Most Business Owners go Through the Sale of a Business Only Once in a Lifetime
by Terry Stidham
Selling a business can take 1500-2000 man hours and can easily be drawn out to over a year or longer.
Where to Begin - The first step is to ask yourself the question, “Why do you want to sell?” Before you get too far into the process, examine your reason for selling. You don’t want to make a decision that you will later regret. There are many reasons to sell a business, including:
Where to Begin - The first step is to ask yourself the question, “Why do you want to sell?” Before you get too far into the process, examine your reason for selling. You don’t want to make a decision that you will later regret. There are many reasons to sell a business, including:
- Retirement - one of the best reasons to sell a business
- Lack of Operating Capital - usually results in selling the business in a hurry and at a “discount”
- Lack of Growth Capital - can be a good reason if business is profitable and you can still dictate sales terms
- Burnout - might want to consider taking some time away first (even a four- or five-day getaway trip) to think of ways to reduce stress before selling simply because you are “burned out
- Boredom - business is no longer a challenge or exciting
- Partnership Issues - irreconcilable differences
- Divorce - a very difficult situation if the husband and wife have been working together
- Declining Business - identify the reason why...new owner can possibly fix
- Too Many Assets Tied up in Business - might be ready to diversify risk
- Lack of Time for Family and Friends - "No one ever said on their deathbed, 'I wish I'd spent more time at the office'"
- Health - usually not a good time to sell, but all too often this is the reason
- Regulations - Business does not have the critical resources to manage
You should have a well-thought-out reason to sell your business. Selling for the wrong reason hurts the seller on multiple counts. For one, you are subject to receiving a below-market sale price for your business. Frequently this also means that your future options are limited by your age and financial position. So you might wind up selling without getting enough money to retire on and then need to seek employment where you’d be making a lot less than if you had simply kept the business! In any case, if you become convinced that your reason to sell is viable, the next key step is to get started.
The timing of a business sale is critical and planning ahead is key. Too many business owners fail to plan for the day when they will want or have to to sell.
The timing of a business sale is critical and planning ahead is key. Too many business owners fail to plan for the day when they will want or have to to sell.
Why Buyers Buy
Think like a buyer once you have decided to sell your business. In so doing, you will take steps to make your business more attractive to prospective suitors. From a financial perspective, the buyer will be looking for three key results on the other side of the purchase.
- Cash Flow
- ROI
- Market Penetration/Expansion
- Competitors/suppliers/customers
- Individual Investors
- Investment Groups
- Public Companies
- Foreign Buyers
- Employees
- Family Members
Key Components of ROI: cost of money, degree of risk, greed, liquidity and future expectations of profits.
- Cost of Money -The cost of money has an inverse relationship with the denominator in ROI. As the cost of money rises, profits fall and earnings multiples also decline. Lower cost of money leads to higher profits and higher earnings multiples. Interest rates for the cost of money are set by government and market forces. A recent example of these forces at work has been U.S. Federal Reserve Chairman Alan Greenspan’s lowering of short-term interest rates an unprecedented 400 basis points from January to October 2001.
- Degree of Risk - The more risk perceived by the buyer, the higher the expected return will be. If your revenue and earnings have been erratic in recent years, the buyer may perceive the purchase of your business to be a higher risk than it would be to buy one with stable sales and profits. If so, he will demand a higher return (which means a lower price).
- Greed - Pure greed may motivate the buyer to try to drive the price down.
- Liquidity - The easier it is to convert an investment into cash, the lower the expected ROI and the higher the earnings multiple. In other words, a potential buyer is going to expect a much higher return buying your business than he could get putting the same amount of money into Treasury Bonds.
- Future Expectations of Growth and Profit — The buyer will be more likely to pay a higher multiple of earnings for a company that has a believable forecast for growth in the future.
Calculating Value
Earnings Multiple x Earnings before Interest Depreciation Taxes and Amortization (EBIDTA) = Business Value is the most common method for calculating value.
Rules of thumb are valuation methods that should be used as guidelines only. Valuations vary greatly from business to business. The true value of a business lies in the future as seen by the buyer.
Rules of thumb are valuation methods that should be used as guidelines only. Valuations vary greatly from business to business. The true value of a business lies in the future as seen by the buyer.
Book Value of a business is computed by adding retained earnings, paid in capital, common stock and shareholder loans. However, book value multiples are rarely used in computing business sale calculations, because the buyer will be dependent on the earnings capacity of the business to earn a living, pay back debt and generate an acceptable return on investment.
One will not be able to compute the potential sales value of a business just from reading this article. Depending on many factors (business age, location, market potential, financial trends, potential financial adjustments, gross margin level relative to the recognition and identification industry, and condition of business assets, to name a few), the earnings multiple could vary widely.
There are a number of different financial earnings measurements that can be used to value a business. The five most commonly used are:
- Shareholder Discretionary Earnings
- Adjusted Earnings before Interest and Taxes (EBIT)
- Net Profit Before Tax
- Net Profit After Tax
- Earnings before Interest, Taxes, Depreciation and Amortization (EBITDA)
Earnings multiples are generally established as the result of a transaction. They shouldn't be used to drive a transaction, because there are so many extraneous factors that affect the value.
Importance Of Recasting
The historical financial statements alone seldom portray the true financial picture of a business. It is virtually impossible to value a privately held company without careful analysis and recasting to determine the true level of profits.
Recasting is the process of adjusting the out “extra” expenses that are typically run through a closely held business. These expenses are designed to reduce the tax liability of the owner, but they understate the earnings power of the business. It is up to the seller to provide to potential buyers the detail on these expenses.
Here is an example of some of these expenses. The income statement of an engraving business shows a pre-tax net profit of $100,000 for a given year. However, included in the expenses are the following:
The historical financial statements alone seldom portray the true financial picture of a business. It is virtually impossible to value a privately held company without careful analysis and recasting to determine the true level of profits.
Recasting is the process of adjusting the out “extra” expenses that are typically run through a closely held business. These expenses are designed to reduce the tax liability of the owner, but they understate the earnings power of the business. It is up to the seller to provide to potential buyers the detail on these expenses.
Here is an example of some of these expenses. The income statement of an engraving business shows a pre-tax net profit of $100,000 for a given year. However, included in the expenses are the following:
- A $30,000 salary for a family member who works part time and could be replaced by a part-time employee earning $10,000 per year
- $15,000 per year for the owner’s leased vehicle
- $30,000 in overly conservative inventory write-down
- $8,000 per year in country club dues
This could have a substantial impact on the potential sales price of the business. There are many expenses that can be adjusted out of the recast income statement to maximize the reported earning power of a business. Some of the most common are:
- Excessive owner compensation
- Family compensation to spouse, siblings or children
- Owner expenses such as vehicles • Owner perks such as club dues and travel
- Accelerated depreciation or amortization
- Use of nonconforming accounting principles
- Conservative inventory write-downs
- Conservative bad debt write-offs
- Unusual expenses such as legal expenses associated with a lawsuit
- Excessive maintenance that appears in one year
- New product or division start-up costs
- Capital items expensed (such as a new computer system) that could be depreciated
- “Toys” such as boats, airplanes and hunting camps
- Charitable contributions
Deal Structure
The structure of the deal is often more important than the actual sales price of a business. For instance, if it is important for you to cash all the way out now, you might take $1,000,000 less for a cash offer rather than take another offer that requires owner financing. In fact, there are numerous ways for you to be paid in the sale of your business:
- Cash — The most certain way to collect the entire sales price, but has immediate tax consequences.
- Secured notes — Seller is paid over time out of the cash flow of the business and has the right to foreclose as a secondary repayment source if the buyer defaults.
- Unsecured notes — Riskier than secured because the claim is unsecured; limited secondary repayment source if the buyer default
- Shares in purchasing company — Typically only included as part of the package when selling to a publicly traded company
- Consulting agreement — Seller required to stay involved for a fairly short period of time (usually from six months to two years) in exchange for part of the purchase price.
- Employment contract — Seller required to stay involved on a longer-term basis (usually three to five years) to help with transition to new owner.
- Lease on assets retained by seller — Most common with real estate or equipment; if you agree to this, you should require the buyer to sign a long-term lease (five years or more).
- Non-compete agreement — Seller receives payments over a period of time (usually three to five years) in consideration for agreeing not to open up a competing shop down the street.
- Royalty program — Seller receives part of sales price based on future sales generated by the business.
- Earnout — Seller receives part of sales price based on future earnings generated by the business; can be problematic if profits decline after the sale.
- Selling shares vs. selling assets — Buyer purchases the shares of the business directly from the owner(s) of the stock. While some businesses are sold on an all-cash basis, most sales include seller financing in the form of a secured or unsecured promissory note or some other form of future payout to the seller (such as a consulting agreement and a non-compete agreement). This can prove beneficial to the seller from a tax-planning standpoint. However, the seller becomes a creditor and takes some risk that the business will continue to perform well enough to generate sufficient cash flow to meet future obligations to all creditors.
Don’t Fail To Plan
“Business owners never plan to fail, but they do sometimes fail to plan, giving the buyer an added advantage. Be prepared for a process that will require a great deal of time and effort that should pay off in maximizing the sales price of your business in the long run.
Feel free to contact me if you have any question about your next steps or need any recommendations for additional help.
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