PREPARING TO SELL YOUR BUSINESS
I suspect many of you reading this book have gone through the exciting, yet stressful, process of selling your home. When you recall this presumably stressful process, you didn’t just wake up one morning and decide to stick a sign on your lawn or tell a Realtor™ to list it on the MLS (Multiple Listing Service) that very day. In fact, you took weeks and months to prepare for the sale. You may have even invested over a year’s time and thousands of dollars to maximize the value of your home.
The same process couldn’t be truer for the sale of your business, and it’s in fact probably far more involved. But before we get into the complexities of valuation and the types of buyers you may entertain in the sale of your business, there are steps you will need to take to prepare your business for sale.
The more organized you are, the less stressful the process will be, and will also inevitably increase the value of your business.
Later, I will go into detail regarding valuation methods and how to increase the intrinsic or hard core value of your business. In fact, these are things you can not only start to do immediately, but also may take a few years in order to prepare for the sale and maximize the value of your business (see Chapter 18). For now, let’s get into the process of finding an appraiser, determining what you will disclose to potential buyers, how you can protect yourself in the process, and finally, preparing your “books” or “financials” for buyers and appraisers to review.
A business appraiser will be almost a must when you are serious about selling your business. The two biggest reasons why an appraiser is going to be in the mix is to utilize the different valuation methods to arrive at a value for your business. They also provide an arm’s-length valuation that the two parties may be able to agree upon. Believe it or not, your business may not be worth as much as you may think (please read Chapter 2 if you haven’t already).
Now with that said, keep in mind that each valuation method could be an entire book or training manual unto itself. In fact, you may be surprised to know there are several associations in the business appraisal industry providing training, testing, and accreditation for licensed business appraisers. You will want to make sure the appraiser you choose has credentials issued from an organization such as the National Association of Certified Valuators and Analysts, or International Society of Business Appraisers, just to name a couple.
Additionally, www.bvresources.com and www.hadleycapital.com are a couple of prominent business appraisal service companies in the industry that may be a good starting point for you when the time is right. I suggest you interview several appraisers in the process of selecting the right professional for you.
In the end, a business appraiser will use a combination of several valuation methods to arrive at an “average” or “fair market value” for the asking price. Moreover, it’s important as a business owner that you at least understand the basics of these methods because it will help you learn how to increase the value of your business now and give you a range of what your business may be worth before you officially engage a broker or appraiser.
When the appraisal begins, it is based on the financial disclosures of the seller. This will most certainly be uncomfortable for you as the business owner, but it is expected and a common practice. To protect you in this process, all the parties involved (especially ANY potential buyers) will be obligated to sign a nondisclosure agreement, or NDA, as they are called in the industry.
Just as the seller is nervous to disclose information, the buyer is generally also concerned about signing an NDA. The buyer doesn’t want to be held back from still moving into the industry (even if they don’t buy the seller’s business). For example, a buyer could learn something insightful in the process (even unintentionally), and they won’t want the seller to later claim that they, the buyer, “stole” a secret that threatens the seller’s business if the buyer doesn’t follow through with the sale. As such, the NDA is carefully drafted to protect both parties and, again, it is highly recommended for both buyer and seller to sign and abide by its terms.
RANDY LUEBKE
The disclosure covered by the NDA will typically be the seller’s current and prior year’s financials, with up to two to three prior years of tax returns, an asset list, and even a list of debts that may be assumed by the buyer in the deal. These financials are critical for both parties and should be as accurate and honest as possible. I’m not suggesting that you offer a full-blown set of “audited financials.” Doing so is a very time-consuming and expensive process. In fact, most business sales aren’t based on audited financials; although in larger transactions, they may be more common before the deal is done.
It’s also typical that a new term will start to get thrown around during the discussions and valuation: the concept of the normalized financials. These are financial statements that are adjusted from a business owner’s tax returns or financials he or she may give to a bank. Essentially, the owner needs to create a normal set of financials or books for a buyer to review and get a sense for the value and health of the business. Why do the financials need to be adjusted, you may ask? Well, a good business owner should be writing off a variety of expenses particular to their family needs or tax strategies.
For example, the seller may have justified four-wheelers in the warehouse for moving supplies around or travel expenses to attend a semi-annual convention and taking the board of directors (typically the spouse and older family members) along for the trip. These are costs that a buyer would probably cut out. The seller wants to show “normalized financials” with these types of costs removed so it drives up the profit and thereby a potential valuation and asking price.
Finally, the financials disclosure will need to indicate the owner’s compensation. It will need to be set forth clearly as to whether the owner was taking a salary, a draw, or a combination of the two. A buyer wants to know how turnkey this operation will be. In other words, they want to know how the buyer will replace the seller’s personal service in running the business. Will the buyer need to hire anyone, one person or maybe several, to replace the seller? This is a scenario buyers need to be prepared for at this point.
The goal in the disclosure process is for the buyer to get as clear a picture as possible of the profitability of the business. Then the buyer and seller can engage the business appraiser to tear apart the financials and list of assets and liabilities to come up with a valuation. This is where EBITDA comes into play. But what is EBITDA?
EBITDA is an equation and stands for:
Earnings Before Interest, Taxes, Depreciation, and Amortization
It’s certainly a mouthful, but the equation itself is really quite simple: subtract expenses from revenue (excluding interests and taxes) without depreciation and amortization. The remaining number gets to the heart of the cash flow the business might produce and provides clarity for the valuation.
As I stated earlier, one of the first priorities in the appraisal process, is to get to a set of agreed-upon normalized financials or normalized EBITDA. As such, there are positive and negative “add-backs” you can make to EBITDA depending on the party’s perspective, goals, and needs. The term of procedure of “add-backs” means you will add back to income or expenses certain dollar amounts that are personal or particular to the current business owner that won’t apply to a buyer if they were to take over the business. Let’s look at some examples.
To determine sustainable cash flow, some positive add-backs that increase EBITDA may include:
Owner’s excess compensation
Rental expense above market rates
Owner’s benefits that are not required to run the business, such as automobiles, vacations, etc.
Tax strategies particular to the owner’s family or personal/business lifestyle
Unnecessary employees that are part of the owner’s family or friends
Add-backs that may decrease EBITDA may include:
Rental expense below market value
Increased expenses due to special rates or deals exclusive to the owner’s contacts
Recent or significant annual capital expenditures
Additional salaries required when the owner departs
Once “normalized EBITDA” is determined, the owner, buyer, and appraiser can start to implement various valuation methods more clearly and start to arrive at a fair asking price for the business.
Bottom line: starting to fine-tune your financials and engaging an appraiser early on can help you understand what your true income is. Please allow me to caution you and suggest you brace yourself. It’s very common for business owners to be living off their business and be implementing creative tax strategies that give a seller the impression the business is worth more than it really is. Remember, a buyer may not value the same benefits or strategies you do. Get your financials dialed in, and start to look at valuation methods and learn what steps can truly increase the value of your business—our next topic and chapter!
TAKEAWAY 1—Choosing the right appraiser for the sale of your business is critical to having a smooth sale and maximizing the value of your business. Make sure to interview several professionals before deciding on a specific appraiser or appraisal company.
TAKEAWAY 2—Be prepared to disclose everything from assets and liabilities, client and asset lists, and the systems and procedures of your company. Your buyer should be equally prepared to sign a Nondisclosure Agreement, and it’s important to have an ironclad legal document for this purpose.
TAKEAWAY 3—You need to know your EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). During the process of calculating EBITDA, you will also prepare normalized financial statements to reflect the true profitability of your company.