Valuing your business accurately is essential if you do not want to risk leaving money on the table or pushing away potential buyers. Before undertaking the valuation, put time into sprucing up your business and its financials. Efforts spent on the outside will pay dividends down the road.
The value of a typical business should be greater than the total value of its tangible assets. For a buyer, the appeal is that an ongoing business has everything necessary for successful operation — equipment, location, and inventory if applicable, not to mention experienced employees, suppliers, business processes, and a customer list — all in place, in the right amounts. These intangible assets are frequently referred to as goodwill or going-concern value.
The question is, how do you put a price on the goodwill or going-concern value? In fact, how do you determine the true market value of the hard assets used in your business? The answer is that you make a valuer professional or Firm a key player on your selling team.
Many business owners don’t want to spend the time or money to do a valuation. However, saving money on the valuation is likely to be disadvantageous. Guessing the value of your business is likely to result in either a price that’s unrealistically high and turns off many potential buyers or an unnecessarily low price that keeps you from cashing out at full value.
Business appraisers are generally chartered accountants (CA/ACCA) or certified public accountants (CPAs) with specialized training and experience in business valuation techniques. As a profession, they have established several ways to quantify the value of crucial aspects of your business and roll them up into an overall figure. As part of the process, they will write a valuation report explaining how they arrived at their final value. A valuation document prepared by an outside expert adds excellent credibility to your asking price because the buyer can see exactly how you arrived at your final figure.
Remember that if you sell out to a larger company, you’ll probably be dealing with MBAs who are used to seeing sophisticated financial analyses. They will be much more comfortable going through with the sale (and more impressed with your management ability) if you have a detailed valuation prepared.
On the other hand, remember that value is in the beholder’s mind. A professional valuation can tell you the price an average buyer might pay for your business. However, the valuation is just a starting point when negotiating with an actual buyer. A particular buyer may have a solid strategic reason for acquiring your company and be willing to pay a premium over the average buyer’s offer. Another buyer might simply be looking for certain assets to augment their business and may not be willing to pay for your company’s going-concern value. You and your business broker must determine the buyer’s reasons for acquiring your business before naming a price.
If you have a professional valuation prepared for your business but decide not to sell, keeping the valuation document separate from the rest of your business documents is a good idea.
In the event of your death, you would not necessarily want your executor to be tied down by the numbers shown in the valuation. After all, the valuation purports to show market value, but if no sale occurred, it’s hard to know whether that assessment was reasonable. Moreover, many things can make the valuation obsolete in the intervening years.
Using the valuation to set your initial price
Once your appraiser has come up with an approximate value for your business, you may decide to set the listing price slightly above the top end of the price range to allow yourself some room to negotiate and still realize the total value of the business (or at least come close to it.) Or, you may decide that you want to sell quickly and would prefer to set the listing price close to the actual appraised value or even below it.
You should think carefully about this decision and base it on your priorities your broker’s experience, and a sense of the current market for businesses like yours. It’s much easier to drop your asking price later than to raise it. Of course, your actual selling price will be determined during negotiations with the buyer, preferably after all the other significant terms have been worked out.
In placing a price tag on your business, you need to consider the following:
- What factors are most important to buyers?
- How can you boost these crucial factors before the sale?
- How might your accountant adjust your financial statements before showing them to potential buyers?
- What are some of the methods and formulas that are commonly used to put a price tag on a business?
- How does that affect the price if you only sell part of the business?
Some brokers prefer not to set a listing price at all. Instead, they’ll hold a controlled auction were several potential buyers are contacted and given vital information about your business, and bids are solicited. This can be a way to achieve a reasonably quick sale at a competitive price, provided the market for your type of business is pretty strong.
Cash flow and assets are key selling points
It’s essential to recognize that what you love about your business is not necessarily the same thing a buyer will love. You may appreciate the intangible benefits you get from being your boss, from your status in the community, from knowing that you provide an excellent product to your customers and a good working environment for your employees. Possibly you value some of your perks even more highly than the salary you take out of the business.
Buyers focus on cash flow
Buyers tend to look at a business in a much more cut-and-dried way. Most buyers are interested in the essential factors of earnings (net income after all expenses but before capital expenditures or debt payments) and cash flow (the inflow and outflow of cash in the business.)
Buyers want to know that your business will provide a stream of the amount that’s predictable, steady, and high. Some buyers prefer to look specifically at cash-flow statements, while others will focus on your income statement to examine earnings before interest and taxes (EBIT). Still, others will place the most weight on earnings before interest, taxes, and depreciation (EBITD). The point is that your income stream is vital. You must prove the size and regularity of your positive cash flow, preferably with audited financials going back at least three years.
An essential aspect of your cash flow and earnings is their ability to be replicated in future years without your presence . Suppose your professional expertise or salesmanship is the main reason the business makes money. In that case, you will have difficulty convincing the buyer that the cash stream will continue in future years.
Buyers are most concerned about the future earnings of your business and less concerned about the past. However, the future is difficult to predict with any certainty, so most valuations are primarily based on your historical financial statements. You will, however, be expected to provide projected financial statements that show how the business might be expected to perform after the sale. You may also want to emphasize your plans: new products in development, promising new distribution methods, and other items that should contribute to income growth in the future.
Do not make your predictions too rosy — they may come back to haunt you as a lawsuit for fraudulent conveyance if they don’t pan out. Some advisers say those absent particular circumstances; you should predict only that your business will match current growth in your industry.
For information on how we help our clients sustain and increase their business value, read our Enterprise Value Building advisory service.
Assets are an important consideration
A secondary consideration for most buyers will be the verifiable assets of the business: the real estate, equipment, patents or trademarks, and even such things as inventory, customer lists, and contractual relationships you have established. These items are the buyer’s “insurance” — things that can be sold or used elsewhere if the earnings stream dries. Here is where owning your business location and equipment, rather than leasing them, can be substantial.
Buyers will examine your critical financial ratios to see how your business compares to the industry average, to other acquisitions they may be considering, and to the criteria for purchases they have set up for themselves. A key consideration is that your business has a clean balance sheet with low debt. The buyer may have to increase the debt burden to make the acquisition and would not want total debt too heavy for the business to support. Furthermore, a low debt load is evidence that your business has a strong flow of earnings.
Some buyers will be interested in knowing you have an experienced manager or team of employees to take over when you leave. They will want to know that you have groomed your successors and that the successors will stick around. Other buyers will be looking for a business to manage activities and want to avoid long employment contracts with existing managers.
In preparing to sell your business, your best bet may be to choose your most likely successors and prepare them to take over management of the company but hold off on establishing or renewing any contracts with them until the buyer’s identity and plans are known.
Buyers will demand documentation of business assets and financial health
Buyers will also prefer that you have a lot of documentation for your business. They will look closely at what the papers say during the due diligence process as negotiations proceed. But the very existence of documentation like sales reports, production reports, employee organization charts, job descriptions, operations manuals — all that paperwork you have tried to minimize or avoid up to now — serves to tell your buyer a lot about your business and also increases their comfort level with the professionalism of your management style.
Add value to boost the selling price
Regardless of the state of the economy and of your industry, there are many actions that you can take to improve your business’s appeal to buyers before the sale. The main problem is that many of these things take time. You cannot add much value if you need to sell right away. Consequently, a lot of the potential value of the business may go down the drain.
Improve your income statement
Since cash is king, the essential step you will want to take is to clean up your income statement. One way is to have your accountant recast your financials to reflect how the company should look with new owners. However, this procedure turns some buyers (particularly larger corporations) off. They will judge you only by your trustworthy, audited financials; if you want to be able to hook these buyers, you have to clean up the business itself, not just the statements.
This means doing whatever it takes to increase your EBIT (earnings before interest and taxes). This may mean something as simple as increasing your advertising expenditures, hiring another salesperson on a commission basis, keeping your store open an extra 10 hours per week to generate more revenues, and taking a hard look at your expenses to see whether you can reduce them. For example, this may be the time to drop some of the business’s perks to you or your family members.
Where possible, your accountant might capitalize and deduct certain items that might otherwise be expensed and deducted in a year. Your accountant should also review your depreciation and inventory reporting methods. Ideally, you would start working on these three years before the sale since most buyers will want to see three years of financials. (Plus, depreciation and inventory method changes must be in line with the standards and any required internal or external approvals, which can be lengthy.)
Improve Your Assets
Take a good look at the assets of the business. Indeed, you will want to sell off or dispose of unproductive assets or unsalable inventory. The buyer would not want to pay you for them, and they will only drag you down — better to get what you can from them now and write off any losses that may result.
Another move you may want to make is to replace any machinery nearing the end of its useful life and do any necessary repairs and upgrades. The average buyer wants to purchase a turn-key operation so that all they have to do is walk in, turn on the lights, and the business will operate with no immediate need for investment on their part.
You will also want to metaphorically (or literally) put a new coat of paint on the entire place. This is not to say that you should spend a great deal of money on this “curb appeal,” but be sure that your location is clean, your landscaping is fresh, any areas open to the public are decorated appropriately, etc.
Disentangle assets that will not be sold with the business. The business may own certain assets primarily for your personal use (the most common example is a company car) that you want to retain after the sale. Now is the time to buy the asset from the business, perhaps at the current book value.
If the business owns real estate, you might consider removing it from the business and placing it in a limited partnership so that it will not be transferred in the sale. You can continue to lease it to the new owners or someone else and retain an income stream.
This is a judgment call — real estate provides the main appeal to buyers for some businesses, and you would not get much for the business without it. Your business broker should be able to tell you whether this is true for you.
Clean up potential liabilities
It would be best if you made an effort to clear up any pending or potential legal problems, such as product liability claims, employee lawsuits, tax audits, insurance disputes, etc. A buyer who purchases only the assets of your business (instead of corporate stock) generally would not get stuck with inherited legal problems; however, lawsuits or other problems may raise red flags in potential buyers’ minds or even turn them completely off.
Address environmental issues
One concern buyers increasingly have whether there might be any lurking environmental problems on your property. Where problems arise, it is possible that any former owners can be held accountable by the government for costly cleanup costs.
If the real estate is part of the sale of your business, make every effort to see that there are no leaking underground storage tanks, asbestos, lead paint, hidden hazardous waste, or other nasty surprises around the property. If it is reasonable to conclude that problems are unlikely, an environmental transaction screen conducted at your lawyer’s direction may be all that is necessary.
Obtain Phase I environmental audit. To be safe from future claims, you will generally have to obtain a satisfactory Phase I environmental audit by an environmental consultant. The Phase I report will document the clean condition of your property at the time of sale and provide evidence that subsequent owners must have caused any problems. The price of an audit depends primarily on the amount and type of real estate your business owns but can also vary among environmental professionals. Like any other significant expenditure, you should get estimated bids from several licensed consultants before hiring one.
If problems arise during the Phase I audit, a Phase II environmental audit may be required to investigate the problems and determine how to clean them up. If it turns out that problems are so extensive that you can not fix them before the sale, you will probably have to reduce your asking price for the business. As an alternative, you may consider trying to sell the business without the hard assets.
Simply not telling the buyer about existing problems is not an option; many states require you to sign a disclosure form that reveals any and all problems you know about. This is one area where your lawyer’s advice will be critical.
Recast financial statements
One way that virtually all businesses “dress up” their business before a sale is to recast historical financial statements for the last three to five years and draw up projected statements that reflect how the business would look with a new owner.
If you are like most business owners, you have operated your business in a way that is calculated to minimize taxes. You may have given yourself, and your family members as many perks and benefits as possible, kept your children on the payroll, ploughed many profits back into capital improvements, etc. These and other tactics are designed to reduce your profits (and taxes), perhaps artificially.
However, when you put the business on the market, you want to make your company look as profitable as possible. Ideally, you would take steps to improve your actual earnings for several years before putting the company on the block. If time does not permit (or in addition to) this step, you can have your accountant adjust your past income statements to reflect what would have happened if you:
- removed your salary and perks and those of family members you do not expect to remain with the company
- removed any expenses or income that would not be expected to recur or continue after the sale (for example, income or expenses associated with discontinued products or gains or losses from the sale of any business assets)
- removed any investment or other nonoperating expenses or income
- Remove interest payments on any business loans since you will remove such liabilities from the balance sheet.
Furthermore, your accountant can adjust your past balance sheets to:
- Remove any assets that will not be sold to the company.
- Remove any obsolete or slow-moving inventory. Value the remaining inventory at the current replacement cost.
- Value your remaining balance-sheet assets at current fair market value.
- Write off any accounts receivable that are uncollectible.
- Write off any loans the company made to you (bearing in mind this might trigger cancellation of indebtedness income on your tax return).
- Remove other debt that the buyer might not assume.
Your accountant may have some other ideas; for example, you may have expensed some costs that could have been capitalized.
Whatever you do in the way of recasting your financials, make sure that any changes to your historical statements are carefully documented on the face of the statements so that the buyer knows you are not trying to cover anything up.
Finally, it would be best if you had your accountant take these recast financials and use them to project how your future statements are likely to look for the next five years, making reasonable assumptions about future growth or decline in income, expenses, the value of assets etc. In most cases, that means assuming that trends established over the past several years will continue; for example, if revenues have increased by 5% a year, it is probably reasonable to assume that growth will continue at that rate.