In Part 1 of One Chance to Get It Right, we reviewed the seven categories of buyers and how buyers assess targets in the context of return on investment (ROI). In this part 2, we review how to value a business, the importance of recasting numbers and, finally, the deal structure.
Calculating Value
The most common method of calculating value is by taking a multiple of EBITDA to calculate enterprise value. However, this is only one method available which can serve as a rule of thumb valuation. The fact is that valuations vary greatly from business to business and rules of thumb should only be used as guidelines. The true value of a business lies in the future potential as determined by the specific buyer. Another rule of thumb method is to compute the book value of the business. This is usually done by adding retained earnings, paid-in capital, common stock and shareholder loans. However, book value multiples are seldom used in computing the value of a business because the buyer will be dependent on the earnings capacity of the business to earn a living, pay back debt and, ultimately, generate an acceptable level of return.
There are a number of different financial earnings metrics that can be used to value a business. The five most commonly used are:
- Shareholder discretionary earnings;
- Adjusted earnings before interest and taxes (EBIT);
- Net income before tax;
- Net income after tax; and
- Earnings before interest, taxes, depreciation and amortization (EBITDA).
The Importance of Recasting
The historical financial statements alone seldom portray the true financial picture of a business. It is virtually impossible to value a privately held company without careful analysis and recasting to determine the true level of profits.
Recasting is the process of adjusting for the “extra” expenses that are typically run through a private company that is closely held. These expenses reduce the tax liability of the owner(s), but they understate the earnings power of the business. It is up to the seller to provide potential buyers the detail on these expenses.
Here is an example of some of these expenses. The income statement of an engraving business shows pre-tax net profit of $100,000 for a given year. However, the following is included in the expenses:
- A $30,000 salary for a family member who works part-time and could be replaced by another part-time employee earning $10,000 per year;
- $15,000 per year for the owner’s leased vehicle;
- $30,000 in an overly conservative inventory write-down; and
- $8,000 per year in country club dues.
These extra expenses could have a substantial impact on the potential valuation of the business. These are all expenses that should be “adjusted out” to recast the income statement in order to maximize the reported earnings power of the business. In general, some of the most common expenses include:
- Excessive owner compensation;
- Family compensation to a spouse, siblings or children;
- Owner expenses such as vehicles;
- Owner perks such as club dues and travel;
- Accelerated depreciation or amortization;
- Use of nonconforming accounting principles;
- Conservative inventory write-downs;
- Unusual expenses such as legal expenses associated with a lawsuit;
- Excessive maintenance that appears in one year;
- New product or division start-up costs;
- Capital items expenses (such as a new computer system) that could be depreciated;
- “Toys” such as boats, airplanes and hunting camps; and
- Charitable donations.
Deal Structure
The structure of the deal is often more important than the actual purchase price of the business. For instance, if it is important for you to cash all the way out now, you may take considerably less for a cash offer than another offer that requires owner financing. In fact, there are numerous ways for you to get paid in the sale of your business. Some of these ways include:
- Cash – the most certain way to collect the entire sales price, but has some immediate tax consequences;
- Secured notes – the seller is paid over time out of the cash flow from the business, and has the right to foreclose as a secondary repayment source if the buyer defaults;
- Unsecured notes – riskier than secured notes and limited secondary repayment source if the buyer defaults;
- Shares in the purchasing company – typically only included as part of the package when selling to a public company or a private company that can substantiate its internal valuation;
- Consulting agreement – seller is required to stay involved for a fairly short period of time (usually six months to two years) in exchange for a lower purchase price;
- Employment contract – seller is required to stay involved on a longer-term basis (usually three to five years) to help transition to the new owner;
- Leases on assets retained by the seller – the most common leases are with real estate or equipment. If you agree to this, you should require the buyer to sign a long-term lease (five years or more);
- Non-compete agreement – the seller receives payments over a period of time (usually three to five years) in consideration for agreeing not to open a competing shop down the street;
- Royalty program – the seller receives part of the sales price based on future sales generated by the business; and
- Earnout – the seller receives part of the sales price based on future earnings generated by the business. This can be problematic if profits decline after the sale.
Don’t Fail to Plan
Business owners never plan to fail, but they do sometimes fail to plan, giving the buyer an added advantage. Be prepared for a process that will require a great deal of time and effort that should pay off in maximizing the purchase price of your business in the long run.