Many business owners have some idea as to the value of their business. We often hear something like, “My friend had a similar business that he sold for one times sales revenue.” Or “My brother-in-law had a business which was sold for 3 times cash flow.” Or, “Businesses in our industry typically sell for 2 times profits.” None of these “anecdotal estimates,” however, will truly establish a reliable value for selling a business.
The “real market” operates under the concept of Fair Market Value – what a willing buyer and willing seller would agree to pay assuming equal access to information and no undue pressure or time constraints. FMV is an accepted concept and tends to level the playing field in a process that is inherently adversarial.
“We tell our clients that it is not so simple to determine value and goodwill, and no one single ratio is the right ratio,” says Michael Gersten, Managing Director, A Neumann & Associates, a New Jersey-based M&A and Business Brokerage firm. “So we use a formal appraisal process, which we call a ‘business valuation.’”
The first step is to interview the business owner and to record the business particulars in our Business Information Organizer (BIO). This document describes the business ownership structure, its operations and business development methods, other assets like patents, copyrights and trademarks, plus the business’ general advantages and disadvantages.
Secondly, we work with the business’ financials – the last three years tax returns, the current profit & loss (year to date, with year over year comparisons), an asset list, and revenue projections for the next three years. From this information, a recasting is performed to determine the true cash flow of the business by adding back non-cash expenditures, owner benefits, and unusual or one-time items to show Seller’s Discretionary Cash Flow.
Independent, nationally-accredited valuation firms will then review the recasting and the BIO to determine the true business value. They use multiple valuation approaches: (i) Asset Based Approaches (based on the fair market value of the assets to be included in a particular sale); (ii) Income Based Approaches (based on how efficiently an enterprise uses the assets to produce income); and (iii) Market Based Approach (based on value multiples for similar business sales). All in all there are 7 different valuation computations that get weighted differently depending on the particular company and industry. The result of this valuation process is that the Fair Market Value is accurately determined, independently derived, and substantially supported by the financial investing community. From the buyer’s perspective, the valuation justifies the asking price and supports the buyer’s financing requirements.
Once that value is established for the entire company, a business owner needs to make a decision regarding what percentage of the company to sell. In many cases a business owner is not ready to completely sell the entire business, but instead wants to find investors or potential partners. Some owners are in need of ongoing income in anticipation of a succession plan or exit strategy. Others are looking to “take some money off of the table” and perhaps spread their wealth so that they are less dependent on the business.
From the buyer’s perspective, having a seller stay on could result in increased stability for the business if handled correctly. Another reason that having a seller stay on is potentially attractive to a buyer is that it’s an indication that the seller has confidence in the numbers, and that there are no surprises in the deal structure.
There are many ways to structure a deal so that the present owner can remain as part of the new ownership team if so desired. The simplest way is to just hire the former owner as an employee. Although simple, this might not meet the needs of the seller, particularly, from a future growth perspective.
Another way to structure the deal is to have the future payments tied to business performance as an “earn out,” whereby the former owner receives future payments quarterly or annually based on a predetermined algorithm. One benefit for the seller is that the potential for “upside” – payments in excess of the minimum selling price – can be built into the deal structure. From the buyer’s perspective, an earn-out reduces risk and keeps the knowledge and experience of the seller “in house.”
A final way to structure a deal in which the seller stays on is through a personal services or consulting contract. In this scenario, the timeframe, specific responsibilities, and compensation are laid out in the agreement. This form is normally used when there are specific skills of the seller that are material to the business.
In sum, once a Fair Market Value is established, there are various ways to structure a business transfer deal in which the seller stays with the business, and the probability of attracting multiple qualified buyers is greatly increased. . Our team at A Neumann & Associates is well-versed in all of these deal structures and has developed extensive experience over the past ten years in implementing them.
About A Neumann & Associates, LLC
A Neumann & Associates, LLC is a professional merger & acquisition and business brokerage firm with 30 years of experience in New Jersey, New York, Pennsylvania, Delaware and Maryland that assists business owners and buyers with the business transfer process in a completely confidential manner. The company is affiliated with BBN with access to a national network of qualified buyers and sellers, and the company is a long standing member of 30+ Chambers and networking events. For more information, please contact A Neumann & Associates at 732-872-6777.