Consider two different companies in virtually the same industry. Both companies have an EBITDA of $6 million – but, they have very different valuations. One is valued at five times EBITDA, pricing it at $30 million. The other is valued at seven times EBITDA, making it $42 million. What’s the difference?

One can look at the usual checklist for the answer, such as:

• The Market
• Management/Employees
• Uniqueness/Proprietary
• Systems/Controls
• Revenue Size
• Profitability
• Regional/Global Distribution
• Capital Equipment Requirements
• Intangibles (brand/patents/etc.)
• Growth Rate

There is the key, at the very end of the checklist – the growth rate. This value driver is a major consideration when buyers are considering value. For example, the seven times EBITDA company has a growth rate of 50 percent, while the five times EBITDA company has a growth rate of only 12 percent. In order to arrive at the real growth story, some important questions need to be answered. For example:

• Are the company’s projections believable?
• Where is the growth coming from?
• What services/products are creating the growth?
• Where are the customers coming from to support the projected growth – and why?
• Are there long-term contracts in place?
• How reliable are the contracts/orders?

The difference in value usually lies somewhere in the company’s growth rate!

© Copyright 2015 Business Brokerage Press, Inc.

Photo Credit: jeltovski via morgueFile

The following is a memo I recently published, that’s a re-write of one I did several years ago. I have found that this “Baby Boomer” prediction has turned out to be ultra true.

LOOK AT THESE FACTS…

The Baby Boomers (about 70,000,000 of them) are poised to make a great impact on the American economy.

• Retiring Boomer business owners will sell or bequeath $10 trillion worth of assets over the next two decades.
• These assets are held in more than 12 million privately owned businesses.
• More than 70 percent of these companies are expected to change hands.
• The sale of almost 12 million businesses over the next 10 to 15 years represents a significant increase in the annual number of businesses that will be sold.
• These owners of businesses should have a valuation performed by a business broker, to map out a strategy for selling and structuring the sale of the business.
• Planning ahead will enable business owners to achieve the best transaction possible during this Boomer-induced wave of business sales.
• The 12,000,000 businesses likely to change hands over the next 10-15 years might involve a large number of boomer-to-boomer sales.
• Baby Boomers ages 45 to 64 form businesses at a higher rate than other age groups.
• 55 to 64 year olds form businesses at the highest rate of any age group.
• Many of the Baby Boomers are too young to retire; they typically have ample capital through savings, investments or other assets; they have job-related skills accumulated through a lifetime of work; and many have lost faith (and money) as a result of large company layoffs and restructurings; and many will buy their own business in coming years.
• Many Boomers find themselves unhinged from their traditional employment safety nets. This dislocation has fueled an intense desire and need to have control of their destinies.
• Ironically, now small business ownership is seen as much more safe and secure than working for a large company.
• So, in the coming decades, not only are we likely to see millions of Baby Boomers selling businesses they now own, we will also see additional millions of Boomers (who’ve spent their lives working for someone else), buying businesses.
• The next two decades will see a significant increase in the number of small and mid-sized businesses being bought and sold by Baby Boomers, in addition to the other generations of Americans that business brokers regularly deal with.

NOW’S THE TIME FOR  HARD WORKING BUSINESS BROKERS, AT THE BEGINNING OF THIS EXCITING WAVE OF BOOMER BUYING AND SELLING, TO BE ENERGETIC, ENGAGED, FOCUSED, AND “TALKING TO THE PEOPLE”…

To be continued Thursday with specifics on what business brokers should be doing to take advantage of this exciting wave.

The main difficulty in valuing small business is the record keeping of the small business owner.  Since he or she is the proverbial “chief cook and bottle washer,” keeping the financial records is down at the bottom of the list in running the business.  In many cases, the owner keeps the business checkbook, bills and receipts and then dumps them all on an accountant’s or bookkeeper’s desk periodically.  From these “records,” the accountant is expected to prepare not only income tax returns, but all of the other reports necessary to stay in business.  Preparing accurate profit and loss statements is not high on the agenda.

It is important for business brokers, buyers and others who attempt to put a value on a small business, to keep in mind that financial records are prepared to minimize profits and, in turn, to reduce tax liabilities.  This is the opposite of what public corporations do, who attempt to maximize profits to impress shareholders and Wall Street.  In many small businesses, it is very difficult to establish their real earning power.  Small business owners are experts at “reducing” income for tax purposes.  It is important that the profit and loss statements (schedule C) be restated to reflect as much real cash flow as possible.  An in-depth interview with the owner may be necessary to reconstruct a true picture of earnings.  This must be done in such a way as not to implicate the owner in any questionable tax avoidances.  Owners may also try to point out that not all income is reported.  This is obviously illegal, and it can play no part in determining how much the business is really earning.  In other words, it has no place in the valuation process or in any subsequent marketing of the business.  If it’s not in writing, it does not count.

Another difficulty in valuing a small business is how much of the earning power is attributable to the owner.  In many small businesses, the present owner plays a significant role in the success of the business.  We recently talked to a good friend who was valuing a restaurant chain.  Present management, who has no equity interest in the chain, is showing gross sales and bottom line profit of 25 percent over similar operations.  This management is obviously doing a great job.  Is this business worth the same if management leaves?  (Remember they have no equity — or contract.)  We don’t think so.  Business brokers, valuers, and buyers have to take into account the present owner/operator.  He or she could be a real asset to the business, and a new owner could suffer the consequences.  However, new ownership can, and often does, increase business.  Small business is much more flexible and more easily influenced by new energy and enthusiasm.

 (Watch for tomorrow’s posting which will continue this article with some suggestions of considerations when valuing a small business.)

Two businesses for sale could report the same numeric value for “earnings” and yet be far from equal. Three factors of earnings are listed below that tell more about the earnings than just the number.

1. Quality of earnings
Quality of earnings measures whether the earnings are padded with a lot of “add backs” or one-time events, such as a sale of real estate, resulting in an earnings figure which does not accurately reflect the true earning power of the company’s operations. It is not unusual for companies to have “some” non-recurring expenses every year, whether for a new roof on the plant, a hefty lawsuit, a write-down of inventory, etc. Beware of the business appraiser that restructures the earnings without “any” allowances for extraordinary items.

2. Sustainability of earnings after the acquisition
The key question a buyer often considers is whether he or she is acquiring a company at the apex of its business cycle or if the earnings will continue to grow at the previous rate.

3. Verification of information
The concern for the buyer is whether the information is accurate, timely, and relatively unbiased. Has the company allowed for possible product returns or allowed for uncollectable receivables? Is the seller above-board, or are there skeletons in the closet?

The initial response to the question in the title really should be: “Why do you want to know the value of your business?” This response is not intended to be flippant, but is a question that really needs to be answered.

• Does an owner need to know for estate purposes?
• Does the bank want to know for lending purposes?
• Is the owner entertaining bringing in a partner or partners?
• Is the owner thinking of selling?
• Is a divorce or partnership dispute occurring?
• Is a valuation needed for a buy-sell agreement?

There are many other reasons why knowing the value of the business may be important.

Valuing a business can be dependent on why there is a need for it, since there are almost as many different definitions of valuation as there are reasons to obtain one. For example, in a divorce or partnership breakup, each side has a vested interest in the value of the business. If the husband is the owner, he wants as low a value as possible, while his spouse wants the highest value. Likewise, if a business partner is selling half of his business to the other partner, the departing partner would want as high a value as possible.

In the case of a business loan, a lender values the business based on what he could sell the business for in order to recapture the amount of the loan. This may be just the amount of the hard assets, namely fixtures and equipment, receivables, real estate or other similar assets.

In most cases, with the possible exception of the loan value, the applicable value definition would be Fair Market Value, normally defined as: “The price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.” This definition is used by most courts.

It is interesting that in the most common definition of value, it starts off with, “The price…” Most business owners, when using the term value, really mean price. They basically want to know, “How much can I get for it if I decide to sell?” Of course, if there are legal issues, a valuation is also likely needed. In most cases, however, what the owner is looking for is a price. Unfortunately, until the business sells, there really isn’t a price.

The International Business Brokers Association (IBBA) defines price as; “The total of all consideration passed at any time between the buyer and the seller for an ownership interest in a business enterprise and may include, but is not limited to, all remuneration for tangible and intangible assets such as furniture, equipment, supplies, inventory, working capital, non-competition agreements, employment, and/or consultation agreements, licenses, customer lists, franchise fees, assumed liabilities, stock options or stock redemptions, real estate, leases, royalties, earn-outs, and future considerations.”

In short, value is something that may have to be defended, and something on which not everyone may agree. Price is very simple – it is what something sold for. It may have been negotiated; it may be the seller’s or buyer’s perception of value and the point at which their perceptions coincided (at least enough for a closing to take place) or a court may have decided.

The moral here is for a business owner to be careful what he or she asks for. Do you need a valuation, or do you just want to know what someone thinks your business will sell for?

Business brokers can be a big help in establishing value or price.

There is the old anecdote about the immigrant who opened his own business in the United States. Like many small business owners, he had his own bookkeeping system. He kept his accounts payable in a cigar box on the left side of his cash register, his daily receipts – cash and credit card receipts – in the cash register, and his invoices and paid bills in a cigar box on the right side of his cash register.

When his youngest son graduated as a CPA, he was appalled by his father’s primitive bookkeeping system. “I don’t know how you can run a business that way,” his son said. “How do you know what your profits are?”

“Well, son,” the father replied, “when I came to this country, I had nothing but the clothes I was wearing. Today, your brother is a doctor, your sister is a lawyer, and you are an accountant. Your mother and I have a nice car, a city house and a place at the beach. We have a good business and everything is paid for. Add that all together, subtract the clothes, and there’s your profit.”

A commonly accepted method to price a small business is to use Seller’s Discretionary Earnings (SDE). The International Business Brokers Association (IBBA) defines SDE as follows:

Discretionary Earnings – The earnings of a business enterprise prior to the following items:

• income taxes

• nonrecurring income and expenses

• non-operating income and expenses

• depreciation and amortization

• interest expense or income

• owner’s total compensation for one owner/operator, after adjusting the total compensation of all other owners to market value

Here are some terms as defined by the IBBA:

• Owner’s salary – The salary or wages paid to the owner, including related payroll tax burden.

• Owner’s total compensation – Total of owner’s salary and perquisites.

• Perquisites – Expenses incurred at the discretion of the owner which are unnecessary to the continued operation of the business.

Developing a Multiplier

Once the SDE has been calculated, a multiplier has to be developed. The following (just as a guideline) should be rated from 0 to 5 with 5 being the highest. For example, if the business is a highly desirable business in the current market, “desirability” would be rated a 4 or 5. If the business is in an industry that is quickly declining or nearly obsolete, “industry” would be given a 0 or 1 rating.

Age: Number of years the seller has owned and operated the business.

• Terms: Is the seller willing to offer terms?  For example, will the seller accept 40 percent as a down payment with the seller carrying back 60 percent at terms the business can afford while still providing a living for the buyer?
• Competition: Consider the local market.
• Risk: Is the business itself risky?
• Growth trend of the business: Is it up or down?
• Location/Facilities
• Desirability: How popular is the business in the current market?
• Industry: Is the industry itself declining or growing?
• Type of business: Is the business type easily duplicated?

The average business sells for about 1.8 to 2.5. Obviously, if the SDE is solid and the multiple is above average, the price will be higher. Keep in mind that the price outlined includes all of the assets including fixtures and equipment, goodwill, etc. It does not include real estate or saleable inventory. The price determined above assumes that the business will be delivered to the buyer free and clear of any debt.

Veteran Wisdom

When all else fails, the words of a veteran business broker will work.

Asking Price is what the seller wants.

Selling Price is what the seller gets.

Fair Market Value is the highest price the buyer is willing to pay and the lowest price the seller is willing to accept.

Sellers should keep in mind that the actual price of a small business is about 80 percent of the seller’s asking price.