One inevitable decision facing all business owners at some point in their lives centers around “Should I sell and if so, then when? With respect to the general question of “Why should I sell?” there are no simple answers. There are however certain issues that should be considered in making this determination. The question of “When do I sell?” is somewhat easier to answer. I will outline my thoughts on these issues in the following paragraphs.
Many closely held businesses will have next generation family members active in the business. Succession potential is a critical component in the decision-making process. You should determine whether one or more of these family members wish to take on a future ownership role. You should also be satisfied that those family members do, if fact, have the skills and motivation to successfully operate the business. There may also be the opportunity for an employee or management buyout, depending on the size and nature of the business. In the great majority of cases, both of these alternatives require the seller to carry larger amounts of financing than would typically be necessary when selling to an outside party.
Most business owners with no succession strategy will eventually reach a point where they will think about having to sell. Reasons for selling can include age, health, stress or burnout, and pursuit of other business ventures. Other reasons may center around growth issues. Is the company growing faster than the present ownership can accommodate? Does this growth require additional capital and/or operational resources that could best be provided by a new owner? Is the company flat or declining and is the present owner in the best position to build it up?
It is incumbent on the business owner to consider their options and develop a detailed exit strategy in consultation with his legal and financial advisors well before the desired exit date. My personal view is that these determinations should begin at least 3 to 5 years prior to the anticipated exit date.
Timing is everything! That old adage “Buy low & sell high” is good advice for business owners at all stages of their business life. Unfortunately the principle is often lost in the selling process. There is a strong tendency for business owners wanting to hang onto an up-trending business for as long as possible. The desire to sell will kick in as the business begins to flatten or decline. Buyer, however, will pay premium prices for businesses that are showing up-trends and tend to heavily discount businesses showing decline even in the short-term. Often, the loss in sale value is much greater than the earnings gained by hanging on that extra year.
If the business is under-performing, then the business owner should determine the possibility for turn-around. If the present owner does not have the skills, energy or resources to facilitate the turn-around, then the decision to sell should be made as soon as possible. Even though the current value may be below expectations, the equity value of the business will deteriorate quickly if a new owner is not put in place at the earliest opportunity.
Business owners must look at all the issues as objectively as possible. Above all, any exit strategy must be thoroughly planned and properly executed.
When I take on a new business listing the seller will often inform me that his accountant “strongly recommends” that he should do a share sale. This is theoretically good advice for the seller from a tax perspective, unfortunately the prospective buyers are being told by both their accountant and their lawyer not to buy shares under any circumstances. As a Broker, how do we rationalize this significant difference in the parties advice?
Let’s start with a brief explanation of the differences in the two types of sales. First, let me say that this discussion applies only to legally incorporated limited companies. A limited corporation (Ltd, Inc. etc) is a legal entity in and of itself, and the ownership of that entity is held via the issuance of shares to the participants involved in the company. The corporation owns and controls the assets and liabilities of the business. Unincorporated Partnerships and sole proprietorships do not have shares and any assets are effectively owned by the individuals involved.
A buyer can acquire the business by way of the purchase of specific assets (vehicles, equipment, fixtures, property, goodwill, etc.). In this case the corporation will sell those assets at a pre-agreed value to the buyer …the buyer will typically roll those assets into a new or existing company and the selling corporation will receive the proceeds of the sale directly. The original shareholders of the corporation still control the selling company but have effectively sold off the active operating business assets.
In the case of a share sale, the buyer will, either personally or through a new or existing company, buy all of the outstanding shares of the selling company for an agreed value directly from the shareholders. The buyer then assumes control of the selling company including all of the operating assets including capital assets, cash, prepaid accounts, deposits, contracts, etc., all of the payables, and other short and long-term liabilities of the company. Capital assets are assumed at depreciated cost value, and the Corporation continues to assume the risk for any unanticipated liabilities (such as lawsuits, tax reassessments etc.) that might surface after the purchase, even though the event may have occurred prior to the sale.
In order to make a share sale work we must, as Brokers, find reasons for the buyer to justify a share purchase. Compelling reasons to buy shares could be to make use of existing financing within the corporation, or to protect significant non-transferable on-going contracts in place that could be voided if the selling company ceases active operations, although in most transactions this is not the case. Most often, we need to look at some pricing advantage to the buyer to offset his tax disadvantages and liability risks. This will, of course, mitigate to some extent the benefits of a share sale to the seller. It is the Brokers job to help find that middle ground.
A business sale is completed when a buyer and a seller agree on price and terms. Once a price has been determined, the buyer must look at how they will fund the purchase. This funding is usually a combination of buyer cash (equity) and bank financing. Often the deal may incorporate some vendor financing or take-back (VTB).
NO seller wants to do vendor financing, nor should they unless absolutely necessary. Vendor financing is often a key issue however, and is a consideration in the majority of deals involving the sale of businesses. In order to assess whether some vendor financing may be required to sell a particular business we must first consider the options available to a buyer from outside sources including lending institutions and private equity sources.
A significant amount of conventional bank financing may be difficult for a buyer to obtain. Banks look at a number of factors when making a lending decisions. One key aspect is the hard asset base of the business. Banks will typically lend 70% to 85% of the current “fair market value” against capital assets such as furniture, fixtures, equipment, land and buildings for security purposes. A portion of leasehold improvement value in a rented business location may be financed in certain cases, however it is next to impossible for a lender to realize on that security in the event of a default so there is an inherent reluctance to lend on leaseholds. In businesses where inventories are a significant component of value, financing can be difficult. Banks will typically lend between 40% to 60% of value depending on the relative ease of liquidity of that inventory. Goodwill is often a component of the value of a business and banks will almost never finance any portion of this value regardless of the cash flows of the business. Banks are, and always have been hard asset-based lenders.
The other key area that banks look at is the cash flow of the business. Underpinning any lending decision, the banks will look at the ability of the business operations to support any debt-servicing that the bank financing requires. If the business is under-performing, the banks will typically not lend even with securable assets available, unless the buyer is able to produce a business plan that demonstrates an opportunity for the business to grow. Even then the banks will look outside the business assets an look to personal assets of the buyer or other private backers to further secure any loans against the business assets.
Private equity sources are typically companies or individuals that provide investment in return for an equity position in the business, or in the alternative, a loan to the company that may have the option of conversion to equity at some future point in time. Generally These sources are typically looking at larger dollar investment placements (generally $2 million and up). The effective cost of this type of funding to a buyer is considerably higher than bank lending rates, but can be effective in funding businesses with high cash flow and/or growth potential but low hard asset levels.
As a broker, we must make our selling clients aware of the realities of market financing potential for their specific business. If the potential for a significant component of bank financing does not exist, then the seller must accept the fact that some component of vendor financing will likely be required in order to complete a sale. Waiting for that elusive all cash buyer with “deep pockets” is often an exercise in futility for all parties involved. It is our job to make sure that the amount, repayment terms and security of the vendor financing are as reasonable as possible.
One of the most frequently asked question that I receive relates to the value of a business. The simple answer is that a business is worth what ready, able, and willing buyers and sellers in open and fair market conditions would agree to on that particular business.
How do we determine value prior to taking a business to the market? This is both a complex and subjective issue. To begin with, there are few if any valid direct comparisons to draw from. No two businesses exactly alike, even within the same sector or industry, and there are no public sources providing information on sale of businesses.
There are many “rules of Thumb” methods utilized in various industries to get an indication of value. These can be helpful to a certain extent but tend to be of little value in assessing the specific issues surrounding a particular business. A simple example of this might be two identical franchises each generating the same gross sales revenues. A “Rule of Thumb” approach based on gross sales would suggest that both should be valued equally. But what if one location was locked into a punitive long-term lease? It is not likely that an astute buyer would then consider the two businesses of equal value.
What then determines the amount that a buyer might pay for a business? In simple terms it is “Risk vs. Reward”… how much am I investing, what is my potential future return on that investment, and what is my risk? To reasonably value a business we must truly put ourselves in the buyer’s shoes!
The price of a business is commonly defined by way of a “multiple” of earnings. (i.e.: 3 times earnings). One must be careful to use the proper methodology when determining the earnings figure to be used (i.e: typically a “Normalized” value based on “EBITDA” or “SDC”). The “multiple” is a numerical value reflecting the various risk factors associated with the business and its perceived ability to sustain earnings into the future …. higher perceived risk yields lower multiples. These multiples can typically range anywhere from 1 to 5 times earnings, depending on the perceived risk and the methodology used to calculate earnings.
In order to value any business we must take a comprehensive look at the specific aspects of the business. We must attempt assess the factors that any prudent buyer might consider such as earnings, hard assets, human resources, desirability to a buyer, financing, operational complexities, and the strengths and opportunities of the business. Clearly, many of these assessments are inherently subjective, and will vary from buyer to buyer. In general however, as we look at each individual element as objectively as possible, a picture of the risk aspects of the business becomes apparent, and a range of price begins to emerge.
Buyers will look at four primary issues when considering the purchase of a business. Suitability or fit, affordability, risk, and return. Suitability and affordability are individual to each buyer and do not directly affect price determination when pricing a business for sale. There is no question that a highly motivated buyer may pay more for a business, but pricing should not be set at a level that only that one “special” buyer might pay. As brokers, we can only look at pricing based on what a normal market might assess on a risk vs. return basis, taking into account any market data that may be available on businesses of a similar type.
Most business transactions in the small market are “Asset Sales” comprised of hard assets (equipment, vehicles, stock etc.) and in certain cases goodwill. Putting a market or “on-going concern” value on working assets in generally not difficult as there are a number of qualified CPPA’s (Certified Personal Property Appraisers) that can value these assets. The market price of the assets will often set the “Floor Price” for the business. If the business is under-performing, the end price of those assets might very well be discounted… with the floor price falling anywhere between “market” value and liquidation value. The Broker’s job is to assess a value, if any, for goodwill in addition to the liquidation value of those hard assets.
It is a common mistake among sellers to assume that there is a finite amount of goodwill attached to their business simply because of the years that they may have put into the business (sweat equity).
Unfortunately, buyers will not pay goodwill expressly on this basis. If the recent earnings are weak then it is difficult to find price support for goodwill, regardless of past performance. In some cases there may be an argument for some level of goodwill if the business has a new product, technology or service that has yet to be fully developed and marketed, however this form of goodwill is most often tied to a future performance-based payout, commonly referred to as an “earn-out”.
The amount of goodwill that a prudent buyer might pay over and above the value of the hard assets is dependent on any number of factors, but is generally tied to the level and sustainability of current earnings, or anticipation of future earnings in a range sufficient to justify that goodwill. Put another way, buyers will look at the earnings potential, and first determine if those earnings provide a reasonable return on the investment in hard assets. If those earnings provide a return in excess of that, some level of goodwill can be considered.
This website is not intended to solicit businesses or property already listed for sale, nor is it intended to solicit buyers under contract with a Buyer’s Agent for the purpose of identifying and purchasing a business or property.