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Accurate Valuation Is Critical When Selling Business

Filed under Exit Strategies/Selling Business. Fact checked on May 24, 2012.

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Valuing your business accurately is essential if you don't want to risk leaving money on the table or scaring away potential buyers. Before undertaking the appraisal, put time into sprucing up your business and its financials. Effort spent at the outside will pay dividends down the road.

The value of a typical small business should be greater than the total values of its tangible assets. For a buyer, the appeal is that an ongoing business has everything necessary for successful operation — equipment, location, and inventory if applicable, not to mention experienced employees, suppliers, business processes, and a customer list — all in place, in the right amounts.

These intangible assets are frequently referred to as goodwill or going-concern value. But how do you put a price on goodwill or going-concern value? In fact, how do you determine the true market value of the hard assets used in your business? The answer is that you make a business appraiser a key player on your selling team.

Many business owners don't want to spend the time or money to have an appraisal done. However, trying to save money on the appraisal, is likely to be to your disadvantage. Guessing at the value of your business is likely to result in either a price that's unrealistically high and turns off many potential buyers, or a price that's unnecessarily low and keeps you from cashing out at full value.

Business appraisers generally are certified public accountants (CPAs) that have specialized training and experience in business appraisal techniques. As a profession, they have established a number of ways to quantify the value of key aspects of your business, and roll them up into an overall figure. As part of the process they will write up a valuation report, which explains in detail how they arrived at their final value. Having a valuation document prepared by an outside expert adds a great deal of credibility to your asking price, because the buyer will be able to see exactly how you arrived at your final figure.

Keep in mind that if you sell out to a larger company, you'll probably be dealing with MBAs who are used to seeing sophisticated financial analyses. They will be much more comfortable going through with the sale (and much more impressed with your management ability) if you have a detailed appraisal prepared.

On the other hand, remember that value is in the mind of the beholder. A professional valuation can tell you the price that an average buyer might pay for your business. However, when it comes to negotiating with an actual buyer, the appraisal is just a starting point. A particular buyer may have a strong strategic reason for acquiring your company, and may be willing to pay a premium over what the average buyer might offer. Another buyer might simply be looking for certain assets to augment his or her own business, and may not be willing to pay for your company's going-concern value at all. It's important that you and your business broker size up the particular buyer's reasons for acquiring your business before naming a price.

Warning

If you do have a professional appraisal prepared for your business, but then decide not to sell, it's a good idea to keep the appraisal document separate from the rest of your business documents.

In the event of your death, you won't necessarily want your executor to be tied down by the numbers shown in the appraisal for estate tax purposes. After all, the appraisal purports to show market value, but if no sale occurred it's hard to know whether that assessment was reasonable. Moreover, any number of things can happen in intervening years to make the appraisal obsolete.

Your estate will often come out better if your executor does a completely new appraisal for the purpose of computing estate taxes when the time comes.

Using the Appraisal to Set Your Initial Price

Once your appraiser has come up with an approximate value for your business, you may decide to set the listing price slightly above the top end of the price range, to allow yourself some room to negotiate and still realize the full value of the business (or at least come close to it.) Or, you may decide that you want to sell quickly, and you'd prefer to set the listing price close to the actual appraised value or even below it.

You should think carefully about this decision and base it on your priorities, and your broker's experience and sense of the current market for businesses like yours. It's much easier to drop your asking price later than to raise it. Of course, your actual selling price will be determined during negotiations with the buyer, preferably after all the other major terms have been worked out.

In placing a price tag on your business, you need to consider:

  • What factors are most important to buyers?
  • How can you boost these important factors before the sale?
  • How might your accountant adjust your financial statements, before showing them to potential buyers?
  • What are some of the methods and formulas that are commonly used to put a price tag on a business?
  • If you're only selling part of the business, how does that affect the price?

Some brokers prefer not to set a listing price at all. Instead, they'll hold a controlled auction where a number of potential buyers are contacted and given key information about your business, and bids are solicited. This can be a way to achieve a fairly quick sale at a competitive price, provided the market for your type of business is fairly strong.

Cash Flow and Assets Are Key Selling Points

It's important to recognize that what you love about your business are not necessarily the same things that a buyer will love. You may appreciate the intangible benefits you get from being your own boss, from your status in the community, from knowing that you provide a good product to your customers and a good working environment to your employees. Possibly you value some of your perks even more highly than the salary you take out of the business.

Buyers Focus on Cash Flow

Buyers tend to look at a business in a much more cut-and-dried way. The essential factors that most buyers are interested in are earnings (net income after all expenses, but before capital expenditures or debt payments) and cash flow (the inflow and outflow of cash in the business.)

Buyers want to know that your business will provide a stream of dollars that's predictable, steady, and high. Some buyers prefer to look specifically at cash-flow statements, while others will focus on your income statement to examine earnings before interest and taxes (EBIT). Still others will place the most weight on earnings before interest, taxes, and depreciation (EBITD). The point is, your income stream is key. You need to prove the size and regularity of your positive cash flow, preferably with audited financials going back at least three years.

A very important aspect of your cash flow and earnings is their ability to be replicated in future years, without your presence. If your professional expertise or salesmanship is the main reason the business makes money, you will have a hard time convincing the buyer that the cash stream will continue in future years.

Buyers are most concerned about the future earnings of your business, and less concerned about the past. However, the future is difficult to predict with any degree of certainty, so most valuations are largely based on your historical financial statements. You will, however, be expected to provide projected financial statements that show how the business might be expected to perform after the sale. You may also want to emphasize your future plans: new products in development, promising new distribution methods, and other items that should contribute to income growth in the future.

Warning

Don't make your predictions about the future too rosy — they may come back to haunt you in the form of a lawsuit for fraudulent conveyance if they don't pan out. In fact, some advisers say that, absent special circumstances, you should predict only that your business will match current growth in your industry.

Assets Are an Important Consideration

A secondary consideration for most buyers will be the verifiable assets of the business: the real estate, equipment, patents or trademarks, and even such things as inventory, customer lists, and contractual relationships you've established. These items are the buyer's "insurance" — things that can be sold or used elsewhere if the earnings stream dries up. Here's where owning your business location and equipment, rather than leasing them, can be important.

Buyers will examine your key financial ratios to see how your business compares to the industry average, to other acquisitions they may be considering, and to the criteria for purchases they have set up for themselves. A key consideration is that your business have a clean balance sheet with low debt. The buyer may have to increase the debt burden in order to make the acquisition, and won't want total debt to be too heavy for the business to support. Furthermore, a low debt load is more evidence that your business has a strong flow of earnings.

Some buyers will be interested in knowing that you have an experienced manager or team of employees in place to take over when you leave. They'll want to know that you have groomed your successors, and that the successors will stick around. Other buyers will be looking for a business to actively manage, and will want to avoid long employment contracts with existing managers.

Tip

In preparing to sell your business, your best bet may be to choose your most likely successors and prepare them to take over management of the company, but hold off on establishing or renewing any contracts with them until the buyer's identity and plans are known.

Buyers Will Demand Documentation of Business Assets and Financial Health

Buyers will also prefer that you have a lot of documentation available for your business. They'll be taking a close look at what the papers actually say during the due diligence process, as negotiations proceed. But the very existence of documentation like sales reports, production reports, employee organization charts, job descriptions, operations manuals — all that paperwork you've tried to minimize or avoid up to now — serves to tell your buyer a lot about your business, and also increases his or her comfort level with the professionalism of your management style.

Add Value To Boost Selling Price

Regardless of the state of the economy and of your industry, there are many actions that you can take to improve your business's appeal to buyers before the sale. The main problem is that many of these things take time. If you need to sell right away, you're not going to be able to add much value. Consequently, it's possible that a lot of the potential value of the business will go down the drain.

Improve Your Income Statement

Since cash is king, the most essential step you'll want to take is to clean up your income statement. One way is to have your accountant recast your financials to reflect the way the company should look with new owners. However, some buyers (particularly larger corporations) are turned off by this procedure. They will judge you only by your true, audited financials. If you want to be able to hook these buyers you have to clean up the business itself, not just the statements.

Basically, this means doing whatever it takes to increase your EBIT (earnings before interest and taxes). This may mean something as simple as increasing your advertising expenditures, hiring another salesperson on a commission basis, or keeping your store open an extra 10 hours per week to generate more revenues, and taking a hard look at your expenses to see whether you can reduce them. For example, this may be the time to drop some of the perks the business provides to you or your family members.

Where possible, your accountant might capitalize and deduct over time certain items that might otherwise be  expensed and deducted in a single year. Your accountant should also review your depreciation and inventory reporting methods. Ideally, you'd start working on this three years before the sale, since most buyers will want to see three years of financials. (Plus, depreciation and inventory method changes must be approved by the IRS, which can be a lengthy process.)

Improve Your Assets

Take a good look at the assets of the business. Certainly, you'll want to sell off or dispose of any unproductive assets or unsalable inventory. The buyer won't want to pay you for them, and they will only drag you down — better to get what you can from them now, and write off any losses that may result.

Another move you may want to make is to replace any machinery that's nearing the end of its useful life, and do any necessary repairs and upgrades. The average buyer wants to purchase a turn-key operation, so that all they have to do is walk in, turn on the lights, and the business will operate with no immediate need for investment on their part.

You'll also want to metaphorically (or even, literally) put a new coat of paint on the entire place. This is not to say that you should spend a great deal of money on this "curb appeal," but be sure that your location is clean, your landscaping is fresh, any areas open to the public are decorated appropriately, etc.

Disentangle Assets That Will Not Be Sold with Business. The business may own certain assets that are primarily for your personal use (the most common example is a company car) and that you want to retain after the sale. Now is the time for you to buy the asset from the business, perhaps at the current book value.

If the business owns real estate, you might consider removing it from the business and placing it in a limited partnership, so that it will not be transferred in the sale. You can continue to lease it to the new owners, or to someone else, and retain an income stream.

This is a judgment call — for some businesses, the real estate provides the main appeal to buyers and you won't get much for the business without it. Your business broker should be able to tell you whether this is true for you.

Clean Up Potential Liabilities

You should make an effort to clear up any pending or potential legal problems, such as product liability claims, employee lawsuits, IRS audits, insurance disputes, etc. A buyer who purchases only the assets of your business (instead of corporate stock) generally won't get stuck with inherited legal problems; however, the very existence of lawsuits or other problems may raise red flags in potential buyers' minds or even turn them completely off.

Address Environmental Issues

One concern that buyers increasingly have is whether there might be any lurking environmental problems on your property. Where problems turn up, it's possible that any and all former owners can be held accountable by the government for very expensive cleanup costs.

If real estate will be part of the sale of your business, make every effort to see that there are no leaking underground storage tanks, asbestos, lead paint, hidden hazardous waste, or other nasty surprises around the property. If it's reasonable to conclude that problems are unlikely, an environmental transaction screen conducted at your attorney's direction may be all that's necessary.

Obtain Phase I environmental audit. To be safe from future claims, you'll generally have to obtain a satisfactory Phase I environmental audit by an environmental consultant. The Phase I report will document the clean condition of your property at the time of sale, and provide evidence that any problems must have been caused by subsequent owners. The price of an audit depends primarily on the amount and type of real estate your business owns, but can also vary among environmental professionals. Like any other major expenditure, you should get estimated bids from several licensed consultants before hiring one.

If problems turn up during the Phase I audit, a Phase II environmental audit may be required to investigate the problems and determine how to clean them up. If it turns out that problems are so extensive that you can't realistically fix them before the sale, you'll probably have to reduce your asking price for the business. As an alternative, you may want to consider trying to sell the business without the problematic assets.

Simply not telling the buyer about existing problems is not an option; in fact, many states require you to sign a disclosure form that reveals any and all problems you know about. This is one area where your lawyer's advice will be very important.

Recast Financial Statements

One way that virtually all small business "dress up" their business before a sale is to recast historical financial statements for the last three to five years, and draw up projected statements that reflect how the business would look with a new owner.

If you're like most small business owners, you've operated your business in a way that's calculated to minimize taxes. You may have given yourself and family members as many perks and benefits as possible, kept your children on the payroll, plowed a lot of profits back into capital improvements, etc. These and other tactics are designed to keep your profits (and your taxes) low, perhaps artificially so.

However, when you put the business on the market, you want to make your company look as profitable as possible. Ideally, you would take steps to improve your actual earnings for several years before putting the company on the block. If time does not permit (or in addition to) this step, you can have your accountant adjust your past income statements to reflect what would have happened if you:

  • removed your salary and perks, and those of family members you don't expect to remain with the company
  • removed any expenses or income that would not be expected to recur or continue after the sale (for example, income or expenses associated with discontinued products, or gains or losses from the sale of any business assets)
  • removed any investment or other nonoperating expenses or income
  • removed interest payments on any business loans, since you'll be removing such liabilities from the balance sheet.

Furthermore, your accountant can adjust your past balance sheets to:

  • Remove any assets that will not be sold with the company.
  • Remove any obsolete or slow-moving inventory. Value the remaining inventory at current replacement cost.
  • Value your remaining balance-sheet assets at current fair market value.
  • Write off any accounts receivable that are uncollectible.
  • Write off any loans the company made to you (bearing in mind this will trigger cancellation of indebtedness income on your personal tax return.
  • Remove other debt that will not be assumed by the buyer.

Your accountant may have some other ideas; for example, you may have expensed some costs that could have been capitalized.

Warning

Whatever you do in the way of recasting your financials, make sure that any changes to your historical statements are carefully documented on the face of the statements, so that the buyer knows you aren't trying to cover anything up.

Finally, you should have your accountant take these recast financials and use them to project how your future statements are likely to look for the next five years, making reasonable assumptions about future growth or decline in income, expenses, value of assets etc. In most cases, that means assuming that trends established over the past several years will continue; for example, if revenues have increased by 5 percent a year, it's probably reasonable to assume that growth will continue at that rate.

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