BizQuest's Business for Sale Blog

Weighing the Financials When Valuing a Business

As we have discussed in prior posts, business valuations are an art, not a science. So when the time comes for valuing a business, you need to consider how to weigh the financial reports to determine your price.

While there are no hard rules; the fact is that the most recent past will provide you with the best guess of the near-term future.

Generally, you will want to analyze at least three years of tax returns and company profit/loss statements to determine an average profit level.

It is normal for a seller to alter the weight of each year and arrive at their asking price depending upon how the business has performed in the most recent fiscal period. If sales and profits were up, it is almost a sure bet that they will provide the greatest weight to that period.

Of course, if the past few years have been consistent, then determining what percentage you should allocate to the past one, two and three years, is quite easy.

Personally, I like to use a weight of 70/20/10 percent respectively – meaning take 70% of the recent year, 20% of the one before, and 10% of the statements from three years ago. If however, the most recent year is either unusually high or low, then the scenario may very well be set for a performance-based earnout. In today’s economy, more deals are being done this way, and it makes sense.

Of equal importance, you should be looking at the results of a rolling twelve month period. This means you need to analyze the financials for the twelve months preceding today and compare them to the prior to twelve month periods. The reason you must do this is because if a business is in decline, it may not have shown this trend as of the last calendar or reporting period.

The one area where buyers also need to be cautious is with annualizing financials. For greater clarity, annualizing numbers is when you take a specific recent period (i.e. four month of financials) and simply multiply them by three to get a figure of what the full year will “look like”. The problem is this is really going out on a limb in the guessing department.

I generally will never annualize anything less than a full nine month period. A business can change so quickly and so using a very limited period and simply extrapolating numbers, is a stretch.

When the overall economy gets tough like we are experiencing today, valuing a business becomes a bit more cumbersome. The reason being you have to look beyond the financials to understand what the industry trends may be and also what looming threats may exist that can adversely impact the business in the near future after you take over. For example, the business may doing okay but a number of key customers could be having their own financial challenges and this may only become evident over the next year.

Do yourself a favor and read the Special Report we have compiled that addresses all of the fundamental issues you need to address including valuations when buying a business in today’s economy. You can sign up and download the report at: http://www.diomo.com/tips.html

The Basis for Valuations When Buying a Business

I want to continue to discuss valuations and this week we will touch upon the basis upon which the majority of business you will encounter will be valued by the seller.

First, let’s get some clarity because there is a wide range of terms that are used in the industry. You will come across definitions such as: Owner Benefits, Adjusted Earnings, Seller’s Cash Flow, Seller’s Discretionary Earnings and many others. Ideally, they are supposed to mean the same thing, but don’t take anything for granted (we’ll talk about this further in a moment). For this discussion, we will use the term Owner Benefits.

This basis should not be confused with other accounting terms like EBITDA or EBIT and that is why an asking price multiple of different businesses can range greatly if you are working with a different basis.

For all intents, Owner Benefits should be the total of:

Net income (off the tax return) + Owner’s Salary + Perks + Depreciation + Interest.

It must also be noted that in asset-heavy businesses, a reduction MUST be made to replace machinery and equipment. This is called a Capital Expense Allocation or reduction. You will not see this done very often in listings because it reduces the Owner Benefits but it is something you must do when applicable.

The Owner Benefit figure is used in an effort to normalize earnings. The premise is made that the new owner will assume the role of owner-operator.

In our next posts we will go into great detail about add-backs but for now, here are a few points to keep in mind:

• Many buyers have the perspective that one must always reduce the Owner Benefit figure to account for a manager. The rationale is that a business purchase is an investment and so if the buyer will be working the business, the only way to compare it to other investments is to do so as a passive investor. While there is certainly logic to this argument, it is strictly a way for you to calculate the return on your investment. However, it is not a valid point to debate an asking price multiple necessarily because it is not the industry standard and again, you would be comparing apples and pears.
• It is normal for a seller to try to make the numbers look as good as possible. That does not mean that their add-backs are correct – it is strictly their formula. As such, you absolutely must review what is includes in the Owner Benefit figure. In other words, get a detailed breakdown and validate the rationale and backup to these claims.

If you want to learn more about business valuations before next week’s continuing discussion, read through the articles and Ask the Expert series at http://www.diomo.com/valuing-a-business.html

How to Value a Business for Sale

Our company conducted a survey last month with 566 prospective business buyers (people who stated they were actively looking to buy a business). We asked them to identify their single biggest concern about the business-buying process. Twenty-three percent stated that knowing how to value a business and arriving at a fair price was their biggest worry. 

Given the large response to that subject, in the next few posts, I want to discuss some of the issues that come up about how to value a business.

One area that comes up constantly in business valuations is the concern about a lack of hard (tangible) assets. There are a number of points you need to come to grips with on this topic which include:

• Most small businesses will have very few tangible assets.
• Asset-based valuations do not work for most small ongoing companies.
• Assets are the mechanism you can leverage to obtain financing.
• A business valuation needs to be based upon an investment model and the cash flow you can realistically expect to achieve based upon the past financials assuming everything will remain status quo after you take over.

While there may be some exceptions in asset-heavy industries, assets are strictly a means to drive revenues – on their own; they do not hold the most important value for a business buyer. You need to determine the value of a business based upon what it can realistically expect to generate in cash flow to service the debt, pay you a salary, and have available to grow the business.

So now there are a few people reading this and shaking their hard heads because they are fixated on the idea that any business they consider must have substantial hard assets to justify the price. If you fall into this category, here is my question –

Which would you rather own……...

A business with brand new, state of the art equipment that has zero profit, or a company that has aging, but functioning equipment, that makes a lot of money? Obviously, the latter is more attractive. The point here being is that assets on their own do not form the basis of a business valuation – they are strictly a vehicle to generate sales and profits.

Now you absolutely need to adjust a business valuation to account for replacing any assets in the near future and we will cover this topic in future posts.

However, for the time being, do yourself a favor and focus upon buying an active business that will immediately provide you with cash flow, instead of being stuck in the mud about having all new shiny equipment. After all, you pay your bills with cash, not machinery.

If you are going to buy a small business, adjust your thinking and get comfortable with the fact that you are going to be paying the bulk of the price, in most cases, for Goodwill (the difference between the purchase price and the identifiable tangible assets less any liabilities you may assume).

Your goal is to purchase an ongoing business with immediate cash flow – that is what you will be buying; assets are strictly what you will be getting.

P.S. I want to thank all of you for your comments on my pre-Memorial Day blog post. I appreciate your feedback regarding my citizenship but more importantly I am so thankful for all of your well-wishes regarding my father's health. He had surgery on Tuesday, June 3rd and is now recovering well minus a kidney, gallbladder and two other significant malignant masses. I flew up and surprised him this weekend for Father's Day and got back in time to celebrate part of the day with my four kids as well. My father is a street-wise, street-raised and street-tough guy, and so he will undoubtedly fight this awful ailment as he has done his entire life - without backing down. The silver lining to all of this is the immediate increase in appreciation for life itself and the importance of family by all of us. Thanks again!

How to Evaluate Legitimate and Non-Legitimate Addbacks - Making sense of the Seller's Discretionary Cash Flow number

Question:
When reviewing a company's recast statement, what addbacks are considered legitimate when a buyer is evaluating the cash flow of a business? My understanding of this evaluation process is that Depreciation, Interest, Amortization, and Owner's Salary are the only items that are truly considered addbacks. Yet when I review a business for sale, addbacks such as travel, auto, health insurance, etc., typically show up. Are those items legitimate addbacks and, if so, to what extent? Please give an overview of the correct way to evaluate the Seller’s Discretionary Cash Flow. Thanks.

Answer:
You raise an excellent point and this is clearly something that comes up with many buyers. Let me first discuss the guiding rule for add backs and then touch upon the correct way (formula) to evaluate the Seller’s Discretionary Cash Flow. In addition to Interest, Depreciation, Amortization, and Owner’s Salary, any personal perks that are not regular or essential business expenses, or ones that you as the new owner must incur, can be added back, as long as they are provable. This can include non-business-related travel, auto, health insurance, and other expenses. However, if you as the new owner will require a vehicle to operate the business, then certainly it is not an add back. Insofar as health insurance, the choice will be up to you but it is not imperative that the business covers this expense and it is not an essential operating expense and so the add back is legitimate. With regards to travel, if it is for personal trips, then again, the add back is legitimate.

Unfortunately, there is a wide interpretation of these add backs which at times can make for an interesting debate. Again, the golden rule is that if the add backs are for legitimate personal expenses not required to operate the business, they can stand; all others are disqualified.

The theory behind the Seller’s Discretionary Cash Flow or Owner Benefit number is to take the business’s profits plus the owner’s salary and benefits and then to add back the non-cash expenses. Then, a multiple, based upon a variety of factors, is applied to this number and a valuation is established. For the sake of all our readers, I will also outline below the rational behind adding back Depreciation and Interest.

The Owner Benefit formula to use is:
Pre-Tax Profit + Owner’s Salary + Additional Owner Perks + Interest + Depreciation LESS Allowance for Capital Expenditures

Why Add Back Depreciation?
Depreciation is an expense that allows a business to deduct a certain amount of money each year from an asset so that its purchase value is reduced by its overall useful life. As an example: if the business buys a $25,000 truck and its useful life is estimated at 5 years, then each year the company can deduct $5,000 off its income to lessen its tax burden. However, as you can see, it is not an actual cash transaction. No money is physically leaving the business or changing hands. As well, when you purchase a business, it will likely be an asset sale whereby the assets come to you free and clear. You may be able to “step up” the assets’ value and depreciate them again for tax purposes. Therefore, this amount is added back.

Why Add Back Interest?
Each business owner will have separate philosophies for borrowing for the business and how to best use borrowed funds, if necessary at all. Furthermore, in nearly all cases, the seller will pay off the business’s loans from their proceeds at selling; therefore, you will have use of these additional funds.

A Note About Add-Backs and Capital Expenditure Allowance
After completing any add backs, it is critical that you take into consideration the future capital requirements of the business as well as debt-service expenses. As such, in capital intensive businesses where equipment needs replacing on a regular basis, you must deduct appropriate amounts from the Owner Benefit number in order to determine both the true value of the business as well as its ability fund future expenditures. Under this formula, you will arrive at a "net" Owner Benefit number.

Buying a Business that Includes Real Estate - Given a choice, should buyers purchase property as well? How should the property be valued?

Question:
I need some advice on a business I am evaluating and would like to move forward with an offer shortly. The company has good books and records, profitable on the tax returns, and I believe will be approved for bank financing. The business is priced including real estate that is owned personally by the seller and the company pays rent to him. My questions are: how do I do value the business considering the real estate, should I buy the property as well -what other options if any, do I have, and are there any issues to look for with this type of transaction? Thank you.

Answer:
These are great questions and I want to address of them individually. Let’s take one at a time:

Valuing a Business that Includes Real Estate

This is actually far simpler than you think. First, you need to separate the business and property and value them independently. The good news is there are established market values for real estate even though we may be in a bit of an inflated period right now. You can inquire with the business broker (if one is involved) whether they have experience and can assist you with the property valuation. They may simply recommend a good commercial realtor if necessary to get industry comparables on “like” property. Although real estate valuations can vary, they are far less subjective than valuing a business. As such, keep the property valuation completely separate from the business valuation.

Ask the seller if they have a recent appraisal on the property which can assist you. If not, it may be something you want to consider. In any event, if you obtain a mortgage, it will be required by the lender.

Conduct the valuation on the business using a variety of methods. There are some excellent past articles on this subject in the ‘Ask the Expert’ section on the BizQuest website. You will learn that business valuation is an art, not a science; however, an accurate valuation can be obtained using these methods in large part because the company has good books and records.

Financing the Purchase
With real estate being involved, coupled with good books and records and a historically profitable business, you will greatly increase your options to leverage third party financing. Banks, and any other lenders, will almost always prefer to have bricks as an asset over any other business asset that may be required as security above your personal security. Plus, some lenders may in fact be willing to blend the real estate and business loans which can result in a longer term to repay it. Here again, this plays heavily in your favor.

Should You Buy the Property?
I have very mixed feelings about doing so. I know that there are plenty of reasons why someone would want to acquire the real estate, and they’re all valid. My concern stems mainly from a cash flow perspective. One of the main objectives when buying a business is to be able to grow it beyond what the current owner has done. You will need capital to do so. Further, it is not uncommon for a business to decline slightly and temporarily after a new owner takes over and the last thing you want is a cash crunch.

That being said, I always prefer to negotiate a 12-24 month option to acquire the property at a pre-determined price or formula. This way, you can retain your capital, and be certain that the property itself makes sense for the business operations. Then, you can always choose to exercise your option. At the very least, if you do not buy the real estate, include a “Right of First Refusal” clause in the business purchase contract to buy the real estate.

What to Look Out For
One of the biggest issues that arises when a seller personally owns the property and collects rent from the business is the actual rent rate, and what is and isn’t included. This may necessitate an adjustment of the Owner’s Benefit. If, for example, the rent the seller has charged the business is less than what you will have to pay for a mortgage, taxes, insurance, maintenance, etc., you will have to adjust the Owner’s Benefit downwards to reflect these added costs.

Similarly, if you decide not to buy the property and lease it from the seller, these same costs that the seller paid himself need to be reconciled against what your rent will be after you take over. It may require an adjustment either way.

In Summary
Buying a business that includes real estate will generally provide the buyer with a number of viable options. You should be open-minded to any of the scenarios, and sometimes the direction may not be entirely up to you. As an example, a lender may insist that you acquire the property along with the business.

The key now is to speak with the seller/broker and see if they are open to the opportunities outlined herein. If so, you can table all of the possibilities and move the deal forward with the goal of successfully completing a transaction that is favorable to all of the parties.

Should FF&E be included in Asking Price? - Is Seller "double-dipping" by seeking a high earnings multiple plus large additional amount for FF&E?

Question:
I saw a listing for a granite fabrication company with an asking price that included a multiple of over 3.5, plus a significant additional amount for FF&E.  I understand there is a lot of industrial equipment involved but, this seems like double dipping to me, is this reasonable?

Answer:
You bring up an excellent point: the sellers cannot have it both ways. There is a great misconception regarding assets and the role they play in business valuations. Assets are a means to drive revenue, but a business must be valued based upon the historical seller cash it has produced or, in some cases, what it is expected to generate.

With all due respect to the accounting industry, they typically place too much emphasis on assets when valuing a business. I am not suggesting that assets are unimportant. They do in fact have their role in analyzing a business but less so in determining the actual purchase price. For example, when calculating the Owner’s Benefit or Sellers Cash Flow, one must adjust this amount downward for future capital expenditures in asset heavy businesses, and by this I mean ones with machinery and equipment (not inventory) which will need to be replaced over time.

Generally, you will find that sellers may over-value their assets altogether and present buyers with a replacement or fair market value and expect to get dollar for dollar in the sale. Unfortunately, most equipment is not worth anything near these values and all you need to do is try to sell these assets quickly and you’ll soon discover they’re worth a fraction of the amounts represented.

So to answer your double dipping question, yes it is, but on the other hand, the multiple itself may be low. One must consider numerous additional factors including:

1. Total Owner’s Benefit
2. Is business trending up or down?
3. Are there customer concentration issues?
4. Any threat of foreign production (lots of granite coming from overseas now)?
5. Any large contracts in place for the new owner?
6. Can you significantly build the business?
   

I would suggest that you perform your valuation based upon the Owner’s Benefit and attach a multiple in keeping with the points above plus the many others that one must consider. Then, make your capital expenditure allowance and attach a multiple that provides you with an acceptable return on your investment. If the business is generating under $500,000 in OB, then a 2-3 multiple is in line. Above that, and up to $1,000,000 should be around 2-4 and 3-5 beyond.

How to determine the value of a real estate sales office? - Many factors must be considered in valuing businesses with more "goodwill" than assets.

Question:
How can a value be reach on an independently owned real estate sales office? What should be the main factor?

Answer:
It is important to understand that establishing the value of any business is an art, not a science. In service businesses where there are no hard assets (i.e. equipment, machinery, etc), the valuation will typically be tied mostly to goodwill. In a real estate office this is especially important since all they are really selling is the reputation they have established for themselves. That being said, there are really three main components to consider in valuing a real estate sales office:

1. The total potential profit from existing listings
2. The place this office holds within the marketplace
3. The impact that a change of ownership may have on securing future listings

Before we get into the nuts and bolts, let's discuss some of the potential "issues" in this type of acquisition.

Does the agency/office carry the name of the seller (i.e. Bob Jones Realty) versus a generic name such as Rainbow Realty? If it is a person's name, one must seriously consider how the business may trend should Bob Jones no longer be there. This is especially important where the seller has built this business through years of networking in the community. In other words, is this business a case where when out the door goes the seller, so too can go all the clients, current and future?

Are there any local/state laws that prohibit the transfer of the listings from the current owner to a new one? Will the independent agents remain on board after the transaction?

These are just a few of the key considerations and there are more. The point being that there is a lot to consider in determining the valuation.

The value of the business, at least in the immediate future is what revenue/profit the existing listings will generate. Plus, you as the buyer would want some assurance that prior listing to sales ratios will continue. One must also consider what the average agent can be expected to generate in listings and commissions. So, what's an "asset light – goodwill heavy" business worth? In this particular case, I believe that one must rely somewhat on industry Rules of Thumb although I am generally not a fan of these. I also believe that a substantial earnout and/or performance based terms package makes the most sense. Notwithstanding this, a business' valuation MUST be based on historical profitability or what is known as Owner's Benefit.

With all of this said, there are a few general guidelines to be used:

1. If you calculate the value based upon revenues, then you can factor in around 25% - 50% of average annual commissions.
2. If you use a multiple method of Owner's Benefits, which is the formula I prefer, then an average real estate sales office should trade around 1 -2 times this figure.
3. There is one valuation formula that I was presented a number of years ago in this business which was attaching a dollar figure of around $10,000 per agent. Personally, I would not use this at all since agents move around quite a bit in this industry, with a high degree leaving the trade and the number of "bodies" has no bearing whatsoever on the profitability in these types of businesses.

I would also recommend that part of the purchase price be based upon an earnout whereby the seller can get their price as long as certain trends such as the average annual commissions remain consistent for the first 12-24 months after you take over.

How are "Multiples" Determined for Specific Industries in Business Valuation?

Question:
I am familiar with the concept of multiples of sellers' cash flows or owners' benefits as a means to determine value. My question is: How is the multiple determined? With the scarcity of verifiable information on business sales, how does one determine an appropriate multiple for an industry, specifically, the property management industry?

Answer:
If you spend anytime looking at businesses for sale, you'll see multiples that can be "all over the place". However, when a seller has the right professional assistance (i.e. CPA, business broker) the valuations will subscribe to certain historical formulas. Unlike residential or commercial real estate where comparables rule, every business is different and so it is difficult to have any standardization that can be used without margin of error.

Keep in mind that business valuation is an art, not a science.

That being said, there are some general parameters regarding the range of multiples. Many of these evolved from the concept of what a buyer can expect as a reasonable return on their investment and the level of risk to the new owner of each potential venture.

As an example, small businesses will generally sell for 1 - 3 times the Owner Benefit number. However, this is an enormous spread. My own rule is that for any business where "out the door goes the seller, so too go the customers" should be closer to 1 multiple. Examples can be professional practices, businesses with very high customer concentration issues, distribution companies where the seller has a long-standing personal relationship with suppliers/key customers, etc.

On the other hand, businesses with solid fundamentals including good books/records, increasing revenues, a stable marketplace, no major customer concentration issues, ease of transition, growth opportunities, etc, will naturally all trade on the high side at, or even above 3 times.

A typical Property Management business will likely have components of both of the examples noted above and will likely sell near the middle. However, you certainly want to look out for customer concentration issues, contract assignability, potential properties bringing the management function in house, the bidding process to maintain/acquire accounts, etc.

Historically, Property Management businesses sell for a much higher multiple because they generally appeal to a very large buyer pool, they are considered "easier" businesses to operate, and they are pure service businesses with no inventory and can be operated with little overhead. I've seen them sell for 3 - 5 times the Owner Benefit figure but in these cases an earnout and substantial seller financing is usually involved.

Since this is very much a relationship business, you have to consider an earnout deal structure (see prior articles) to be certain that revenue is sustained and key clients remain on board or, if there is a big drop, the purchase price may be adjusted accordingly after a review period.

Although the comments herein outline an extremely wide range of potential multiples, the core strength and possible future threats will dictate a realistic figure. If you want to give yourself a frame to operate in then the more creative the deal structure (earnout, seller financing, specific contingencies materializing) the higher the multiple.

Valuation of Small Independent Motel

Question:
What is the best way to determine the asking price of an independent motel business? The motel I am looking at has an asking price of $435,000 and annual revenue of $145,000. This motel is in a very small city with a population of only 12,000 people, but the location is right off the major highway exit.

Answer:
When it comes to valuing motels, there are a wide range of options available to you that are somewhat standard within the industry. These include multiples of the annual revenues, per room valuations, net income "cap rates" and multiples of what may be referred to as "Owner's Benefit" or "Sellers Discretionary Cash Flow" or "Adjusted Net".

Personally, I prefer a multiple of the Owner's Benefit figure because what you ultimately can put in your pocket, and have available to service debt and build the business is really what any business owner should be concerned with when valuing any business. After all, if the business is producing solid revenues but weak profits, who cares what the revenues are?

Having said this, the various barometers are:

• 2.5 - 3 times the annual revenues for motel/small hotels
• $18,000 - $22,000 per room
• 6 - 8 times Owner's Benefit

The Owner Benefit Calculation is a combination of:
Pre tax Profit + Owner Salary + Owner perks + Interest + Depreciation.

Although I prefer to use this technique, be certain that you properly adjust the Owner's Benefit Figure to allow for any anticipated capital expenditures that are required now, or within the next few years.

On a separate note, be certain that you visit with city hall to determine if there is any major roadwork planned for the highway or road which the motel borders. Usually, you can expect to have construction at least every 10 years so you'll want to check this out.

Valuing a Service Business

Q: How do I go about determining the value/selling price of a service business?  I am a CPA who is interested in selling my practice and purchasing a practice in another state but I am confused about how to determine the price at which to sell and to buy.

A: Great question. The good thing about service businesses and especially professional practices is that they are not complicated transactions. The bad news is that they do rank at the top of potentially risky acquisitions. Depending on the practice itself, if the owner is perceived as "the business" the possibility exists that as the owner goes out the door, so too can go the clients.

Generally speaking, the valuations should be around one time the annual Owner Benefit figure (Pre-tax Profit + Owner Salary + Owner Perks + Interest + Depreciation). Plus, you should also have an earnout formula based upon retention of certain key clients for a period of about 12 months. You need to be sure that the business you take over will be the same or better in a year as long as you are as effective in running it as the current owner.

"Quick Way" to Get a Valuation?

Q: What is quick way to get a general sales value for a residential maintenance landscape company? Is gross sales, number of clients, margin the most important component?

A: There is no "quick way" to value any business. Nor are there any bulletproof generic rules. Valuation is an art, not a science. But when all is said and done, the valuation must be based upon the total owner benefits number which includes: Pre-tax Profit + Owner Salary + Owner Perks + Interest + Depreciation less any foreseeable allocation of profit for capital expenditures. In the lawn and landscape business, they usually trade at around 1.5 times this number. But, each business is different: are the financials provable? Are there more commercial or residential accounts? Commercial accounts can bring in big dollars but they can be lost quicker than residential maintenance accounts where you perform the old "Mow, Blow & Go" routine. Are all the employees paid on the books? If not, you need to adjust the profit downwards because you should always run your business legally.

Having said all of this, if you were already in the business, and were buying out a competitor, then you could pay them on a per account basis. Industry averages on the ones that sell for a percentage of sales are usually around 40% - 60% of annual sales but I would recommend staying away from this formula. Profit, not sales are what you take to the bank!

Valuing Inventory - The best way -- review the previous year's sales

Question:
I am involved in a transaction and I'm having trouble valuing the inventory that is part of the deal. The seller says it's all good but is there really a way to measure this or should I take their word for it?

Answer:
Never take their word for it! Assuming that it's non-perishable product, you need to classify the inventory as either "Good and Resaleable" or "Obsolete". G & R is product that you can sell in the normal course of business over the next 12 months (this way it's still a "Current Asset").

The way to calculate this is by reviewing the prior year's sales and making sure that you do not have more on hand of any item than the company would normally sell in that period. As an example, if there are 24 widgets in stock and the company sold 18 in the last 12 months then 18 are G & R and 6 are "Obsolete". Therefore, you can pay full acquisition cost of the 18 but you need a drastic discount on the 6 "Obsolete" ones.