How Privately Owned Businesses Are Valued by Buyers and Lendors

In your taking the time to read this, the last thing I want to do is waste your time or mislead you, so I’m going to give you the disclaimer right up front --- there is no one single formula that applies to all types, sizes and businesses in all areas across the US. So, after that initial disappointment, read on and you will start to have an understanding of the many different, very subjective issues that are involved in valuing a privately owned business.

In the vast majority of cases, a Buyer will come to a decision as to the value of a business they are interested in buying based upon six primary issues: {a} the business’ demonstrated and historic earning power, {b} what the buyer believes that they can generate in the way of future earnings with their efforts, talent, drive, capital, etc., {c} the value of the assets, minus any liabilities that are assumed, that come with the business as part of the purchase price, {d} the tax benefits, or lack thereof, that are part of the structuring of the business, {e} the type and nature of financing that is available, and {f} the buyer’s perception of the risks involved in the particular business, its industry and the anticipated economic environment.

While some of the above are simply mathematical computations, the others are highly subjective issues that vary from one buyer to another. Thus, the first understanding of business valuation is to be aware that it is not a single number to designate value but, more appropriately, it will be expressed as a range of value. Why a range? Simply because different buyers view the above 6 factors quite differently and therefore come to very different assessments of value.

Other than a buyer’s evaluation of the degree of the risk involved, a buyer’s perception of future earnings will drive their Return on Investment (ROI) calculation. Simply stated, all buyers tend to have minimum ROI expectations, and those expectations vary from buyer to buyer. The ROI calculation is made by determining the business’ recast stabilized earnings (typically expressed as EBITDA --- Earnings Before Interest, Taxes, Depreciation and Amortization), which is after a reasonable rate of Owner Compensation. EBITDA is then computed as a percentage of the total Purchase Price to determine the projected ROI for someone acquiring the business at that purchase price, regardless of whether they pay cash or finance the purchase.

In the preceding paragraph I refer to the word ‘recast’, and it simply means that few privately owned businesses operate in such a manner as to maximize their earnings (and taxes) on their tax returns. Therefore, a vital and necessary step in the valuation process is to recast the tax return numbers so as to eliminate the influence of owner discretionary and non-cash items.

The degree of risk, high or low, that is anticipated in a given business will be reflected by the buyer demanding either a higher ROI or a willingness to accept a lower ROI. Thus, as a buyer’s ROI expectation goes up, the purchase price goes down and vice versa. To further add to the variability of value conclusions is the fact that different buyers will assess risk differently, and an issue that might really concern one buyer might be of little concern to another. An extension of this axiom is that the same earning power in two businesses that are in two different industries will have very different market values, just as two ‘identical businesses’ located in different parts of the US can sell for significantly different prices as there are regional differences in both supply and demand.

The reality of ‘the range of value’ in valuing privately owned businesses underscores the critical importance of effectively and confidentially marketing a business. By logic and reason, a minimal marketing effort, or simply waiting for an unsolicited buyer, does little to assure your business being exposed to enough different buyers to come across those who will consider paying the upper end of your range of value.

While I know that you have heard of people who sold their businesses at ‘x’ times revenue or ‘y’ times earnings or some other shortcut abbreviation of valuation, please don’t make the mistake of assuming that the same shortcut formula applies to your business. Whether a business sells at 3 times revenue, 1 times revenue or 50% of annual revenue, those numbers are an incidental and meaningless relationship as, most assuredly, that is not how the buyer determined a price that they were willing to pay. To prove the point, two businesses with identical revenues but with very different levels of profitability will obviously have different market values.

Another key aspect of selling a business is to make certain that you get paid for it, as agreed. ‘Seller provided financing’ is a very high risk approach, and thus getting either cashed out or substantially cashed out is invariably in your best interests. The fact of the matter is that, unless the value of your business is a very low dollar amount, few buyers will have all the cash necessary for the purchase and will need to have an outside lender involved. While it will vary by the value and type of your business, you will find that conventional bank loans are ‘collateral based’ --- they will only lend a small percentage of the purchase price of a given business --- and are therefore are not an attractive resource.

If your business has a market value of less than about $2.5 million, you will find that SBA guaranteed financing can provide your buyer with a high percentage of the funds needed to get you either completely of very nearly fully cashed out. Above that value range, the SBA is not meaningful source; however, the nature of the buyers tends to change so that they tend to have access to greater funds, etc. You should also be aware that out of all of the SBA ‘preferred lenders’, only a small percentage are highly responsive to and effective in expediently approving, processing and closing transactions.

So much for lender background. Let’s look at how lenders approach the issue of valuation of a business. Non-SBA lenders will generally loan about 60% to 80% of the liquidation value of the assets or collateral provided to secure the loan. On the other hand, SBA guaranteed lenders are ‘cash flow lenders’ who look at the last two years for which tax returns have been filed and recast the reported earnings, from which they deduct a reasonable owner salary and determine the ‘available pre-tax cash flow’. This dollar amount is then compared to the annual debt service necessary to amortize the loan (generally over 10 years), and a reasonable ratio between the two is required. In practical experience over a number of years, the SBA valuations tend to be higher than most buyers will agree to pay for a given business.

Hopefully the foregoing will have been of assistance in understanding that in valuing a privately owned business ‘one size does not fit all’ and that the process is highly subjective and best approached by an honest and experienced individual who is actively involved in the sale of privately owned businesses.

Sub-Prime Borrowers, the Credit Crunch and What it Means to Your Business

Isn’t it amazing that those folks with bad or marginal credit (sub-prime borrowers) who had taken out 95%, or higher, percentage home loans with variable interest rates are now falling behind in their payments! Who would have ever expected that? Isn’t it somewhat akin to when ‘junk bonds’ collapsed and sank in value? Hello?? They didn’t call them sub-prime for any other reason that to put the world on notice that they were ‘highly marginal borrowers’, and they called them junk bonds because that is basically what they were … JUNK.

Who are the folks who ended up holding all these sub-prime loans and mortgages? They are: {a}investors who bought the ‘securitized’ real estate loans {loans ‘bundled’ into a package as backing for securities that were then sold}, {b} banks and other lenders who provided the mortgage/loan brokers with the ‘front money’ necessary to make and then inventory loans before they were ‘securitized’ or ‘bundled’ and sold to others, and {c} hedge funds who bought portfolios of sub-prime loans with borrowed money to leverage their investments.

The game has been to buy a $100 million sub-prime portfolio yielding a higher interest rate than the cost of the interest on the money that they borrowed to buy the ‘bundle’, thus enabling them to pocket the ‘spread’ in interest. Why were all these folks attracted to the sub-prime market? GREED. The interest rates paid by the not so bright and/or credit worthy borrowers were higher than those available on real estate loans made to more creditworthy borrowers. The age old practice of investment leveraging works only as long as {a} the money (interest) keeps coming in, {b} the underlying collateral remains solid, and {c} everyone ‘keeps the faith’.

How did all these sub-prime loans get made? You would have to have been living in a cave for the last several years to have not been aware of the non-stop radio, TV, newspaper and internet advertising directed at homeowners. Virtually all of these mortgage/loan hucksters have been offering ‘savings’ by offering home refinancing, or getting marginal borrowers into a home purchase, or providing money to buy real estate that was supposed to rapidly go up in value. Hello?? --- If you refinance and borrow more on your house and make variable interest-only payments for a longer term to lower your monthly payments --- exactly what are you saving? Further, if you refinance to pay off accumulated credit card debt, and then run up more credit card debt, isn’t all of this a self ordained death spiral?

What happened over the last 12 to 24 months is that the rapid escalation in real estate values cooled, prices have come down, while interest rates have been going up, and the inevitable and predictable is taking place. Those who bought speculative properties now owe more on them than they are worth. They can’t even rent them for enough to cover the debt service. Compounding this is the fact that the public fell in love with the lower initial interest rates offered by variable rates and gobbled them up by the billions. As interest rates have risen, so have their payments, and now they are having to ‘pay the piper’. Another part of this mix is the creativity of loan brokers who created ‘no doc’ loans --- meaning borrowers did not have to document their income, finances, or other debt and merely had to fill out loan papers. A final measure of crisis was then added with recent revelations of aggressive loan brokers altering borrower applications in order to ‘ram them through the system’ to earn commissions.

Now just about everyone has lost faith in the system and is starting to realize that the real estate loan collateral behind the securities that have been issued, and the loan portfolios that have been pledged as collateral, are worth a lot less than everyone was told, chose to believe, or expected. The house of cards is imploding and banks, hedge funds, investors and other lenders will no longer lend on, or purchase, these ‘less than prime’ real estate loan portfolios. This means loan brokers’ employees are being fired at a high rate as loan processing grinds to a halt, and many of the industry’s players look at bail out acquirers, bankruptcy or dramatically downsized operations as a means of either liquidation or survival.

You know that things are tough (and getting closer to the end of a cycle) when you read and hear about pleas for the government to bail out the idiots who have been trapped by their own GREED and STUPIDITY --- referring to virtually all of the players, including the borrowers, the loan brokers and those who chose to believe that there really was a free lunch!

What does all of this mean to you and I as the owners of privately owned businesses? It means that money is tightening and credit standards are going to be more restrictive for all types of loans, financing and leases --- not just for real estate loans. The CYA phase of the sub-prime aftermath will be litigation, some firings and everyone in the credit world requiring more documentation and perhaps a tad higher rate of interest. It also means that the Fed will most probably reluctantly have to lower the cost of money, earlier than otherwise might have been the case.

If you happen to own a well financed and managed business, there is a silver lining to all this madness. These events will most probably not negatively impact the economy in the intermediate or long run, but will make life much more difficult for our under capitalized and poorly managed competitors! You will also find that if you are about to implement an exit strategy, both the value you receive from your business and the financing for your buyer will probably be unaffected by the interim sub-prime fiasco. Further, if you have prudently accumulated capital, you will find that the coming months will provide you with some outstanding opportunities to add to or start a portfolio of residential rental properties that can be acquired at very favorable prices and accommodating financing from the banks who will be doing the foreclosing.

7 Ways to Get More from the Sale of Your Business

Thinking about selling your business? You are not alone. CNN Money report that 35 million baby boomers are expecting to retire between 2000 and 2020.

The value of your business represents a significant percentage of your total net worth. If you wish to adequately fund the retirement lifestyle you have earned, you must get every last after-tax dollar and get paid in cash when selling your business. Here are seven proven strategies for receiving the most value for your blood, sweat and tears:

Preplan the sale of your business. This should not be a spur of the moment decision. Rather, it should be well planned in advance. It is much the same as a home which will sell rapidly and bring top dollar with the benefits of a strong market, good financing options, a new coat of paint, and flowers in the yard.

Maintain complete confidentiality. It is vitally important that your employees, competitors and customers not be aware of your plans. The loss of employees or customers can rapidly decrease both the value and marketability of your business.

Do not put a price on your business. Once you put a price on your business, you create a ceiling, and you miss the opportunity to find the ideal buyer who would have otherwise paid top dollar.

Recognize the importance of finding the right buyer. Most businesses don’t have a value that is set in stone. Rather, they have a range of value. This means that different buyers will have different perceptions of the same business’ value. Thus, it becomes important to pre-plan your confidential marketing effort to gain exposure to multiple buyers, especially synergistic buyers – those buyers who because of their location, complementary customer base, financial resources, or market position, can profit more from owning your business and are therefore willing to pay more.

Recognize the risks in financing the buyer. Your objective should be to get “cashed out”, as the risks involved in financing buyers are very considerable. A default can have a major negative impact on your retirement plans.

Get professional help. Unless you have a background in taxes, legal issues and merger and acquisition work, you will probably unknowingly make a multitude of costly mistakes by trying to sell your business yourself. In fact, those mistakes, when combined with money lost from a transaction that doesn’t yield the best possible value, will typically cost you substantially more than any professional and competent assistance would require.

Do not pay advance fees. While you ultimately will need help in determining the value of your business and will need the right merger & acquisition firm to take you to market, what you don’t want to do is pay for their services in advance. Their fees should be earned and not paid until they have achieved the results that you want.

If you follow this advice and use good judgment, you will be well on your way to getting the maximum value for your business and moving forward with a well-earned retirement.

When is the Best Time to Sell My Business?

Question: When is the best time to sell my business?

Answer: The best time to sell your business is determined through a careful consideration of the factors that can and cannot be controlled to maximize the amount of cash you receive. These factors include:

Environmental/External Issues- Beyond our Control
Low interest rates and a low inflation environment with plenty of liquidity and a buoyant economy create an ideal scenario for mergers and acquisitions. Clearly, we have enjoyed this scenario in the United States over the last few years. As a consequence, there has been a flurry of activity in corporate America as well as small business America . Well-run, sound businesses are selling relatively easily for nice multiples. Yet, as we all know, the economy goes in cycles. If the sale of your business is on the immediate horizon, then perhaps consideration should be given to bring the “sell” decision forward in order to take advantage of these robust conditions.

Internal Issues-Within our Control
A potential buyer is going to pay significantly more for a business that demonstrates a consistent track record of growing revenues and profitability. However, all too often a business is allowed to stagnate or even decline because the owners have taken their foot off the accelerator. Getting “burned out” and other health issues are probably the most often cited reason for a small business owner wanting to sell. This is understandable, but also often controllable. Recognize the warning signs and take whatever corrective action possible. Again, choosing to sell for a good price while the business is buoyant is far superior to forcing a sale because of health or other issues that have impacted revenues and reduced the business's value.

Above all, think with the head and not with the heart. A decision to sell can be very difficult for a host of good reasons. Most small businesses don't have boards of directors holding management accountable. However, sometimes it is prudent to seek outside objective advice from respected confidantes or professionals. These individuals bring a fresh perspective and insight that will assist you in making good strategic decisions for the future of your business.

Minimize Your Tax Obligations When Selling Your Business

Question: How do I legitimately minimize my tax obligations when I sell my business?

Answer: Plan well in advance by reviewing your corporate structure on an ongoing basis. This will enable you to maximize the amount of proceeds you retain from your business's eventual sale.

As one would expect, the tax rules make it difficult for any quick fixes that give rise to immediate benefits. Consider changes to structure now that may result in more favorable tax treatment when the business is sold in five or ten years.

Start by getting up to speed on recent developments in the tax code. Chances are the code is very different today than when you bought or started your business. So sit down with your professional advisor and review your current business structure and its appropriateness for your business's eventual sale. For example, if you are structured as a corporation, the substantial difference to your after tax dollars on sale depends on whether you proceed with an “asset” sale or a “stock” sale. Selling the corporation's assets can result in proceeds being taxed at the corporate level as well as the individual level when the remaining proceeds are distributed to the stockholders. However, if the stockholders sell their stock, it is likely that capital gains provisions would apply. The difference this makes to retained proceeds can be enormous.

Paying our share of taxes in the United States is an economic reality of life. Yet after tax dollars in the sale of a corporation can vary between 45 percent and 85 percent of the sales price based solely on tax structuring issues. The earlier you start planning for the sale of your business, the more likely you will be to minimize tax obligations.