller‖.
Positioning Your Company
One might define positioning as ―Not what you see but how you see it."
During the prior step we adjusted several items to enhance value in the
company. Positioning allows those things we couldn’t or didn’t want to
change to be viewed in a positive light. ―All the right things are wrong with
the company." The savvy seller is aware of this and either learns how to
accomplish it or engages a professional, usually a business intermediary, for
assistance in this most important phase.
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Purchasers have become much more sophisticated and will insist on
substantial amounts of information for even the smallest of companies. In
recognition of this an attractive, persuasive -- yet frank selling document is
prepared. This document, or business profile, should contain the information
necessary for an investor and his advisors to make intelligent decisions. The
profile serves as a track that leads to a successful transfer.
Financial information, although important, represents a minor portion of the
document. The savvy seller knows that buying a business is not solely a
financial play but rather a very personal and life changing event for both
parties. The numbers are important but do not tell the entire story.
Price and Terms
The savvy seller understands how different buyers value and price companies
and will position his accordingly. The first three steps, (business profile and
buyer identification, preparation and positioning) are designed to identify the
right buyer and obtain the best price. You are in control. Your company is
viewed as a prize representing exciting opportunities. You are viewed as a
serious, reasonable and astute business person. Your price and terms can be
defended with confidence and credibility. The business is sold and stays sold!
Negotiations
Negotiating in the emotional atmosphere surrounding every business
transfer requires skill and experience. The Savvy Seller generally engages a
third party, usually an experienced business intermediary, to handle this
important function. Emotion and ego prevent individuals from negotiating as
effectively for themselves as they would for others. Know what form or mix
of purchase price consideration is best for you. Be familiar with tax, legal
and accounting implications.
Determine which items are important to you, and be prepared to trade off the
less essential ones. Preparation and planning pay handsome dividends
during the negotiation process. When your position is supported by
comprehensive documentation, and when you understand the buyer’s
motivations, the transaction progresses smoothly. You obtain your price.
The buyer is satisfied, he and the business are destined to prosper.
Summary
The seller who takes a casual approach to selling, or waits for a suitor who
will make an offer that ―just can’t be refused,‖ is destined to lose. Generally,
the sale is not made, or is made at less than optimum value. Very often word
leaks out that the company is being sold. Possible results? Loss of
employees, customers, credit, etc. that could prove fatal to the firm. It is no
accident that a savvy seller sells his business at a premium price quickly and
quietly. Preparation and planning result in a sale that is rewarding both
financially and emotionally.
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Suppose you were an idiot
and suppose you were a member of congress.
But I repeat myself
Mark Twain (1835-1910)
Given the stakes,
business owners owe it to themselves, their families,
and employees to take steps calculated to
maximize success.
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Chapter 25
Ratio Analysis and Value
t does not require an MBA to understand and compute Financial Ratios for your
for your business. Days receivable, % of Gross Profit or % Cost of Sales and, %
and, % Net Profit, are examples of financial ratios used regularly by astute
astute business people. Your banker and the Sophisticated Buyers will likely add
more to those mentioned when assessing, strength and, quite frankly, you as the
present operator.
It is to your benefit to understand how both bankers and suitors interpret financial
statements. Remember, those who consider themselves financially sophisticated
quite often assume they can evaluate an enterprise solely with historical financial
statements. The fact that financial data is assembled by you to suit your individual
operating style is often overlooked or not understood. ―Seat of the pants‖ and ―It’s
all in my head‖ operating styles produce financial information that is difficult to
interpret. A lack of data leads to diminished confidence in the enterprise and the
operator. Diminished confidence produces diminished value.
Comprehensive financial statements, whether prepared by a respected accounting
firm or yourself, will tend to increase buyer’s and banker’s confidence in you and
your firm.
Ratio analysis can be a most useful tool and is often best performed by comparing
the subject company with others within the same industry. Bankers and buyers
generally refer to industry data collected and compiled by Robert Morris Associates
(RMA), Annual Statement Studies. Copies are available in most city libraries, or
can be obtained by ordering from: Robert Morris Associates, The Association of
Lending and Credit Risk Professionals, One Liberty Place, Suite 2300,
Philadelphia, PA 19103-7398 (see sample RMA. data sheet in exhibit section).
Their financial information is collected and compiled using the Standard Industrial
Classification codes (SIC). Although their data is useful, more accurate information
generally can be obtained from trade associations where data is segregated more
specifically. For example: RMA lists eleven categories of printing, publishing and
allied industries - Two are commercial printing classifications, Commercial
Printing, Letterpress & Screen (SIC 2759) and Commercial Printing, Lithographic
(SIC 2752). A ―Quick Printer‖ could obtain more germane ratio information from
I
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the ―Industry Operating Study‖ produced by the National Association of Quick
Printers, 401 North Michigan Ave., Chicago, IL 60611-4267.
Ratios are grouped by the following headings:
Liquidity Ratios
Coverage Ratios
Leverage Ratios
Operating Ratios
Brief ratio descriptions and their formulas follow.
LIQUIDITY RATIOS
These ratios measure a firms ability to meet current obligations as they come due.
Current Ratio
This ratio is a rough indication of a firm’s ability to service its current
obligations. Generally the higher the current ratio, the greater the ―cushion‖
between current obligations and a firms ability to pay them.
total current assets
total current liabilities‖
Quick Ratio
Also Known as the ―Acid Test‖ ratio, it is a refinement of the current ratio
and is a more conservative measure of liquidity. The ratio expresses the
degree to which a company’s current liabilities are covered by the most liquid
current assets.
cash & equivalents + trade accts & notes receivable
total current liabilities‖
Sales/Receivables
This ratio measures the number of times accounts and notes receivable
(trade) turn over during a year. The higher the turnover of receivables, the
shorter time between sale and cash collect
net sales
accounts receivable‖
Days Receivables
This figure expresses the average time in days that receivables are
outstanding. Generally, the greater number of days outstanding, the greater
the probability of delinquencies in accounts receivable.
365
Sales/Receivable Ratio‖
Sales/Working Capital
Working capital is a measure of the margin of protection for current
creditors. It reflects the firms ability to finance current operations.
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Net Sales
Net Working Capital
COVERAGE RATIOS
Coverage Ratios measure a firm’s ability to service debt.
Earnings Before Interest And Taxes (EBIT)/Interest
This ratio is a measure of a firm’s ability to meet interest payments. A high
ratio may indicate that a borrower would have little difficulty in meeting the
interest obligation of a loan. This ratio also serves as an indicator of a firm’s
capacity to take on additional debt.
EBIT
Annual Interest Expense
Cash Flow/Current Maturities Long Term Debt
This ratio expresses the coverage of current maturities by cash flow from
operations. Since cash flow is the primary source of debt retirement, this
ratio measures the ability of a firm to service principal repayment and is an
indicator of additional debt capacity.
Net Profit + Depr., Depletion, Amortization Expense
Current Portion Long Term Debt
LEVERAGE RATIOS
Highly leveraged firms (those with heavy debt in relation to net worth) are more
vulnerable to business downturns than those with lower debt to worth positions.
Fixed/worth
This ratio measures the extent to which owner’s equity (capital) has been invested
in plant and equipment (fixed assets).
Net Fixed Assets
Tangible Net Worth
Debt/worth
This ratio expresses the relationship between capital contributed by creditors and
that contributed by owners. It expresses the degree of protection provided by the
owners for the creditors.‖
‖Total Liabilities
Tangible Net Worth
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OPERATING RATIOS
Operating ratios are designed to assist in the evaluation of management
performance.
% Profits Before Taxes/Tangible Net Worth
This ratio expresses the rate of return on tangible capital employed.
Profit Before Taxes
Tangible Net Worth
% Profit Before Taxes/Total Assets
This ratio expresses the pre-tax return on total assets and measures the
effectiveness of management in employing the resources available to it.
% Profit B4 Taxes •
Total Assets x 100
Sales/Net Fixed Assets
This ratio is a measure of the productive use of the firm’s assets. Largely
depreciated fixed assets or a labor intensive operation may cause a distortion of this
ratio.
Net Sales
Net fixed Assets
Sales/Total Assets
This ratio is a general measure of a firm’s ability to generate sales in relation to
total assets.‖
Net Sales
Total Assets
Cost Of Sales/Payables Ratio
This ratio measures the number of times trade payables turn over during the year.
The higher turnover of payables the shorter the time between purchase payments.‖
Cost of Sales
Trade Payables
Days Payable
The cost of sales/payable ratio divided into 365 (the number of days in the
year).
365
Cost of Sales/Payable Ratio
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Cost of Sales/Inventory Ratio
This ratio measures the number of times inventory is turned over during the year.
Cost of Sales
Inventory
Days Inventory
Division of the inventory turnover ratio into 365 days yields the average length of
time unit are in inventory.
365
Inventory Ratio‖
Sales or Revenues (Definition)
The dollars generated by the enterprise less returns and allowances. Cash
accounting registers sales as money is received, Accrual method registers sales
when orders are received whether the cash is in the till or not.
Cost of Sales or Cost of Goods
This computation and title will vary by industry and to a degree your or your
accountant’s preference. The major difference in computation has to do with labor.
Some industries (retailing and food service for example) will include only cost of
goods/inventory sold, Cost of Goods. Manufacturing companies will include
material and labor expended to produce a product, Cost of Sales.
Cost of Goods or Cost of Sales
Sales or Revenues‖
Gross Margin or Gross Profit
The titles generally follow the same lines as above. Sales less Cost of Goods
produces Gross Profit
Gross Profit
Sales
Expenses
Sometimes referred to as G&A (General and Administrative expenses) includes
expenses not included in Cost of Goods/Sales.
Expense to Sales Ratio
Expenses
Sales
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Profit
Also called Operating Profit, Net Profit, Earnings, Profit before taxes, Profit before
taxes/interest, Earnings and the Bottom line.‖
Before Tax Profit/Sales
Profit•
Sales‖
Comparing your companies performance against the performance of others in your
industry can be an eye opening and beneficial experience. Ratio analysis is also a
helpful tool to use when attempting to identify the strengths required of your ideal
buyer. The review will also allow you to pinpoint those areas where management
assistance might be required for improved operations.
Ratio Analysis and Comparison with Industry
Before a decision to buy is made, buyers often will perform a comparison of
your company in its relationship to others companies within your industry.
These comparisons can be informal, or even intuitive in cases involving
Financial buyers. A Sophisticated or Corporate buyer, on the other hand,
will be much more formal and exacting in their analysis.
Outside comparative data most often used is taken from Robert Morris and
Associates, and likely will emanate from other sources as well. Dun and
Bradstreet, and Industry trade associations are two other common sources.
The purpose in this exercise is to help identify strengths and weaknesses
within the subject company, and to thereby verify opportunity. The
likelihood in a transaction providing a fair price can be greatly enhanced
when the areas of company weakness are neutralized by strengths of the
acquirer.
The actual analysis will take on two forms: review of most current years, and
comparisons of several years (Comparative Ratio Analysis). The comparative
analysis is undertaken to identify trends, and while computations can be
tedious, they can also be informative management tools, especially when
combined with industry data. With comprehensive knowledge of your
financial and operating history, you will be in the maximum position to:
1. Identify your ideal acquirer,
2. take steps to improve your operating or financial situation, and to,
3. position your firm as an exciting opportunity.
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Interpretation of Statement Studies Figures
RMA cautions that the Studies be regarded only as a general guideline and
not as an absolute industry norm. This is due to limited samples within
categorization of companies by their primary Standard Industrial
Classification (SIC) number only, and different methods of operations by
companies within the same industry. For these reasons, RMA recommends
that the figures be used only as general guidelines in addition to other
methods of financial analysis.
You say I started out with practically nothing,
but that isn't correct.
We all start with all there is.
It's how we use it that makes things possible
Henry Ford
I rate enthusiasm even above
professional skill.
Edward Appleton
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Chapter 26 Ratio Analysis and Comparison with Industry
efore a decision to buy is ratified many buyers will perform a
perform a comparison of your company with other companies within
companies within your industry. The comparison may be very
very informal or even intuitive in the case of the Financial buyer. The
Sophisticated or Corporate acquirer, on the other hand, will take a schooled
approach comparing your numbers with the numbers generated by others in
your business.
The data used most often comes from Robert Morris and Associates, a
financial reporting firm, but may emanate from other sources as well. Dun
and Bradstreet and Industry trade associations are the two most common
sources after Robert Morris.
The purpose of this exercise is to determine strengths and weaknesses of the
company, and ratify the opportunity the company represents. The likelihood
of a transaction occurring at a fair price are greatly enhanced when the areas
of weakness are the strengths of the acquirer.
The analysis usually will take two forms: a review of the most current year
and a comparison of several years (Comparative Ratio Analysis). The
comparative analysis is performed in order to identify trends. The
computations can be tedious to perform, but can be very informative and
important management tools, especially when combined with industry data.
Operating Ratios measure the effectiveness of management and therefore are
of most interest to both operators and acquirers. Liquidity, Coverage and
Leverage ratios are important also as they measure a firm's financial ability
to service debt and other obligations.
When you have a comprehensive understanding of what your financial and
operating history will mean to an acquirer you are in an excellent position to:
1. Better understand who your ideal acquirer might be
2. Take steps to improve your operating or financial situation
3. Position your firm to the proper buyer as an exciting opportunity
B
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Sample Ratio review formats:
Comparative Ratio Review
Robert Morris Associates and other sources publish ratio information against which one can
compare a company’s performance
Most years 3 years
Selected Ratios Recent Yr ago ago Industry Quartile
Current Ratio
Total current assets 308.9 264.0 275.5 2.3 Upper
Total current lia. 119.5 113.9 123.0 1.4 Median
Ratio 2.6 2.3 2.2 .9 Lower
Quick Ratio
Cash & equivalents +
trade & notes receivable 146.0 130.0 120.0 2.1
Total current liabilities 119.5 113.9 123.0 1.1
Ratio 1.2 1.1 1.0 .6
Sales/Receivables
Net sales 850.0 800.0 750.0 13.8
Accounts receivable 123.0 115.0 110.0 9.8
Ratio 6.9 7.0 6.8 8.0
Days receivable
365 365 365 26
Sales/receivable ratio 6.9 7.0 6.8 37
53 52 54 46
Debt/worth
Total liabilities 195.0 199.4 123.0 1.2
Tangible net worth 312.3 283.6 312.3 2.7
Ratio .6 .7 .4 (22.4)
Cost of sales/payables
Cost of sales 375.0 320.0 300.0 24.5
Trade payables 101.0 95.0 86.0 11.4
Ratio 3.7 3.4 3.5 6.1
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Days payable
365 365 365 15
Salespayables ratio 3.7 3.4 3.5 32
Days 98 108 104 60
Cost of sales/payables
Cost of sales 375.0 320.0 300.0 10.8
Inventory 124.0 105.0 91.0 31.5
Ratio 3.0 3.0 3.3 11.2
Days inventory
365 365 365 3
COS ratio 3.0 3.0 3.3 12
Days 121 120 111 33
Comparative Operating Ratio Review
Most 2 years 3 years Industry
Ratios Recent yr. ago ago Results
Cost of sales 44.1% 40.0% 40.0 40.0
3 year average 41.4%
Expenses 58.8% 60.0% 58.0% 46.0
3 Year average 58.7%
Profit -2.9% 0% 2.0% 12.0%
Comparison of Profitability With That of Industry
Industry Subject Co.
Upper Lower
Quartile Median Quartile
Profit .12 .12 .12 -.03
Owner’s compensation .08 .06 .04 .15
Depreciation .02 .01 .01 .01
Basic Discr. Earnings .22 .19 .17 .13
(Other usual adjustments
not included)
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When one door closes another door opens; but we so
often look so long and so regretfully upon the closed door, that we do not see the ones which open for us.
Alexander Graham Bell
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Chapter 27
Subtle Factors that have Dramatic Impact on Value
usiness owners often wait too long to sell. Businesses are seldom sold
seldom sold too soon. Most businesses, like old soldiers, just fade or
just fade or are given away.
Examples are legion where long established businesses simply close their
doors. Many others are sold under duress because of ill health, divorce,
partner disputes, owner burn out, business slow down and death. A business
sold under adverse or distress conditions does not command much value.
Many are sold for mere liquidation value.
Conversely, we all have heard stories of companies selling for fantastic
prices, and often reportedly for all cash!
The million dollar question, (perhaps literally) is why? After much thought,
and more than fifteen years of experience gained in selling several hundred
companies, the answer appears quite simple yet, beneath the surface,
complex.
The major factors threatening the value of your business.
The decision to sell a viable company can be continually postponed.
Entrepreneurial nature of most business owners.
Conventional wisdom as to how, and to whom, a company should be
sold is generally inappropriate.
There exists a general misunderstanding of the factors that drive
the value of a company.
The inability of business owners to position their company so as to
obtain its highest value.
B
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Sell or Not to Sell
Perhaps the most difficult decision you as a business owner ever have to
make may be your decision to sell. Unfortunately, most business owners
agonize over the many variables involved in selling without ever making the
decision to sell.
Result of postponement force the final decision on you. Poor health, divorce,
slumping sales, creditor demands, poor employee relations, lack of operating
or expansion capital very often are the symptoms of an owner who could have
sold, but failed to heed ―early warning signals.‖
By failing to make the decision to sell, a business owner allows it to be made
for him.
Nothing stays the same. Over time a business changes and so does the
owner. Eventually, demands and needs of the business grow to conflict with
an owner’s perspective and skills.
Something has to give. Will it be the owners personal life and health, or will
it be the business that suffers? Perhaps both? By failing to make a timely
decision to sell, you, the business owner allow the decision to be made for
you. The result usually ends in an attempt at sale under conditions of
personal or business distress.
Indecision can prove to be very costly not only to the business owner, but also
to your family, employees, vendors and customers.
To avoid this situation a business owner should first make the decision to
sell, then set the process in motion. Once the decision has been made, the
multiple variables can be addressed and professional help obtained to
maximize value.
Entrepreneurial Nature of Business Owners
Unlike management of larger corporations who can draw upon many
resources for support, information and operational advice, the management
of small private companies must wear all the hats themselves. Competition,
and the many financial drains facing small business owner, mandates that
these owners ―do it themselves‖ whenever possible. The luxury of drawing
upon outside resources is generally restricted to limited accounting and legal
advice.
Most business owners have received unsolicited inquiries from potential
buyers. It would seem logical therefore that attracting a appropriate buyer
would be easy.. To the successful do-it-my-selfer, selling the business might
appear simple, especially to the owner who has experience in successfully
selling his company’s product or service.
Actually, an owner making this assumption is partially correct. Finding
buyers is relatively easy. In fact, everyone ―has a buyer‖. Buyers hire firms
to search for companies network actively with lawyers, accountants, bankers
and others searching for the right business. The typical aggressive buyer will
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look at scores of companies, make several offers and still be looking for a
company.
Buyers constantly report to us that most sellers are unrealistic -- don’t know
what their business is worth, often don’t know how much they are making or
loosing, and that getting adequate information on the business is difficult
and frustrating (like pulling teeth).
What really happens is that the businesses have not been adequately
prepared for sale, and are being exposed to the wrong buyers, or are
positioned as less than attractive opportunities. Selling a business should
not be a do-it-yourself project.
Conventional Wisdom is generally inappropriate.
Public perception of how, and to whom, one should sell a company comes from
several sources: newspapers, movies, television and hearsay. Unfortunately,
these sources provide information which is misleading, inappropriate and
wrong, particularly when applied to small or mid-size companies.
These several sources report about or depict public company events which
tend to be much too grand a scale for smaller private companies. There is a
world of significant difference between the two. No one person owns a public
company, many shareholders do. Public company accounting focuses on
maximizing profits to satisfy shareholders demands, and allow management
to retain their jobs. Private company accounting focuses on minimizing
profits to reduce the owner’s tax bill.
Private company owners need not be concerned with hostile takeovers, junk
bonds, P/E ratios or loss of a job because the company did not show
appropriate profits in recent quarters. Most observers agree that major
differences in management convention and culture exists between private
and public companies.
Because virtually no public information is available regarding the sale
process and selling prices of private companies, many business owners and
their advisors attempt to apply public company methodology and
Price/Earnings ratios to the sale process of private companies.
A few examples of unfortunate results:
Wrong Buyer: Most public company acquisitions appear to occur within
their industry or one tangential to it. Therefore, uninitiated private company
owners very often approach competitors, major vendors or customers when
attempting a sale. Unfortunately, private sector, ―Industry Buyers‖ pay
prices based on selected hard assets, which produce low prices.
Result: Generally unproductive. Confidentiality is destroyed with its
attendant problems (employees, creditors, competition, etc.) or, if successful,
the company is sold for essentially its hard asset value.
182
Wrong Price: Public company stock prices are published daily and Price
Earnings (PE) ratios of 15 times earnings, or more, are common. Assuming
that a private company’s value can be calculated by applying Public company
PE ratios will produce unrealistic prices.
Results: When priced too high; possible loss of the best buyer, business stays
on the market for lengthy period. Exposure to many potential buyers results
in loss of confidentiality. If sold, sold at shop worn price, usually after
several costly attempts (legal and accounting fees) to put a deal together have
failed.
When priced too low: The owner obviously fails to receive full value for the
company. Not so obvious is the loss to employees, vendors and customers.
Buyers pay prices proportionate to the opportunity they perceive. Therefore
buyers paying low prices generally have not recognized the full opportunity
the firm represents and therefore cannot capitalize upon it. The firms full
potential is never reached and those it serves are shortchanged.
Misunderstanding of the Factors that
Drive a Company’s Value.
Financial results are surprisingly not the most important factor to drive a
company’s value. Therefore, the old adage ―know your customer‖ is the
driving force! The person or firm recognizing the highest value, will pay the
highest price. To identify your best buyer or customer for your business, you
must first understand both objective and subjective elements within your
company. How does your firm appear from the outside in? To whom will
your problems appear as valuable and exciting opportunities?
The value of a company lies in its future. Financial results reflect only the
past.
Customer or Buyer Identification should be the first item on a list of
important factors that drive a company’s value. Unfortunately, this factor
usually does not receive the attention required. This is understandable since
few of us are able to objectively view ourselves, our business or anything else
we are very close and emotionally involved with. Also, the business owner
and his advisors, although immersed in the business climate, are not familiar
with driving marketplace forces or the various types and categories of buyers
operating therein.
Opportunity is an obvious factor that must be on everyone’s list. But what
is opportunity? Opportunity is different from potential. Buyers will pay for
opportunity but not for potential. Why? Opportunity is perceived as having
been created by the business owner and potential is that which will be
created by the acquiror. Buyers will not pay you for what they will do
(potential). They will pay for what you have done (opportunity). Perception of
opportunity will vary depending on the type of buyer viewing it, emphasizing
the critical need to know your customer.
183
Earnings factor high on most observers list of important factors. Since most
private companies’ financial statements are driven by the owners’ desire to
minimize taxes, reported earnings are usually misleading. The numbers
alone, even after recasting or normalizing, will not adequately reflect a firm’s
true value. The value of a company lies in its future. Financial results alone
reflect only the past.
Inability to Positioning Company Properly
Positioning is similar to attitude in that proper positioning will produce
positive results just as a positive attitude produces a richer and fuller life.
To properly position a company for acquisition one must first objectively
determine the company’s strengths and weaknesses. Identify the firm’s
uniqueness and hidden values. Understand the subjective environment that
surround the business Gather data and research information from outside
sources to substantiate and ratify opportunity. Quantify subjective data so
as to give credibility to expectations of future profits. Weave the gathered
information and data into a comprehensive prospectus on the company and
highlight the opportunity the firm represents.
A properly positioned firm sells for a premium price to a person or entity able
to enhance its operation. Everyone wins. The owner receives an optimum
price. The buyer acquires an exciting opportunity. Customers, employees
and vendors continue their beneficial relationship with the firm.
Conclusion
Obtaining the best price for a business begins with a timely decision to sell.
Doing it yourself should be limited to the decision to sell only. Thereafter,
professional assistance should be obtained in order to maximize value,
maintain confidentiality and avoid costly mistakes.
Major corporations engage ―pros‖ to enhance the value of their products in
the market place. Professional athletes use their promoters, actors their
agents, public companies their investment bankers. An unfortunate fact is
that most small to mid-size companies are never sold, or when sold, transact
for much less than they should. Perhaps this indicates that owners of family
businesses and private companies need professional assistance also.
The Sale of a Business is usually not a
Do-It-Yourself Project
184
Glossary
Accounting policies
The principles, bases, conventions, rules and
procedures adopted by management in preparing and
presenting financial statements.
Accounting system
The principles, methods and procedures relating to the
recording, classification, and reporting of the
transactions of an entity. In most contexts, the term is
synonymous with financial information system.
Acquisition
debt service The cost of monies borrowed to acquire the business.
Acquisition
process
The basic stages of an acquisition are:
Strategy: developing a good strategy for
strengthening the competitive capabilities of the
existing business.
Planning: detailing a well-planned, team-based
approach to making an acquisition.
Execution: executing the right type and amount of
careful assessment and analysis.
Completion: completing the negotiations and closing
the deal on favorable terms.
Adjusted
EBIT
Pre-tax earnings plus owner’s compensation,
depreciation, amortization, interest and non recurring
and discretionary expenses.
Agent/Agency
A person or company that has the authority to act on
behalf of another (e.g., someone who makes an
agreement on behalf of the Buyer).
Acquirer
The prospective buyer of a business or other asset.
Authorization to close
Written authorization by both buyer and seller to
prepare closing documents.
Business valuation
The act of determining the value of, or the estimated
value of, a business enterprise or an interest therein.
185
Business Valuator
A professional employed in the provision of business
valuation and related services.
Buyer
The prospective acquirer of a business or significant
asset (e.g., plant or real estate).
Caveats
A term used in this guidance to describe matters
included in the engagement letter and/or our reports
that help warn the client about the limitations of
the due diligent engagement.
Competitive advantage
The strategies, skills, knowledge, resources or
competencies that differentiate a business from its
competitors.
Conditions
Situations subject to third party control , such as
bank financing, or a list of actions that must be
taken prior to closing.
Confidentiality
agreement
A legal document whereby the Buyer pledges to keep
strictly confidential, and return on request, any and
all information provided by the seller.
Contingency
An existing condition, situation or set of circumstances
involving uncertainty as to possible gain or loss to an
entity that will be resolved when one or more future events occur or
fail to occur.
Contingency removal
Written satisfaction of a condition that must be
met for a sale to be made.
Cost of goods
Cost of goods purchased for resale.
Cost of sales Same as above plus the cost of labor to produce the product.
Counter offer Reply to an offer to purchase with modifications to the
original or last offer.
Covenants
A commitment made by the Buyer or Seller. For
example, a commitment by the Seller that,
subsequent to signing the purchase agreement but
prior to closing, they will preserve the assets and
continue to operate so that the business and
goodwill being acquired will not diminish.
186
Culture
The beliefs, habits and behaviors of an entity. The
culture of a business affects its ability to work in
teams, to manage change, to innovate, etc. Culture
is also reflected in management style and standards
of customer service.
Deal breaker
A deal breaker is a significant issue relating to the
proposed acquisition between the Buyer and the
Vendor that needs to be resolved in order to close the
deal.
Discretionary
earnings
Earnings available for Debt Service, Owner’s
Compensation and actual Depreciation Reserves.
Divestiture team
A group of people formed by the Seller to manage the
sale or divestiture of a company or division.
Due diligence
The process of systematically obtaining and assessing
information in order to identify and contain the risks
associated with buying a business.
Earn-out
A method of structuring a transaction whereby the
ultimate purchase price is dependent in part on the
future performance of the business being acquired.
EBIT Earnings Before Interest and Taxes.
EBIT-D Earnings Before Interest Taxes and Depreciation
EBIT-DA Earnings Before Interest Taxes Depreciation and
Amortization
Engagement
letter
A letter that summarizes the terms of an
engagement.
F
Forecast
Future-oriented financial information prepared using
assumptions all of which reflect the entity's planned
courses of action for the period covered given
management's judgement as to the most probable set
of economic conditions.
187
Fraud
Intentional misrepresentations of financial
statements by one or more individuals among
management, employees, or third parties. Fraud may
involve manipulation, falsification or alteration of
records or documents, misappropriation of assets,
suppression or omission of the effects of transactions
from records or documents, recording of transactions
without substance; or misapplication of accounting
standards.
G
Gross profit Revenues or Income less cost of goods sold.
H There are no glossary entries for this letter.
I
Indemnification
A promise by one person to protect another person
from an anticipated or potential loss. For example, a
promise by the Seller to assume certain potential
future liabilities (e.g., tax reassessments, product or
health and safety liabilities, etc.) relating to past
activities of the business.
188
Information
package
A compilation of corporate information provided by the
Seller to the Buyer in connection with the sale of a
business. The Seller prepares the information or selling
package to expose the business that is for sale to interested
potential purchasers. Frequently, the target will prepare
two separate packages - one which provides general
information on what is being offered for sale and a second
more detailed document made available to potential
purchasers that have shown a serious interest in
proceeding with the acquisition. Due to the sensitive nature
of certain information such as markets, customers and
financial information, the target will often only provide this
information after the signing of the letter of intent.
Furthermore, the client may only be given access to
sensitive and confidential information through a staging
process. Information packages are good sources of
background information and may address the following:
history of the company
reasons for selling and opportunities for potential
purchaser
summary of products and/or services
analysis of market, customer profile and
competition
description of current operations
description of plant, property and equipment
description of important suppliers
analysis of human resources
summary of financial information.
Information
technology
The expertise, facilities, processes, hardware, software
and data available to assist in attaining business
objectives.
Inspection
Review records, documents, plant and facilities prior to
transfer.
J There are no glossary entries for this letter.
K There are no glossary entries for this letter.
L
189
Letter of intent
A document signifying genuine interest in reaching a
final agreement, conditional upon the results of more
detailed due diligence and negotiations, that may
include:
the issues or bases of understanding that have
been agreed, in general terms
the major issues that remain to be resolved
agreed-upon procedures for going forward
including the provision of more detailed
information about the target by the Seller
an indication that the letter of intent is not
intended to represent a final binding agreement on
the parties Remembering that the Buyer has only completed
an initial assessment at this point, the Buyer must
be cautious about entering into any binding
agreement or commitment on important issues
before having obtained all the necessary
information. It is vitally important that the Buyer
obtain legal advice at this stage so that you
understand precisely what commitments, if any,
you are making.
M
Management
Management refers to the individuals in an entity that
have the authority and the responsibility to manage the
entity. The positions of these individuals, and their titles,
vary from one entity to another and, to some extent, from
one country to another depending on the local laws and
customs. Thus, when the context requires it, the term
includes the board of directors or committees of the board
which are designated to oversee certain matters, (e.g.,
audit committee).
N
Non-
competition agreement
An agreement which specifies the period of time during
which a Seller or departing key employee cannot compete
directly with the Buyer.
O
Offer
See letter of intent
P
190
Physical examination
Inspection of a tangible item, usually other than a
document, such as an item of equipment.
Projection
Future-oriented financial information prepared using
assumptions that reflect the entity's planned courses of
action for the period covered given management's
judgement as to the most probable set of economic
conditions, together with one or more hypotheses that
are assumptions which are consistent with the purpose of
the information but are not necessarily the most
probable in management's judgement.
Also see forecast, future-oriented financial information
and "what if" scenarios.
Proforma
financial
information
The financial information that relates to events and
actions that have not yet occurred and may not occur.
Purchase and
sale
agreement
This legal document records the final understanding of
the parties with respect to the proposed transaction.
Q
There are no glossary entries for this letter.
R
Rate of
return
Return on invested capital (calculated as a
percentage). Often a Buyer has, as one of his
investment criteria, a minimum acceptable rate of
return on an acquisition.
Redundant
assets
Assets which are not necessary for the ongoing
operations of the business.
Related party
A person or entity that has the ability to control or
exercise significant influence over the other party in
making financial and operating decisions.
Accordingly, subsidiaries, parent companies, sister
companies and entities accounted for by the equity
method are considered to be related parties, as are
principal owners, members of boards of directors,
management and members of their immediate
families.
191
Related party transaction
A transfer of resources or obligations between related
parties, regardless of whether or not a price is
charged.
Representations
See Warranties.
S
Seller
The owner(s) of the entity being
aquired.
Sunk costs
An unrecoverable cost resulting from an irreversible
past decision.
T
Target
The business, or significant asset (e.g., plant or real
estate) being considered for purchase by a Buyer
from a Seller.
Trend analysis
An analytical procedure involving the analysis of
the changes in a given account balance or class of
transactions between the current and prior periods
or over several accounting periods.
U
There are no glossary entries for this letter.
V
There are no glossary entries for this letter.
W
Warranties
Statements made by the Seller with respect to
certain elements of the proposed transaction (e.g.,
financial position of the business at closing date,
level of sales achieved, collectibility of accounts
receivable, extent of contingent liabilities, exposure
to environmental issues, etc.) which, if proven to be
untrue, may give the Buyer the right to make a
claim for damages from the Seller.
192
"What if" scenarios
Analysis of the effect of possible future situations
such as economic downturns, increased sales,
changes in interest rates or price levels, new
competitors or technologies, etc.
See also forecast, future-oriented financial
information and projection.
X
There are no glossary entries for this letter.
Y
There are no glossary entries for this letter.
Z
There are no glossary entries for this letter.
193
Thinking is the hardest work there is, which is probably
the reason why so few engage in it.
Henry Ford
194
A One Minute Quiz
for Business Owners Only
ircle your answers to the following questions, then turn the page to see how you scored.
1. Is your business less enjoyable now than before? Y N
2. Does your business challenge and excite you less than earlier? Y N 3. Do you think of selling your business more often now than you did previously? Y N 4. Do you find yourself complaining more lately? Y N 5. Has the business come between you and your loved ones? Y N 6. Has you business begun to level off or decline? Y N 7. Are you concerned you no longer have the stamina your business requires? Y N 8. Do you ask yourself "what would I do if I sold?" Y N 9. Do you often wonder "What is my business worth?" Y N 10. Would you be hesitant to personally quarantee a sizeable loan in order to grow your business? Y N
C
A One Minute Quiz
for Business Owners Only
ircle your answers to the following questions, then turn the page to see how you scored.
1. Is your business less enjoyable now than before? Y N
2. Does your business challenge and excite you less than earlier? Y N 3. Do you think of selling your business more often now than you did previously? Y N 4. Do you find yourself complaining more lately? Y N 5. Has the business come between you and your loved ones? Y N 6. Has you business begun to level off or decline? Y N 7. Are you concerned you no longer have the stamina your business requires? Y N 8. Do you ask yourself "what would I do if I sold?" Y N 9. Do you often wonder "What is my business worth?" Y N 10. Would you be hesitant to personally quarantee a sizeable loan in order to grow your business? Y N
C
A One Minute Quiz for Business Owners Only
ircle your answers to the following questions, then turn the page to see
page to see how you scored.
1. Is your business less enjoyable now than before? Y N
2. Does your business challenge and excite you less
than earlier? Y N
3. Do you think of selling your business more often
now than you did previously? Y N
4. Do you find yourself complaining more lately? Y N
5. Has the business come between you and your
loved ones? Y N
6. Has you business begun to level off or decline? Y N
7. Are you concerned you no longer have the
stamina your business requires? Y N
8. Do you ask yourself "what would I do if I sold?" Y N
9. Do you often wonder "What is my business worth?" Y N
10. Would you be hesitant to personally quarantee a
sizeable loan in order to grow your business? Y N
C
195
The question: Is now the time to sell my business?
To determine your answer: Count your yes answers.
0-3 Yes
Congratulations! You are happy and probably quite prosperous in
your business. Keep it up.
4-6 Yes
Pay attention to your "early warning signals!" It's best not to make
the mistake of staying too long! Sell while you're still having fun. Best
to start the preparation process early. The actual sale of a business can
take a long time.
7-10 Yes
Don't let time spoil the fruits of you labor. Most great men and women
in history have had more than one career. Time for you to decide that
you want a change. Choose what you want to do next, then act.
It’s either Grow or Go -- There’s No Status Quo
