- By Toby Tatum, MBA
- Certified Business Appraiser
- Licensed Real Estate Broker/Salesman in Nevada & California
Buying or selling a business is probably one of the most complex transactions there is. The task of establishing a realistic asking price, or for a buyer, an offering price, lies at the heart of the process and is certainly the most complex component of the overall selling or buying project.
As a business owner, you should be aware of the fact that there is general agreement among business brokers that most small and midsized businesses on the market will not sell. (1) The principal reasons they don’t sell is because they are either over-priced and/or not properly positioned to sell.(2)
My mission is to assist business owners in selling their businesses. To accomplish this goal it is imperative that prospective business owner/clients have a solid understanding of the many factors that influence the development of a reasonable asking price and obtain a professional opinion of their businesses’ value. The purpose of this whitepaper is to provide you with this information in order to guide you in establishing an asking price at which you can reasonably expect that someone will buy your business.
There are many factors that have a bearing on the development of a reasonable asking price for your business. The purpose of the remainder of this whitepaper is to identify these factors and explain how they should be taken into consideration as part of your asking price development process.
- The differences between a broker’s price opinion and a certified business appraisal
- What “Fair Market Value” means in the abstract and what it means to you
- Terms used to define a businesses’ earnings
- Recasting the income statements
- Deal structure
- Terms of sale
- How the value of a company’s fixed operating equipment affects the company’s market value
- Business value rules of thumb
- Asking price versus selling price
- Business broker commissions
(1) Based on reliable business brokerage literature it is estimated that only 20% of businesses with annual sales of $1 million or less will sell; that only 25% of businesses with annual sales between $1 million and $2.5 million will sell; that only 33% of businesses with annual sales between $2.5 and $10 million will sell and that approximately half of the businesses with revenue between $10 million and $50 million will sell.
(2) An excellent whitepaper on Positioning A Business For Sale is available free at www.TobyTatum.net
The differences between a broker’s price opinion and a certified business appraisal
All professionally produced business appraisals include a formal certification of value signed by the appraiser. In every case this certification will include the statement that the undersigned appraiser has no present or prospective future interest in the business nor any personal interest or bias with respect to the subject matter of the report. In other words, the appraiser is attesting to the fact that there is no conflict of interest between him and the business he has appraised that could cause a dishonest opinion of value in order to achieve some personal gain.
However, when a business broker provides a prospective client with a recommended asking price or most probable selling price, the specific intent of that endeavor is to obtain a listing on the business in order to sell it and earn a commission. Thus, in this case there is a clear and compelling conflict of interest. The broker may be inclined to provide an unrealistically high value so as to “out bid” competing brokers and win the listing contract. On the other hand, the broker may be inclined to provide a very low value opinion in the hope of making a quick sale with minimal effort.
Moreover, there is a huge difference between an appraiser’s fair market value opinion for a business and that businesses’ most probable selling price based on that FMV opinion. Dependingon the proposed terms of sale and deal structure (explained later in this whitepaper), hundreds of different possible asking prices or most probable selling prices are possible. Thus, if the only information a business owner has is an estimate of his or her businesses’ “fair market value,” that owner does not have enough information to properly price the business for sale.
Given the fact that most small and midsized businesses offered for sale don’t sell seems to suggest that business brokers generally tend to lead business owners in direction of over-pricing their businesses. For the business owner faced with this quandary probably the best course of action is to obtain either a professional business appraisal (which can be very expensive) or obtain an unconditional broker’s price opinion—i.e., engage the broker to provide you with a price opinion for a fee with the understanding that that is the only service you seek—at least for the time being. In this case, it would be a good idea to ask for a sample of the broker’s price opinion report as a precondition of the contemplated engagement.
Business brokers’ pricing advice skills lay across a wide continuum from essentially non-existent to those who are also certified professional business appraisers like me. Interestingly, the State of Nevada is the only state requiring that a business broker be licensed as a business broker and as a condition of obtaining that license the individual must obtain training in business brokerage skills. Nevada Administrative Code 645.913 2(b) requires that this training include six hours in business valuation. That’s not much, but it’s better than nothing which is often the case with business brokers in the other 49 states. As a result, the quality and detail of brokers’ price opinion reports also range across a wide continuum from one number on the back of a business card to very lengthy, detailed, high quality documents.
A high quality broker’s price opinion report for small and midsized businesses generally takes the broker somewhere between 20 to 40 hours to produce. No skilled business broker provides this service for free. However, based on a very recent and reputable survey of business brokers across the country, 40% of them do not charge an advance fee for their services, including providing a price opinion; they work strictly on commission. On the other hand 37% of all business brokers do charge a fee for this service and 23% are in the middle who sometimes charge a fee and sometimes don’t. While considering these statistics, keep in mind the old adage “that you get what you pay for.” Also keep in mind that generally (but not always), brokers who charge an advance fee for their service also charge lower commissions than competing commission-only brokers. Thus a business brought to market that is properly priced based on quality professional advice stands a much better chance of being in the small percentage of businesses that do sell and if sold through a broker who charges an advance fee, the total of the upfront fee and commission paid at closing will probably be less and often much less than the commission that would have been paid to a commission-only broker.
Now, some final comments on the quality of broker’s price opinion reports. Perhaps not surprisingly, the quality of price opinion reports brokerage firms provide vary enormously. I know that the broker’s price opinion reports I produce and provide businesses owners (who are not always my clients for the purpose of selling their business) is the best there is for the type and size of businesses I principally serve. In fact, my demonstration price opinion report for Acme Distribution, Inc. can be reviewed on my website.
Without question, there are many brokerage firms that provide their clients with a credible price opinion report. But, the fact is that many such brokerage firms do not produce their price opinion reports in-house. They subcontract this task to one of several business appraisal “mills” in the country that subsist primarily by producing business valuations and price opinion reports pretty much on a “production line” basis for business brokers. Moreover, as part of this service, in many cases, those firms disguise their reports so as to appear to the broker’s clients that they were produced by their business broker in-house. The fee these appraisal mills charge business brokers for these reports is in the range of $1,000 to $2,000. But, often that’s not the price the business seller client pays the business broker. It is a common practice in the business brokerage industry for some of these brokers to add a little extra to the amount they paid for a report. This “little extra” can range anywhere from an additional thousand dollars or so to something above ten thousand dollars. And keep in mind that the hapless business seller/client could have engaged the same appraisal mill to produce the same report for the same price the broker paid.
For more on this last point, read Attorney General announces $2 million judgment against fraudulent Englewood-based business brokers on page 17 of this whitepaper.
What “Fair Market Value” means in the abstract and what it means to you
“Fair Market Value” is an appraisal term. It is a theoretical estimate of value based on a variety of assumptions. In the case of an estimate of the fair market value of a privately owned business, there are eight key assumptions which form the basis for a “fair market value” opinion.
- Both the seller and the buyer are assumed to be “typical,” in other words, hypothetical or
- theoretical entities who approximate the central tendency in the value opinions of all real business sellers and buyers in the appraiser’s opinion.
- Neither seller nor buyer is under a compulsion to consummate the transaction.
- Both seller and buyer are knowledgeable of all material facts and conditions of the contemplated transaction including reasonable knowledge regarding business valuation.
- The business has been actively advertised for sale on the open market for a reasonable period of time such that all interested buyers have an equal opportunity to make an offer.
- The buyer is a “financial buyer.” A fair market value estimate assumes that the buyer will operate the business after he has acquired it as a stand-alone enterprise. This means there is an implicit assumption in the value estimate that the buyer will not benefit from economies of scale in purchasing, administration or advertising by combining the business with a similar enterprise. Neither does a fair market value estimate assume the buyer is motivated by an opportunity to expand market share or otherwise improve a similar business by acquiring the business’s proprietary technologies, patents or key employees.
- The seller will sign a “non-compete” agreement.
- The buyer will acquire a 100% ownership interest in the company. In cases where the buyer will acquire a controlling interest, but something less than a 100% interest, the value of the percentage ownership acquired may be somewhat less than a pro rata share of the fair market value for the entire company. In cases where a buyer will acquire a non-controlling, minority ownership interest in a company, the value of the percentage ownership acquired can be substantially less than a pro rata share of the company’s fair market value.
- The total purchase price will be paid in cash at close of escrow.
As a practical matter, it is impossible for a business to change hands at “fair market value.” From the buyer’s perspective, the business has been purchased for a price that is uniquely acceptable to that specific individual. Thus the price paid for any business can properly be considered the “investment value” to that buyer and not its fair market value.
However, the only way to approach the task of establishing a reasonable asking price for a business is to first estimate its fair market value. This estimate will then serve as a “base line” price or, if you will, the lowest price the “typical” seller would accept. This is what a fair market value estimate means for you. From this foundation, the ultimately developed asking price will evolve as all other elements that affect actual transaction prices are considered.
Terms used to define a businesses’ earnings
The fundamental concept upon which the value and appropriate transaction price for a business is based is the expected future benefits—i.e., cash flow—that the buyer perceives the business will produce. All business owners are thoroughly familiar with the meaning of the term “net profit”—be it pre-tax or after-tax. However, the expected future earnings stream upon which a determination of a businesses’ value is based is not the businesses’ “net profit.”
There are many different methods that can be employed in estimating a businesses’ value and they are not all based on a single definition of earnings. Actually, there are five different definitions of earnings—or more specifically, cash flow—that are most often employed in a valuation or price setting analysis:
- Seller/Owner’s discretionary cash flow (or discretionary earnings, abbreviated as SDE)
- Earnings Before Interest, Taxes, Depreciation and Amortization (a.k.a. EBITDA)
- Earnings Before Interest and Taxes (a.k.a. EBIT)
- Free cash flow to invested capital
- Free cash flow to equity
It is not at all uncommon for business owners and many brokers to be confused as to which definition of cash flow should be employed with a specific business valuation method. When there is a mismatch between the valuation model and the definition of cash flow the model requires, the resulting value estimate will absolutely be incorrect—and this happens more often than you might think. Here again, when engaging the services of a business broker to offer up a price opinion, its best to insure that you have engaged the services of someone who really knows what he or she is doing.
Recasting the income statements
There is a fundamental difference between one of the principal objectives of financial performance reporting among publicly traded corporations and privately owned businesses.
Within the limits of generally accepted accounting principles (GAAP) publicly traded corporations strive to report the greatest net profit possible. They do this because reported earnings drive the value of their stock and maximizing their stock’s selling price—i.e., maximizing shareholder wealth—is the single most important financial objective of those firms.
Privately owned businesses on the other hand strive to report the lowest profit possible (generally within the legal limits established by the IRS but not always) in order to minimize their income tax liability and thereby maximize after-tax cash flow to the owner, which is to say, maximize owner wealth.
The preceding notwithstanding, the almost universal propensity among the owners of privately owned businesses to intentionally distort the reportable “real” earnings of their companies creates something of a dilemma when it comes to estimating their companies’ value because, axiomatic within the business appraisal profession, the business brokerage industry and the Internal Revenue Service, “a businesses’ recent historical financial performance is the best indication of its expected future performance.”
In addition to intentional reportable-profit-reducing tactics, there are uncontrollable, unplanned events that negatively affect a businesses’ real earnings from time to time. A business may suffer a significant non-recurring decline in sales revenue or increase in expenses for such reasons as perhaps a flood, fire, a law suit, employee theft, a serious on-the-job accident, a labor strike, etc. On the other hand, businesses occasionally experience abnormal, non-recurring surges in sales revenue and earnings.
Regardless of whether the expenses (and occasional earnings) of the types described above are attributable to the proactive actions and decisions of the business owner or were attributable to abnormal, non-recurring events beyond the owner’s control they all have the same thing in common. They obscure what the earnings of the company would have been absent such expenses and revenue and complicate one’s ability to envision a company’s expected future earnings—and it is expected future earnings that drive market value.
Thus, for the purpose of envisioning a privately owned businesses’ expected future earnings, the historical Profit & Loss statements for the past five years must be reconstructed. This is done by re-stating all non-essential business “expenses” (which are generally owner perquisites) as profit, and eliminating all non-recurring and non-operating expenses and income, replacing an owner’s actual salary and bonuses with an estimate of a fair market value wage and much more.
This reconstruction of a businesses’ financial statements is known as “recasting,” or “adjusting” or “normalizing” the statements.
This first step in valuing a business is a big one. It requires a careful and thoughtful effort to study a businesses’ actual financial statements and then appropriately develop recast P&L’s.
This is a very time-consuming project, and requires significant appraiser or broker skills and experience in the analysis of a businesses’ income statements and balance sheets. This process is as much an art as it is a science. Preparing five years’ of recast financial statements takes anywhere from 10 to 20 hours of work—seldom less than that but frequently much more.
In the business valuation and price setting process, there are actually two different definitions of “fair market value” employed. There is the “fair market value of invested capital,” (abbreviated MVIC, also known as the company’ enterprise value) and the “fair market value of owner’s equity.” The value of invested capital means the value of all the company’s current assets, fixed assets and goodwill. The value of owner’s equity is the value of all assets including goodwill minus all debts.
The asking price, price negotiations and purchase agreements for the vast majority of small and midsized businesses are based on the value of the company’s assets. This price is sometimes referred to as the “deal price” and the legal form of the transaction is a sale of the company’s assets. However the asking price, price negotiations and purchase agreements for larger privately owned businesses and all publicly traded companies are based on owner’s equity and such a price is termed the “equity price” and the legal form of the transaction is a sale of the company’s stock. Although a “deal price” and an “equity price” for the same business at the same moment in time will be substantially different, the seller’s net (pre-tax) proceeds from the sale will be the same.
When a transaction is structured as an asset sale, as the vast majority of small and midsized businesses are, then great care must be taken in being absolutely clear in the asking price, the offering price, price negotiations and the purchase agreement what assets are intended to be included in the transaction. For example assume purchase negotiations are underway for a business that has the following balance sheet (and further assume that the seller and the buyer are in complete agreement as to the stated value of these assets including the value of goodwill): In most cases, but certainly not all cases, the only current asset the buyer will acquire will be the inventory. The seller will keep all of the other current assets and convert them into cash after close of escrow. As for the fixed assets, generally the buyer will buy all of them except for the seller’s personal automobile. However, this most common form of the deal structure notwithstanding, all of these assets are potentially subject to negotiating which ones the buyer will buy and which ones the seller will keep.
There are 14 assets identified on this balance sheet. This means that there are 16,384 different combinations of how they may be allocated to either the seller or the buyer. (The number of combinations is 2 to the 14th power). Because the legal form of this transaction is going to be an asset sale, this means that there are 16,384 different prices that can be asked, offered and/or negotiated that will yield the same net proceeds to the seller.
Now consider this businesses’ liabilities:
There are four current liabilities and one long term liability. Most of the time sellers pay off their liabilities in escrow, but not always. In this case, the buyer is going to have to assume the liability for the unredeemed gift certificates. If the business being sold were a newspaper or magazine publisher, the buyer is certainly going to have to assume the liability of prepaid subscriptions. The point here is that the normal way that liabilities are handled in escrow notwithstanding, these too are subject to negotiation as to which ones the seller will pay off and which ones the buyer will assume.
When the buyer assumes some of a businesses’ liabilities, their value becomes a form of partial payment. In other words, the cash the buyer will pay the seller to close escrow will be the agreed purchase price (i.e., the value of all assets being purchased) minus the value of the assumed liabilities. This means that the number of different possible amounts of cash the buyer must have to close escrow is 524,288—2 to the 19th power.
The number of possible prices that may be asked, offered or negotiated for a business in an asset sale may seem mind boggling. However, it’s really not that difficult to do, so long as all parties are aware that unlike negotiating the price of just about anything else, in an asset sale of a business there will always be a huge number of possible prices to consider, all of which will yield identical net proceeds to the seller. The danger in this element of the business transaction process is when the seller and buyer pursue price negotiations where each has a different assumption of which assets the seller intends to sell and which ones he intends to keep. This is not an uncommon misunderstanding between the seller and the buyer and it is one that can easily result in post-transaction litigation.
Also keep in mind that an appraiser’s fair market value opinion of invested capital includes all of the company’s assets. Thus if an appraiser opines that the value of the company’s assets, including goodwill is, say $1,500,000 and the seller’s asking price is that amount but the seller intends to keep all current assets except inventory where the value of the retained assets is, say $300,000, then the business will be over-priced by $300,000.
There is an important teachable moment here and that is that the seller’s gross proceeds from sale (i.e., proceeds before paying off debts) will always be equal to the value of all the company’s assets—the market value of invested capital (MVIC) plus excess assets, if any (like the seller’s personal automobile). Unless the buyer acquires all of the company’s assets, which almost never happens in an asset sale, the selling price will be less than the seller’s gross proceeds from sale. Thus, a seller’s most important focus should be on the proceeds from sale and not the selling price per se. Indeed, the typical deal structure where the buyer only acquires the company’s inventory, fixed assets and goodwill results in the lowest possible asking price.
Terms of sale
Approximately 70% of small and midsize business sales transact on terms wherein the seller partially finances the purchase by accepting part of the price in cash and part in a “seller carryback” promissory note. The introduction of seller financing into a deal structure also has enormous implications for a businesses’ most probable selling price.
This is because a seller can get more for his business if he offers seller carry-back financing.
How much more depends on the terms of the note. The more generous the financing terms from the buyer’s perspective in terms of a cash down payment, the interest rate on the note and the amortization period, the higher the price the seller can get. As the saying goes in the business brokerage business, “the seller names the price and the buyer names the terms; that’s how deals are made.” Seller carry-back financing is attractive to buyers for several reasons:
- As is the case with the purchase of any high-ticket item, few buyers have the wherewithal to pay the full price up front.
- Most buyers want to “leverage” their existing cash with seller financing and will seek those opportunities where this is possible. Thus, if a buyer has, say, $500,000 in cash and has the option of paying all cash for one business worth $500,000 or buying a larger business worth $1,000,000 by putting $500,000 down and financing $500,000, nearly all buyers will buy the larger business.
- Buyers want some assurance that the seller is not dumping a loser. Generally, the seller’s willingness to carry back a significant portion of the purchase price is taken as an indication that he seller believes the business is viable.
- Seller carry-back financing is the principal tactic employed to close the gap between a seller’s “ask” and a buyer’s “bid” price.
Seller carry-back financing is also attractive to sellers for a number of reasons:
- A seller can get a higher price for his business. Indeed, in theory at least, virtually any price a seller asks can be rendered reasonable from the buyer’s perspective by adjusting the terms of seller financing. (For example, on terms of $0.00 down, a 0% interest rate on the note and payments of $1 a year for a million years, you would be getting a great bargain on the purchase of a thrift store wrist watch for $1 million).
- Not only does the seller get a higher price for his business, he also gets interest income off the promissory note—and this can be an additional substantial amount of money. Indeed it is often quite possible for a seller to get twice as much for his business in the form of price paid plus interest income above what the business would probably fetch in an all-cash-at-closing transaction.
- The income taxes the seller pays for his profit-on-sale are spread out over many years and may be somewhat lower.
- The business will attract far more interested buyers.
The obvious downside to seller financed transactions is the ever present possibility that the buyer will default on the note. For sellers who offer financing there is a clear “risk versus reward” decision to be made. And, as mentioned previously, around 70% of small and midsized business sales are consummated on terms other than all-cash-at-closing. It is much easier to sell a business where the seller will partially finance the deal. However, there is an active secondary market for private-party seller carry-back notes. If need be, the seller can probably sell that note—at a discount, of course.
In theory, any top-line selling price can be rendered reasonable from the buyer’s perspective for any business that provides at least enough cash flow to provide the buyer with a fair market value wage, by adjusting the terms of seller carry-back financing. Obviously, if the asking price for a business is ridiculously higher than the most probable all-cash selling price, the seller financing terms that will make this price acceptable to a buyer will also be equally ridiculous— but with absolute certainty, seller financing terms can be developed that will render any asking price reasonable in theory from the buyer’s perspective. I am an expert at determining the exact financing terms that can render any asking price reasonable from the buyer’s perspective by including seller financing in the terms of payment and can demonstrate this fact to a potential buyer. This skill is not something that professional business appraisers ever deal with when rendering a fair market value opinion and, for the most part, probably don’t know how to do.
In all cases where a mutually acceptable selling price has been negotiated where payment includes seller financing and that price is higher than the originally determined all-cash price, which is typically the case, the opportunity exists to introduce yet another powerful deal-making element into the transaction. And, that is the provision for a promissory note prepayment discount! Such a provision can often help cement a deal that otherwise appears impossible to consummate.
For example, most sellers initially want to be paid the full selling price for their businesses in cash at close of escrow. However, most sellers have to give up this requirement in order to attract a buyer. By providing for a prepayment discount in the promissory note, the seller can to some degree “have his cake and eat it too,” so to speak. In other words, the inclusion of a buyer’s prepayment discount option in a seller’s promissory note imbues the buyer with a powerful incentive to pay all or some portion of the balance due on that promissory note off early. In fact I used this technique in a couple of my own businesses that I sold so I can say from personal experience that it really works!
To demonstrate this suggestion, consider the two prices determined for “Acme Distribution”: the precisely calculated all-cash-at-closing price of $1,110,000 and the seller financed price of
$1,500,000.00. Assume the buyer puts $600,000 down and the seller finances $900,000.
Now, suppose the buyer unexpectedly came into some money the day after escrow closed—an inheritance perhaps or perhaps a loan from Mom and Dad and now has enough cash whereby he could have paid all cash for the business the previous day. Do you think such a buyer would then turn around the next day and pay off that note at its face value of $900,000? The answer is “no way.”
From the buyer’s perspective, his desire would be to turn back the clock twenty-four hours and pay the seller another $510,000 in addition to his down payment of $600,000 for a full purchase price of $1,110,000. By including a provision for a prepayment discount, the likelihood of the buyer paying off that note early is very high. Moreover, if the buyer were able to borrow $510,000 from Mom and Dad or perhaps via an SBA 7a business acquisition loan obtained after close of escrow and the seller agreed to accept that amount as payment in full on the $900,000 note, with absolute certainty, that’s what the buyer would do. In fact, only with the provision of a prepayment discount will it be possible for a buyer to get a post-transaction SBA 7a loan because the bank will only make that loan based on the company’s fair market value—i.e., allcash-to-the-seller at COE value. The formula for determining the prepayment discount is the balance due on the promissory note, in this example $900,000, divided by what the balance due would be for the all-cash-at-closing price, in this case $510,000. That equals 1.7467. In other words, the buyer’s prepayment option stated in the promissory note would be a credit of $1.7647 applied against the $900,000 note for every $1.00 of prepayment.
Although it is unlikely that our buyer in this example would unexpectedly come into $510,000 the day after escrow closes, the likelihood of the buyer taking advantage of this option for something less than that amount—say for $100,000—perhaps a year or so after escrow closes is very high. In fact the likelihood of the buyer taking advantage of this option more than once over the life of the note is quite high and the likelihood of the buyer paying off the note early is almost certain.
And there is yet another perspective from which to view this deal-making option. As stated previously, there is an active secondary market for private party seller carry back notes. However, such note buyers always buy those notes for a discount off their face value. Say for example that a note buyer is willing to buy our seller’s hypothetical note of $900,000 but he wants to pay 56.66666% of its face value. This means the note seller has to take a loss of $390,000 and he only gets $510,000. However, add that to the buyer’s down payment of $600,000 and it is exactly equal to the price the seller would have received from the buyer for an all-cash-at-closing price! The point being that a business seller contemplating selling his carryback promissory note to a note buyer should assess the merits of the note buyer’s offer in terms of what he can get for that note compared to what he would have received in an all-cash-at-closing-transaction and not in terms of the discount off the face value of the note.
How the value of a company’s fixed operating equipment affects the company’s market value
This aspect of valuing a business is probably counter-intuitive to most business owners. The fact is that the more money a business must invest in operating equipment in order to produce a given amount of sales revenue and earnings, the less will be that businesses’ market value as a going concern. For example, consider two identical businesses with identical sales revenue and identical operating costs. However, assume one of the businesses generates it sales revenue with operating equipment worth $500,000. Next assume the other business generates its identical sales revenue with operating equipment worth $1,000,000. Assume the useful life of this equipment is 10 years. This means on average that the first business will have to reinvest an additional $50,000 per year for fixed asset replacements. The second business will have to reinvest an additional $100,000 per year for fixed assets replacements. Assume the buyer’s required rate of return on free cash flow to invested capital is 33%. This means that the business with the greater investment in fixed operating equipment will be worth $151,515.15 less than its counterpart (i.e., $50,000 ÷ .33).
There is a very important aspect to this concept that will affect many businesses. It is not at all uncommon for unused operating equipment to accumulate in a business. Be it an older model machine that has been replaced with a new model or perhaps a perfectly good machine that is not being used and there is not much likelihood it will be used in the foreseeable future. If the cost of this accumulated “non-operating” equipment is still on the balance sheet, it will have the effect of reducing the company’s market value. This is so because the buyer will include the cost of this equipment when calculating the average annual fixed asset reinvestment cost which then reduces free cash flow to invested capital. This means that the right thing for an owner to do who is contemplating selling his business is to get that equipment off the balance sheet—i.e., sell it before placing the business on the market.
It should be clear now that a company’s assemblage of fixed operating equipment and its value do not create or improve a company’s market value as a going concern. The only thing that creates value is the after-tax cash flow to the business owners that that equipment generates. In fact, the Uniform Standards of Professional Appraisal Practice (USPAP) Standards Rule 9-3 states that In developing an appraisal of a an equity interest in a business enterprise, an appraiser must investigate the possibility that the business enterprise may have a higher value by liquidation of all or part of the enterprise than by continued operation as is.
What this means for a business owner contemplating selling his business is that there may be a possibility that closing the business down and selling the equipment and inventory will generate greater proceeds than the proceeds that would be generated by selling the business as a going concern at a price the cash flow supports. In fact, this scenario is not at all uncommon. However, in a formal fair market value appraisal, the going concern value estimate includes the assumption of an all-cash-at-closing selling price. If seller financing is introduced into the equation, in many cases it may still be possible to sell a business as a going concern whose liquidation value is greater than its fair market value as a going concern. I am an expert at making this determination.
Business value rules of thumb
There are hundreds of published business value rules of thumb and they are all industry specific. This means that any “heard-on-the-street” business value rule of thumb which has not been further defined as to which industry it reflects is useless information. Virtually every book published on business valuation warns of the danger of relying on rules of thumb and with rare exceptions, a formal, certified business appraisal where the value conclusion is based in whole or in part on a rule of thumb is generally considered unprofessional.
However, rules of thumb do serve a purpose in a formal business appraisal of small businesses and that is as a “sanity check.” This is to say that unless a small business in very extraordinary in some way, the appraiser’s value opinion generally should fall somewhere within the high and low range of the subject company’s industry rule of thumb value. However this range between the high and low value will typically be thousands of dollars and sometimes, tens of thousands of dollars. Furthermore, virtually all rules of thumb assume an asset sale with a deal structure where the buyer acquires only the company’s inventory, fixed operating equipment and goodwill and further assumes some element of seller financing. If a seller is requiring an all-cash-at-closing transaction, most rules of thumb will over value the business to some degree and many will result in a serious overvaluation.
For any given industry, there will typically be business value rules of thumb based on multiples of different definitions of cash flow— either SDE, EBITDA or EBIT. If a business owner or broker multiplies EBITDA or EBIT using an SDE rule of thumb multiple, the business will be grossly over-valued—and this happens all the time with poorly trained business brokers.
There are also rules of thumb which estimate a businesses’ value in terms of a multiple of sales revenue. With some business brokers, this is their most frequently used valuation method because it is easy to use and requires no critical analysis or recasting of a company’s operating statements; just look at gross sales for the past 12 months, multiply that number by the industry revenue rule of thumb multiple and presto! You’ve got your number.
Unfortunately, sales revenue rules of thumb valuation multiples are highly unreliable. This is because those rules of thumb incorporate the tacit assumption that the subject company’s variable and fixed operating costs align perfectly with industry averages. Thus if the subject company’s cost of goods sold, labor cost, rent, utilities or any cost expressed as a percent of sales revenue differs materially from its industry’s average, then the sales revenue rule of thumb multiple will yield in incorrect value estimate. Indeed, it is not at all uncommon for a business to be valued using an SDE cash flow multiple that yields, say a $500,000 value while the sales revenue rule of thumb multiple for that industry applied against the subject company’s sales revenue yields a $2,000,000 value. Typically given this scenario, the ill informed business owner will latch on to the $2,000,000 number and price his business accordingly—and, never find a buyer.
In fact, there are some balance sheet values that also must be close to industry averages for any rule of thumb value estimate to be reasonable. If the subject company’s accounts receivable and/or inventory expressed as a percentage of total assets are materially different from its industry average, then any rule of thumb multiple will yield an incorrect value estimate. This same error will result if the subject company’s fixed asset turn—that is sales revenue divided by the value of the fixed operating equipment—differs materially from its’ industry average.
To summarise all of this, the overriding rule of thumb on pricing a business based on one or more of its industry’s valuation rules of thumb for either cash flow or revenue multiples is to never rely exclusively on industry value rules of thumb.
Asking price versus selling price
There are three very popular transaction databases used by business appraisers and business brokers. These databases report on the actual selling prices of businesses and include information on each sold businesses’ cash flow, sales revenue, value of inventory, value of operating equipment, days on the market, region of the country and so forth.
Following is an analysis of the transaction data reported in the 2010 edition of the Bizcomps Database. In the following graphs, the percentage by which the asking price exceeded theactual selling price is presented for 11,025 reported transactions. For example, the 0%-5% range means businesses whose asking price was 0% to 5% greater than the actual selling price had a total reported number of transactions of 3,085. The second graph indicates that the percentage of transactions sold in this same range was 28% of the total.
So, what does this mean? Keep in mind that these are businesses that actually sold which represent approximately 18% to 25% of all businesses on the market—the remaining 75% to 82% of all small and midsized businesses on the market never sell. It means that once your asking price exceeds around 15% above your businesses’ most probable selling price, the odds of actually selling your business drops below a 10% probability.
Business broker commissions
There are enormous differences between competing business brokerage firms and business brokers. This is especially true when it comes to how they charge for their services. Approximately 40% of main street business brokers work on a commission-only basis. Around 37% charge a fee for providing a broker’s price opinion and the remaining 23% sometimes charge a fee and sometimes they don’t.
Those that charge a fee generally serve businesses with annual sales north of around $2 million. Those that never charge a fee primarily serve the mom-n-pop business community with annual sales for the most part under $1 million but occasionally with sales up to $2 million.
My focus is primarily on businesses with annual sales between $2 million and $20 million. I like nearly all of my competitors who focus on businesses above the mom-n-pop category, charge an advance fee for providing a broker’s price opinion. However, I also charge a much lower commission than the commission-only firms where commissions hover around 8% to 15% of the selling price.
For example, consider what my commission would be for “Acme Distribution, Inc.” the fictional business featured in my online sample broker’s price opinion report. In this report, I have recommended a most probable all-cash-at-closing selling price of $1,110,000. When a client prices their business at my recommended price (which does not necessarily have to be an allcash-at-closing price), my commission is 6% of the first $500,000, 4% of the second $500,000 and 2% of the price above $1,000,000. That results in a commission of $52,200. However, the owner of Acme Distribution, Inc. paid an advance fee of $2,000 for a broker’s price opinion. For this reason I reduced the $52,200 commission by three times the $2,000 advance fee. Thus the brokerage commission paid at closing is $44,200 or 4.16% of the selling price.