Buying or Selling – What is the Right value of a business?

Diane Glover

Aug 22, 2013

Valuation Is Key as the M&A Market Slowly Heats Up

After a lackluster 2012, domestic M&A activity is on the rise. Small business deal volume was up 62 percent in the second quarter of 2013 compared to the same period for 2012, according to the latest Insight Report, which analyzes private business broker transactions in more than 70 major U.S. markets. This is the largest year-over-year jump since the M&A bubble burst in 2008 and the second straight quarter of improvement.

lores_merge_sign_office_building_mbTips for Operating a Sale-Ready Business

Not all business exits are planned. Business owners never know when a competitor or partner will make an offer that’s too good to refuse — or when an unexpected event will strike and they (or their heirs) are forced to sell. So, a business should always be run like it’s up for sale.

Lean and Clean

This means operating as lean as possible, reinvesting in fixed assets, and abstaining from mingling personal and business assets. Buyers are leery when sellers ask them to adjust year-end financial statements for quasi-business expenses (such as country club dues or personal travel expenses), unrecorded cash sales or related party transactions. In other words, keep the income statement as clean as possible.
It’s also smart to purge any nonessential balance sheet items, such as idle or non-operating assets, obsolete inventory, bad debts, noncore business lines and shareholder notes. Buyers prefer financial information that is audited or reviewed by a CPA firm.

Low Risk, High Value

Owners who minimize risk reap a higher return. Future earnings appear more secure if the company is current on all leases, licenses, and contracts, including employment and non-compete agreements that have been signed by all employees.

Note: Laws regarding non-compete agreements vary from state to state. For example, courts in California generally reject non-competes because state law makes them unenforceable except in limited circumstances. Because non-compete agreements aren’t generally allowed, California employers often use confidentiality and other agreements to protect trade secrets and other information.

Owners can further lower risk by reviewing insurance policies on a regular basis to ensure they’ve purchased the right types of policies and coverage amounts.

Due Diligence Recordkeeping

The documents required in today’s M&A environment can be extensive. If your recordkeeping has been shoddy, it can be difficult or impossible to compile the information wanted by a potential buyer or partner. Owners should start preparing the documentation needed for the due diligence process long before a sale.

Above all, operating sale-ready means understanding what the business is worth today and identifying key value drivers. By playing up what matters most to buyers, the business will be more attractive to prospective investors and fetch a higher price in the marketplace.

Even better news for private small business owners is that pricing multiples seem to be slowly rising. It’s been a buyers’ market since the start of 2011. But reports pricing multiples have risen in the first two quarters of 2013. The average multiple of cash flow reached 2.23 in the second quarter of 2013.

Possible reasons for a more robust M&A market include:

  • Economic recovery;
  • Pent up supply and demand from the recession;
  • An aging business owner demographic;
  • Historically low interest rates; and
  • Improved small business financials.

Beware of Do-It-Yourself Values

Many business owners are uncertain — or unrealistic — about what their businesses are currently worth. Relying on gut instinct or industry rules of thumb to set an asking price can be perilous, however. Quick-and-dirty pricing formulas can be outdated, ambiguous or fail to take into account the unique characteristics of a specific business.
For example, an owner might hear a rumor while attending a tradeshow that similar businesses have sold for roughly five times earnings. The formula may provide an interesting starting point or sanity check for a formal appraisal. But it could under- or overstate the eventual selling price for several reasons.

1. The term “earnings” could refer to net income, net operating cash flow, pre-tax earnings, EBITDA (earnings before interest, taxes, depreciation and amortization) or net free cashflow.

2. The formula also fails to specify what assets and liabilities are included in selling price, as well as the presumed sales terms.

3. Rules of thumb fail to take into account the specific company’s financial performance, which could be above or below industry averages.

Put simply, you need to research the details of real-life comparable sales transactions, rather than trust generic industry folklore.

Use a More Scientific Approach

More objective, transaction-based methods of estimating your business’s fair market value include:

The cost approach. The balance sheet is a logical starting point for estimating value. But many items might be stated at historic cost and need to be adjusted to market value. Other items — such as internally-generated intangible assets and contingent liabilities — may not appear on the balance sheet and need to be added.

The market approach. Actual sales of comparable businesses within a meaningful timeframe provide objective insight into what a business is worth, if comparables are available. Private businesses are not required to publish transaction details, but you can access proprietary private transaction databases for a fee or subscription. Larger private companies also consider prices of comparable public stocks when estimating value.

The income approach. A company’s historic financial performance only provides valuation insight to the extent that it predicts future performance. The income approach derives value from a company’s expected risk and return. Return is typically measured by future cash flow. Risk is measured by discount or capitalization rates. Companies with higher returns and lower risk usually sell for more.

Applying these valuation approaches is beyond the scope of most in-house accounting personnel. An outside financial professional with business valuation experience can help adjust balance sheets, research comparables and discount future earnings to estimate the fair market value of a private business.

Establish a Reasonable Asking Price

Fair market value measures how much the “universe” of well-informed buyers and sellers would agree to pay for a business without being under duress to buy or sell. It’s a good benchmark for how much a business is worth overall. But there may be strategic buyers willing to pay more than fair market value. If so, consider adding a premium to fair market value when setting the asking price.

Examples of strategic buyers might include competitors, suppliers, customers and large conglomerates who are rolling up smaller players in an industry. When adding a premium for strategic buyers, be aware that setting the asking price too high may result in scaring away prospective suitors.

Consider Taxes to Structure the Optimal Deal

Equally important to negotiating the selling price is negotiating the terms. The tax consequences of an acquisition can vary widely depending on factors including how long you’ve owned the business, the type of entity (C corporation, S corporation, LLC, etc.) and exactly how the deal is structured. Taxes can dramatically affect how much cash the owner walks away with after closing.

For example, a deal could be set up as an asset sale in which the seller cherry picks the most desirable assets and liabilities. Or it might make more sense to set up a stock sale, which includes everything on the balance sheet. Stock sales allow the business to continue “as-is” without negotiating new licenses or contracts.

In general, sellers prefer stock sales from a tax and liability perspective. Buyers like asset sales because assets are adjusted to market value, which provides a fresh basis for depreciation and lowers future taxable income.
When an S corporation sells, the parties may be eligible for IRC Section 338, which treats stock sales like asset sales for federal tax purposes. Although the election won’t save sellers any tax, buyers reap the previously described tax benefits of an asset sale.

By planning ahead with your tax adviser, you may be able to substantially reduce the tax bill. Don’t forget to assess state and local tax issues.

More Factors to Consider

Other negotiating tools include non-compete agreements, which prevent parties from competing for a prescribed time period within a geographic region, and employment contracts, which help transition the company to the new owners.

Some sellers also accept installment payments or earnouts, wherein a portion of the selling price is withheld and contingent on future performance.

Cross-Border and Sector M&A

While the report described above shows an increase in domestic M&A deals involving small businesses this year, international transactions are not faring as well. According to the latest Thomson Reuters Investment Banking Scorecard, cross-border M&A deal volumes are down by almost a third so far this year from 2012 levels. The Scorecard shows United States M&A activity up 29 percent in 2013 over last year.

In addition to geography, certain industries are having a better year than others. For example, theInvestment Banking Scorecard reports that M&A is up in the healthcare and telecommunications sectors (43 and 44 percent respectively) but down in the financial and high technology sectors (-23 and -13 percent respectively). The Insight Report shows that 38 percent of transactions closed in the second quarter of 2013 were service businesses while only 4 percent were in the manufacturing sector.

Get Professional Help for Optimum Results

Business owners contemplating a sale should meet with their CPAs and attorneys. These professionals have experience closing deals and can assist with business and asset appraisals, brokers and commercial lenders to help with financing issues. A team of experienced financial professionals can help owners reap the most from their private business interests.

About The Author

As the Manager of Practice Growth, Diane focuses on the market awareness and growth of Kirsch CPA Group…

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