PRICING YOUR BUSINESS AND INCREASING ITS VALUE
No matter who you are going to sell to, or over whatever timeline, your process has to start with an asking price. Now, whether the price is proposed by the seller or the buyer, the asking price isn’t pulled out of “thin air.” It’s always based on a valuation; in fact, it’s generally based on a blend of valuations or an “average.” As I discussed in the last chapter, the appraiser you engage will go through a variety of valuation methods to try to come up with the highest and most fair price for your business.
The top six methods of valuation when it comes to pricing a business are:
1. Multiple of cash flow method
2. Balance sheet method
3. Cost to create method
4. Capitalized earnings approach method
5. Discounted cash flow
6. Comparable sales
Before I explain the basics of these valuation methods, it’s important to recognize that a significant benefit of going through this whole process of “appraising,” and why I want to take you through the most common methods of valuing your business, is that this process can give you a roadmap for what might actually increase the value of your business. Because of this side benefit, below I break down the most important steps to take years before you want to sell in order to maximize the value of your business. But for now, let’s dive into the six valuation methods listed above.
1. Multiple of Cash Flow Method
This is probably the most common method and a great starting place for a buyer and seller to begin negotiation. Appraisers will typically apply a multiple to the annual normalized EBITDA to estimate the business’s value.
Most companies (not a dotcom with wild expectations) typically trade for between three to five times their normalized EBITDA. Thus, a company with $400,000 in annual profit (EBITDA) and a “multiple” of five would sell for approximately $2 million. It’s hard to explain where these multiples really started to become commonplace and industry averages for lack of a better word. Some have suggested it’s a realistic estimate as to the number of years it would take to pay off the purchase price if profits remained the same as in the year of purchase. Nonetheless, these multiples vary based on several factors. The difference in the multiple is generally the result of a variety of characteristics specific to your business, including:
Sales growth rate
Gross profit margin
Location and expansion possibilities
Working capital requirements
An appraisal will take all these factors into consideration and then continue with various other valuation methods to arrive at an average.
Rather than focusing on the profit, an appraiser will also consider the assets and liabilities of the business. Sometimes, a business is worth more because of its assets, not necessarily the cash flow. For example, the land, buildings, intellectual property, or even expensive machinery that could be tooled or modified in a way that could be extremely valuable to a buyer would all contribute to the overall value.
When a seller has volatile cash flow or a difficult business to market, it will be in their best interest to focus on the assets and not the income/loss. In turn, a savvy buyer may see underlying value in the assets and may be able to offer a price to an unsuspecting seller who doesn’t realize the assets they are sitting on hold great value because the profit and loss has been less than impressive.
These assets could also be intangible (not physical), such as a customer list, patent, trademark, intellectual property of some sort, or even a brand recognition or logo. In the hands of the buyer, such intangibles could be worth even more if utilized in their distribution system or market reach to expand the brand or to exploit the customer list.
There are times when a buyer will purchase a business simply to avoid the difficulties of starting a new business from scratch. I’ve met with many clients using this approach because they don’t want to “reinvent the wheel.” Welcome to the Cost to Create Method.
Moreover, a buyer needs to consider the time and effort to create trust with customers and the value of the seller’s name and recognition. It can be very unpredictable for a buyer to create a new product, service, and brand. Although the buyer may think it is easy to reproduce, simply acquiring the seller’s business could minimize a lot of risk.
RANDY LUEBKE
Sometimes, the cost to create this method is referred to as the “leapfrog startup method,” and the buyer calculates the startup costs in terms of dollars and time. When I reference “time,” I’m not talking about the hourly cost of the buyer’s time, but the opportunity cost of lost time. For example, the buyer might determine it would take three years to develop a new business to the point where the buyer is already operating. That could be three years of lost profit that needs to be factored into a competitive offering price for the business.
A buyer can use this valuation approach as leverage or a threat to the seller, explaining that the buyer is coming into the market no matter what. I once used this argument on behalf of a buyer in a carpet business transaction and told the seller that my client would be taking at least some market share of the seller’s customers and further tried to motivate the seller with a generous price, rather than see their profits go down when there is another player in the market.
4. Capitalized Earnings Approach Method
Under this valuation method, a buyer has an expectation of a rate of return based on their investment in the purchase. This return can have a lot of different labels, such as Return on Investment (ROI), Cash on Cash Return, CAP Rate, or Internal Rate of Return (IRR). In fact, there are many other terms that could be used, but essentially, it means that the value is going to be based on an expected return in relationship to the investment.
The rate of return is based on the investment of the buyer divided by the annual net income after taxes. For example, if the buyer pays $2 million for a business with a $500,000 down payment and loan for $1.5 million, the investment is really $500,000. Let’s assume that after debt service (payments for the $1.5 million loan), the cash flow is $50,000 after taxes; then, the ROI is 10 percent. This equation may sound simple, but it’s important to compare apples to apples when negotiating. Lawyers and appraisers are notorious for using the definition that supports their value and can easily change numbers and terms creatively to fit their argument.
One of the prominent theories of this ROI approach is that the buyer should be able to sell the business at any time and get their initial investment back. Because of this, risk becomes a critical factor to consider. A buyer will compare their investment in a seller’s business to other options, such as an annuity, mutual funds, or some sort of moderate risk. This puts the investment in perspective for the buyer and involves a lot of comparisons to help the buyer make an informed decision.
The type of buyer interested in this valuation method is typically leaning on the “turnkey” concept often referenced in real estate deals: that the buyer can purchase the business, replace the buyer with a manager/executive (a cost inserted into the normalized financials), and then, the buyer can sit back and see the profit roll out without having to personally oversee the day-to-day operations or put significant time or labor into the business.
5. Discounted Cash Flow Method
This is a type of calculation based on the future cash flow of the company and what a buyer is willing to pay now for those future cash flows. It starts with a seller and buyer first agreeing as to the current cash flow being generated by the company and then projecting that cash flow into the future based on any trends taking place in the business.
Once the parties agree as to the future cash flow, the appraiser will take into account the time value of money and calculate the present value of the future cash flow. That is essentially what the word discounting means and really entails. Buyers can then use this method to determine what the asking price should be and if the seller is asking too much or too little for the business. In reality, there are several variations of this valuation method to consider, and each is based on multiple variables. Such variables include: the estimated cash flows, timing, cost of capital, and the trend or growth rate. A change in any one of these variables can have a big impact on the estimated value of the company. Thus, this is again another method used to come up with an average price during the appraisal.
Comparable sales are obviously a pretty straightforward method here, but worth mentioning because of its importance and common use. If and when possible, an appraiser will try to pull comparable sales of a similar type and nature of business. The difficulty is finding a business that sold within a reasonable amount of time, in a similar market, and that has common characteristics. Nonetheless, with certain types of businesses, it’s easier to find these types of comparables. For example, a restaurant of a similar size, type of food, and city demographics could be easy to find and help a seller and buyer in appraising a business.
Increasing the Value of Your Business
I have had many meetings with clients interested in selling their business, and as we start to go through the different valuation methods, together we quickly discover that they are a few years out before selling. It’s not that they aren’t interested in selling; it’s just that they have come to the realization that they have to take some action to create more value for a potential buyer.
The importance of trends and growth rates cannot be overstated. When a seller can take several years to build a compelling growth rate and trends of sale demands or production output, buyers will take notice.
What happens is that sellers begin to understand how buyers perceive and view the value of their business and are grateful to learn that there are steps they can take to truly increase the value of the business and then legitimately be able to prove it under various valuation methods.
Business owners know deep down where the problems are within their business, and when they are forced to deal with them in preparation for a sale, the value of the business will certainly benefit. It’s actually really exciting. Probably the most important step to take in preparing your business to sell is simply “systemization,” and I mean systemization of everything.
I learned this critical principle when working with a professor of entrepreneurship, Mark Morris. I learned from Morris during our consultations that as he worked with family-owned businesses trying to pass on the company to the next generation, if “processes are implemented to replace key personnel, the business had a much higher value and probability of success.” A buyer wants to buy a system—not a handful of key people who could leave and/or essentially destroy the business for any reason. Ironically, by creating systems and processes in your business that are probably far past due for implementation, you start to find a little financial freedom and even increased profitability (a side benefit I’ll discuss further below).
Nevertheless, regardless of the specific issues you know that need to be cleaned up in your business, here is a list of other important items to get in order as you prepare to value and look for a third party.
Assessing company employees for readiness. Are the proper personnel in place to run the business for a third party? What are the strengths and weaknesses of the management team? Do you need to do more training or make some hard decisions and let some people go?
Reviewing company systems and procedures. Just as I stated above, review every aspect of your business for processes and systems that could be improved or implemented. This includes production, admin, sales, delivery, and customer service. Is there anything you could do to systemize and increase productivity without adding more staff? Consider engaging a business consultant to review your company operations from an outside point of view.
Tightening up the books. Is the bookkeeping in good order? Are tax returns accurate and be reasonably tied to the operational books? It may take a couple years to bring the financials in line with true operations, but start now. A buyer will want to see at least a couple years of solid books that tie to bank accounts, credit card statements, and tax returns. This also includes improving your accounting systems and immediately starting to prepare annual financial statements.
Reviewing your software systems. Is your technology outdated? What is now commonplace in your industry, and what are your competitors using by way of software and automation in the technology sector? It may be time to upgrade your hardware, software, wiring, and even move items to the cloud. The investment could pay off tenfold as a buyer sees that you aren’t running on outdated technology that would have to be upgraded after a purchase.
Wrapping up any litigation or potential claims. You will ultimately need to sign documentation verifying that all outstanding claims are either settled or nonexistent. Don’t let a potential plaintiff screw up the sale of your business. Start reviewing your relationships with prior customers, vendors, and employees, and settle. Get rid of these “problem children” so they will not taint the sale before or after closing.
Determining what regulations the buyer will have to satisfy. If you are in an industry that requires city, state, or federal approval, find out about the process. Who can qualify to buy your business, and what hoops are they going to need to jump through? Get the list now, and create a path for ownership so the process can be streamlined.
Update your marketing plan. Implement an organized, long-term marketing plan that integrates current technology and social media. Does your website need a facelift, and are all of your social media platforms up-to-date with a regular posting schedule?
Intellectual property. File any necessary documentation to lock down your brand, logo, catch phrases, images, and any intellectual property unique to your business. Do you need to file any patents or trademarks? These can create significant value in the eyes of a buyer.
Finally, it may simply be in your best interest to engage an appraiser as I discussed in the previous chapter. By hiring an appraiser, there is a good chance you will discover many of the problems or holes in a higher valuation. Even a semi-successful appraiser should give you a list of areas to improve that would significantly increase the value of your business.
What is interesting is that in every instance that I have helped a client go through these steps of preparing to sell their business, they discover an ancillary benefit: they remember the passion they had for their business! In fact, I have even had clients get a renewed interest and excitement for their business that puts the sale on hold.
RANDY LUEBKE
As business owners, we can get stuck in the trees for months, if not years at a time, but by stepping back and looking at the forest like a buyer might, it can truly be exhilarating for a business owner burned out and wanting to sell. As they organize and systemize the business for a valuation and buyer, they finally take the time to step back and look at the big picture.
Essentially by going through this valuation process, it always involves long-term analysis and planning regarding sales, structure, costs, employees, vendors, systems, and the unique characteristics of their business, which literally takes their business to a whole new level. Profits increase almost immediately. No matter what, the business improves because of this new perspective—this new way of looking at the business.
TAKEAWAY 1—Understanding the most common valuation methods used by business appraisers will help you obtain a realistic view as to the value of your business and help you better negotiate with a buyer and direct your appraiser through the process.
TAKEAWAY 2—By going through the valuation process, you will quickly learn where the weaknesses are in your business. Moreover, there is a long list of things you can do now to increase the value of your business for a future sale.
TAKEAWAY 3—Don’t be surprised when going through this process if you discover a renewed excitement and passion to take your business to the next level. You will inevitably increase the value and profit of your business that could very well change the timeline as to when you will sell.
TAKEAWAY 4—Make a plan now for the sale of your business two to three years from now, and you’ll be amazed at what you can accomplish and the difference it will make in your business.