Reveal Your Company’s Hidden Appeal

Position your company as an attractive investment

Last year was a good year for both the U.S. and Canadian merger and acquisition (M&A) markets, and 2007 is forecast to eclipse 2006’s deal-making activity. According to market analysts, a large number of private-business owners are expected to sell their companies in 2007.

These transfers will be driven by the modest, yet sound profits generated in 2006, an expectation of continued increases in profits in 2007, an economy projected to slow in 2008, an existing surplus of capital allocated for funding anticipated acquisitions, and an increase in the number of strategic buyers.

Unfortunately for small, private company owners interested in selling their businesses, this forecast is intended primarily for owners of larger corporations who have transformed their companies from modest, fledgling investments into industry powerhouses with sexy profits and ample human capital. However, the M&A club of 2007 doesn’t have to be exclusive only to the big corps with hundreds of millions in annual revenue to attract buyers. The small business owner can position their company as an attractive investment and achieve transfer goals utilizing:

  • Pragmatism,
  • Strategic planning, and
  • Business valuation.

Pragmatism: Sellers must be realistic
In general, private companies sell at lower prices than larger publicly-traded competitors (on a price per share basis). Why? There are many reasons, however two of the most obvious are:

  • Sellers are competing with other investment opportunities – A buyer wants the maximum return on investment (ROI). Why purchase a privately-held company that has made little to zero bottom-line profits when the potential buyer can put their money into a mutual fund and gain a return of 10 percent or more?
  • Lack of liquidity – Privately-held stock takes far longer to liquidate than publicly- traded stock. Shares traded on a public exchange can be sold within three to five business days, whereas the sale of a closely-held company can take months or even years.

Oftentimes, an owner sets an unrealistically high expectation for the value of their business. The owner is too close or emotionally tied to the business and has difficulty understanding why an objective, third-party business appraisal results in a value that is nowhere near their own estimation of the business’ worth. Owners also have difficulty scrutinizing their companies from the buyer’s point of view. Quite simply, sellers and buyers don’t speak the same language.

Generally, there are two worlds of value for small, closely-held businesses: ‘Theoretical Value’ and ‘Emotional Value’.

  1. Theoretical Value is determined utilizing sound, recognized professional business valuation methodology by an experienced, accredited appraiser. Value determined theoretically often assumes the standard of fair market value as well as an open and unrestricted market. Negotiations are not a factor in the value conclusion. Typically, theoreticallyderived value is based on earnings, the level of net cash flow, and the hypothetical buyer’s long-term ROI. The lower the selling company’s earnings, net cash flow, and ROI, the greater the risk assessed on the investment and, thus, the lower the company’s resultant value.
  2. Emotional Value, or ‘price’, is usually negotiated between two parties, with one party possessing a greater emotional and financial stake in the sale terms and outcome of the transaction. Typically, price is set somewhere between the seller’s desire to receive the highest return on 46 BUSINESS TODAY | Volume 2 | Issue 2 their ‘blood, sweat and tears’ and the buyer’s desire to receive the highest ROI for the lowest reasonable price possible. Unfortunately for the seller, there is usually a negative correlation (relationship) between ‘blood, sweat and tears’, and purchase price; meaning, the more personal and financial sacrifices an owner has had to make for their business, the less attractive the business is as an investment to a buyer and, thus, the lower the price paid.

‘Price’ is also based on other variables, some of which are not controllable by either buyer or seller, including:

  • Buyers and sellers may have different knowledge, negotiating abilities, and financial means.
  • All potential buyers may not be identifiable.
  • There may be existing or pending legal and contractual restrictions.
  • The sale may be forced or there may be a compulsion to buy or sell.
  • The purchase may not be an all-cash deal (earn-outs may be necessary to bridge price gap).

A popular database utilized by business appraisers as a benchmark for developing a company’s value is BizComps®, which details data gleaned from actual closely-held business sale transactions that occurred in the market place. Sixty-one percent of the deals listed on BizComps report companies with less than $500,000 in annual gross revenue, while 18 percent of the deals have annual company revenues over $1 million. BizComps is also useful for ‘main street’ business brokers and intermediaries as the data indicates deal price, terms, asset information, operating rent expense, gross sales and sellers’ discretionary earnings.

A sample group of 80 subcontractors within industry classification (Standard Industrial Classification group) 1700 is selected to illustrate buyer-seller trends of the closely-held market place. Revenues for the group range from $100,000 to $14.8 million, and sale dates range from January 2004 to the latest listing of October 23, 2006.

For these small, closely-held companies, the data also indicates there is no definitive correlation between: 1) sale price and 2) revenue size, location of company, industry classification code, date of sale or days on market.

According to Jack Sanders, compiler of BizComps data, there is a direct correlation between: 1) sale price and 2) earnings — namely, sellers’ discretionary earnings, a calculation similar to owner’s return. Sellers’ discretionary earnings are defined as pre-tax income plus interest expense, depreciation (non-cash charges) and compensation for one owner. On average, buyers desire to purchase a company that will net approximately 30 percent a year in earnings after deducting officers’ compensation and repayment of debt obligations. Small, closely-held companies that do not indicate this level of return are less likely to sell for a price in excess of fair market value. The rule is quite simple: the lower the trend in profits, the lower the purchase price.

The beauty of market transactional data, such as BizComps, is that it shows the marriage of Emotional Value and Theoretical Value. Generally, the closely-held market does not allow a seller’s emotions to overshadow the findings derived from sound valuation theory. Although not a hard-andfast rule, closely-held companies will sell only for what the market will bear for that type of investment. The lower a company’s earnings, the greater the risk of the investment and the higher the rate of return demanded, thus, the lower the theoretical value derived and the lower the price paid by the buyer.

Strategic planning: Begins before day one
Although selling a business is somewhat similar to selling a house, a business sale is far more complicated with greater life-impacting consequences for the closely-held business owner. Unlike selling a house, selling a business does not begin with a ‘for sale’ sign, an advertisement or a broker’s listing; it should begin the first day an entrepreneur contemplates going into business for themselves. Most small businesses are not saleable, primarily because they are not structured or engineered to run without the owner overseeing the day-to-day operations. Developing a company as a marketable investment with value to a hypothetical buyer takes time.

The company must demonstrate profits consistently over the three most recent years of operation. The balance sheet and income statement should be free of non-operating assets, such as vacation homes, automobiles used by non-employees or for non-work related purposes and other nonbusiness related assets. Personal expenses and unnecessary business expenses should also be removed from the company’s income statement.

Second, does key person dependence exist? Does one person possess the knowledge, licenses, certifications or other related industry skills? For many small businesses, the key person typically is the owner. The greater the company’s profits are dependent on one person the lower the company’s value. The company should have a strong core of transferable human capital, i.e., a management team that is well-trained and can run the company without the constant oversight of the current owner.

Third, documented systems and procedures should be in place (such as an executed business plan) illustrating how the company has achieved its profitability to date and how it will continue to realize profits over the long term. Essentially, the value of the business is dependent on the processes and operations management that will allow the next owner to be profitable and continue to grow the company.

Business valuation: Why hire an independent business appraiser before you are ready to sell?
One of the first things analyzed about a target company by a potential buyer is the financials. The condition of the company’s financials set the tone about the overall condition of the company, i.e. poorly-kept financials, poorly-run company. Additionally, the company’s financial reporting may be structured to minimize income for tax purposes. However, when preparing the business for sale, recordkeeping should be changed to illustrate the maximum owner’s income in order to maximize the sell price.

A professional business valuation prepared by an experienced, accredited appraiser normalizes the company’s financial statements, removes discretionary tax expenditures or non-operating expenses and accounts, reclassifies accounts according to GAAP (generally accepted accounting principles) if necessary, and reclassifies costs according to standard industry reporting so that profit margins and financial ratio performance is as accurate as possible.

An owner can easily calculate the company’s operating assets less operating liabilities – however, this calculation represents only the net tangible value of the company, and will likely result in a value that is too low. Net tangible value does not factor a selling company’s most valuable assets – the intangibles, such as human capital, clientele lists, transferable contracts, leases, patents, copyrights, proprietary processes and/or services or designs. However, the business valuation captures it all—in other words, the valuation illustrates the company’s intangible assets as well as calculates the intangible earnings generated from the tangible assets.

Sellers need to establish a price that will generate interest in the available business. Moreover, prospective buyers must know whether that price is reasonable, because if the asking price is too high, the purchaser sees less of a return.

Getting a professional third-party objective opinion from an experienced, accredited appraiser provides the seller a microscopic view of the business’ weaknesses and strengths from a financial investment perspective. At a minimum, the business valuation addresses the following questions buyers will ask:

  • What is the business’ market share, clientele base, percentage of repeat business, and concentration of clientele?
  • What tangible assets and intangible assets (such as clientele, human capital, and proprietary processes) are transferable?
  • What are the profit margins, historical rate of net cash flow, and ROI, and how do these compare to the industry?
  • What competitive advantages does the company have over the competition?
  • What is the industry’s growth, and how does the company compare?
  • What is management’s plan for continued growth?

Even if an owner decides not to sell today, knowing the value of the business is a good idea. If the value is not what the owner thinks it should be, he or she now has control to make changes that will maximize the company’s future value. Knowledge is power, and therefore when the owner is ready to sell the company, he or she will get the best possible price.