What Is a Business Worth?

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Many courts and the Internal Revenue Service have defined fair market value as: “The amount at which property would exchange between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having a reasonable knowledge of relevant facts.” You may have to read this several times to get the gist and depth of this definition.

The problem with this definition is that the conditions cited rarely exist in the real world of selling or buying a business. For example, the definition states that the sale of the business cannot be conducted under any duress, and neither the buyer nor the seller can be pushed into the transaction. Such factors as emotion and sentimental value cannot be a part of the sale. Surprisingly, under this definition, no actual sale or purchase has to take place to establish fair market value. That’s probably because one could never take place using the definition.

So what does make up the value of a privately-held business? A business consists of tangible and intangible assets. The tangible assets are the most visible and the ones on which buyers too often base a judgment on the value of a business. Factors of value, fixtures, equipment and leasehold improvements are often valued first by the buyer. Well maintained equipment and attractive interior surroundings are the first things a buyer sees when visiting a business for sale. Make no mistake, regardless of what prospective buyers may say, the emotional impact of a physically well-maintained business can be a very positive factor. In addition, it is much easier to finance tangible assets than intangible ones.

However, buyers have to consider what is really behind those well-maintained tangible assets. There are many businesses, especially today, in which physical assets play a very small part in the success of the business. These intangible factors include: the business’ reputation with its customer or client base, and within its industry; mailing lists and customer/client lists; quality of product or service; reputation with its vendors and suppliers; strength of the business’ technology and other systems; plus many other factors that can add a lot more value to the price of the business than can shiny equipment.

Although the intangible assets listed above cannot be seen, they are certainly an important part of the business – and purchase price. Businesses that don’t need expensive fixtures and equipment can, in many cases, be expanded more quickly and inexpensively because they do not require cash-intensive equipment purchases. Buyers, to their own detriment, do not want to pay the same price for equivalent cash flow for businesses that do not have lots of equipment. They want to buy tangible assets.

Business brokers and intermediaries know how to point out to prospective buyers the advantages of businesses that may not require lots of equipment but have those all-important intangible assets that create steady cash flow. Business owners who have a service or other type of business that does not rely on the heavy use of tangible assets and are considering selling, should talk to their professional business broker/intermediary who can point out the pluses and the hidden assets of the business.

What Is a Business Worth?

/in /by

Many courts and the Internal Revenue Service have defined fair market value as: “The amount at which property would exchange between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having a reasonable knowledge of relevant facts.” You may have to read this several times to get the gist and depth of this definition.

The problem with this definition is that the conditions cited rarely exist in the real world of selling or buying a business. For example, the definition states that the sale of the business cannot be conducted under any duress, and neither the buyer nor the seller can be pushed into the transaction. Such factors as emotion and sentimental value cannot be a part of the sale. Surprisingly, under this definition, no actual sale or purchase has to take place to establish fair market value. That’s probably because one could never take place using the definition.

So what does make up the value of a privately-held business? A business consists of tangible and intangible assets. The tangible assets are the most visible and the ones on which buyers too often base a judgment on the value of a business. Factors of value, fixtures, equipment and leasehold improvements are often valued first by the buyer. Well maintained equipment and attractive interior surroundings are the first things a buyer sees when visiting a business for sale. Make no mistake, regardless of what prospective buyers may say, the emotional impact of a physically well-maintained business can be a very positive factor. In addition, it is much easier to finance tangible assets than intangible ones.

However, buyers have to consider what is really behind those well-maintained tangible assets. There are many businesses, especially today, in which physical assets play a very small part in the success of the business. These intangible factors include: the business’ reputation with its customer or client base, and within its industry; mailing lists and customer/client lists; quality of product or service; reputation with its vendors and suppliers; strength of the business’ technology and other systems; plus many other factors that can add a lot more value to the price of the business than can shiny equipment.

Although the intangible assets listed above cannot be seen, they are certainly an important part of the business – and purchase price. Businesses that don’t need expensive fixtures and equipment can, in many cases, be expanded more quickly and inexpensively because they do not require cash-intensive equipment purchases. Buyers, to their own detriment, do not want to pay the same price for equivalent cash flow for businesses that do not have lots of equipment. They want to buy tangible assets.

Business brokers and intermediaries know how to point out to prospective buyers the advantages of businesses that may not require lots of equipment but have those all-important intangible assets that create steady cash flow. Business owners who have a service or other type of business that does not rely on the heavy use of tangible assets and are considering selling, should talk to their professional business broker/intermediary who can point out the pluses and the hidden assets of the business.

What Is a Business Worth?

/in /by

Many courts and the Internal Revenue Service have defined fair market value as: “The amount at which property would exchange between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having a reasonable knowledge of relevant facts.” You may have to read this several times to get the gist and depth of this definition.

The problem with this definition is that the conditions cited rarely exist in the real world of selling or buying a business. For example, the definition states that the sale of the business cannot be conducted under any duress, and neither the buyer nor the seller can be pushed into the transaction. Such factors as emotion and sentimental value cannot be a part of the sale. Surprisingly, under this definition, no actual sale or purchase has to take place to establish fair market value. That’s probably because one could never take place using the definition.

So what does make up the value of a privately-held business? A business consists of tangible and intangible assets. The tangible assets are the most visible and the ones on which buyers too often base a judgment on the value of a business. Factors of value, fixtures, equipment and leasehold improvements are often valued first by the buyer. Well maintained equipment and attractive interior surroundings are the first things a buyer sees when visiting a business for sale. Make no mistake, regardless of what prospective buyers may say, the emotional impact of a physically well-maintained business can be a very positive factor. In addition, it is much easier to finance tangible assets than intangible ones.

However, buyers have to consider what is really behind those well-maintained tangible assets. There are many businesses, especially today, in which physical assets play a very small part in the success of the business. These intangible factors include: the business’ reputation with its customer or client base, and within its industry; mailing lists and customer/client lists; quality of product or service; reputation with its vendors and suppliers; strength of the business’ technology and other systems; plus many other factors that can add a lot more value to the price of the business than can shiny equipment.

Although the intangible assets listed above cannot be seen, they are certainly an important part of the business – and purchase price. Businesses that don’t need expensive fixtures and equipment can, in many cases, be expanded more quickly and inexpensively because they do not require cash-intensive equipment purchases. Buyers, to their own detriment, do not want to pay the same price for equivalent cash flow for businesses that do not have lots of equipment. They want to buy tangible assets.

Business brokers and intermediaries know how to point out to prospective buyers the advantages of businesses that may not require lots of equipment but have those all-important intangible assets that create steady cash flow. Business owners who have a service or other type of business that does not rely on the heavy use of tangible assets and are considering selling, should talk to their professional business broker/intermediary who can point out the pluses and the hidden assets of the business.

A Different Look at Valuing Your Company

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Is there pricing elasticity?
What’s proprietary?
What’s the company’s competitive advantage?
Status of employment agreements and non-competes?

Post-Acquisition:
Are there cost savings after purchase?
Are there significant capital expenditures pending?
Is there synergy with the seller?
Is it perceived the integration will go smoothly?
Are there substantial cross-selling possibilities?
Will the cultures blend?

The Financials: By training and education, many business appraisers emphasize the numbers. They will look at the past, current and future numbers. They will consider all the basic financial figures such as:
• growth rate
• return on investment
• gross profit percentage
• EBITDA percentage
• industry metrics
• debt to net worth
• book value

Fundamentals: Business appraisers should also consider the company’s history, its management, products, distribution, etc. The following should also be seriously considered: multi-products, different markets, wide distribution and the quality of management.

Value Drivers: These are important business elements that are most often ignored or completely overlooked by business appraisers.  However, they are very important to a potential buyer.
• product differentiation
• defensible position
• technology
• dominant market share
• well-known brand(s)
• cost advantage
• proprietary customer

Creating Value in Privately Held Companies

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“As shocking as it may sound, I believe that most owners of middle market private companies do not really know the value of their company and what it takes to create greater value in their company … Oh sure, the owner tracks sales and earnings on a regular basis, but there is much more to creating company value than just sales and earnings”
     Russ Robb, Editor, M&A Today

Creating value in the privately held company makes sense whether the owner is considering selling the business, plans on continuing to operate the business, or hopes to have the company remain in the family.  (It is interesting to note that, of the businesses held within the family, only about 30 percent survive the second generation, 11 percent survive the third generation and only 3 percent survive the fourth generation and beyond).

Building value in a company should focus on the following six components:

  • the industry
  • the management
  • products or services
  • customers
  • competitors
  • comparative benchmarks

The Industry – It is difficult, if not impossible, to build value if the business is in a stagnating industry.  One advantage of privately held firms is their ability to shift gears and go into a different direction.  One firm, for example, that made high-volume, low-end canoes shifted to low-volume, high-end lightweight canoes and kayaks to meet new market demands.  This saved the company.

The Management – Building depth in management and creating a succession plan also builds value.  Key employees should have employment contracts and sign non-compete agreements. In situations where there are partners, “buy-sell” agreements should be executed. These arrangements contribute to value.

Products or Services – A single product or service does not build value.  However, if additional or companion products or services can be created, especially if they are non-competitive in price with the primary product or service – then value can be created.

Customers – A broad customer base that is national or international is the key to increasing value.  Localized distribution focused on one or two customers will subtract from value.

Competitors – Being a market leader adds significantly to value, as does a lack of competition.

Comparative Benchmarks – Benchmarks can be used to measure a company against its peers.  The better the results, the greater the value of the company.

Three keys to adding value to a company are: building a top management team coupled with a loyal work force; strategies that are flexible and therefore can be changed in mid-stream; and surrounding the owner/CEO with top advisors and professionals.

The Value of a Business: Get to the Heart of the Matter

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What is the value of your business? There are many ways to approach that question — based on complex formulas or just a good hard look at the balance sheet, but no answer based purely on numbers is going to be exactly right. Even factoring in that most popular of abstracts — goodwill — the true essence of an operation is not likely to be revealed.

To find the real value of a business, we must go to its very heart: the attitude, work habits, managerial style, customer/marketplace savvy, and community reputation of the person in charge. The business owner or manager is the final, and most cogent, indicator of business worth. Check out the following healthy signs, and then listen to the heartbeat of your own business and its leadership style:

Optimistic Attitude

Many business owners today are more pragmatic and take pride in being less of an “incurable optimist.” The owner of yesterday wasn’t afraid to follow the words of Willy Loman in Death of a Salesman: “A salesman has got to dream, boy. It comes with the territory.” A decline in optimism is an unfortunate trend. In a world driven by technology and scientific analysis, it’s easy to forget the importance of the right attitude. If business owners aren’t positive, how can they expect customers and employers to be? The owner who believes business is bad will probably not see it getting any better. Of course, there are always the real-life factors — banks that won’t lend, customers who stop buying, services that become obsolete. However, if these problems didn’t exist, there would be something else to keep the negative thinkers occupied.

How to project a positive attitude? Begin with the easiest. Sprucing up the place of business with fresh paint, newly-cleaned carpeting, well-stocked shelves, for example, will say a lot for the health of a company. Less visible, but highly important, is a positive outlook on the future of the business. Business owners should be prepared to spend what it takes to generate new business, and should take the time to explore new possibilities for long-range success. If the company currently has no mission statement or business plan, creating one will speak volumes abut owner’s enthusiasm for the future of the operation.

Healthy Managerial Style

In the modern workplace, where you can hardly see the business through the forest of “managers,” it’s good to get back to basics. Too often, owners get bogged down in busy work, or in “managing the managers.” They should occasionally take time off to work the floor, drive the delivery truck, sell the product. Owners who put themselves in the trenches are in touch with the business — and this first-hand understanding will be evident to anyone taking stock of the company’s worth.

An equally healthy approach to managing is preparing for contingencies. The owner’s style should include appropriate delegation of duties and a backup managerial plan in case of unforeseen calamity.

And finally, owners should project a general sense of well-being and energy. This may be easier said than done, but it’s important to note. Anyone taking stock of a business will draw a quick, and key, first impression from the very posture and tone of voice the owner presents.

Customer relations say a lot about the “heart” of a business. The business owner’s approach to handling customers sets the standard for everyone down the ladder. A healthy business avoids treating the customer like a number — or maybe worse, like a stranger. For example, successful big-time operations who deal with customers by telephone make it a point to ask for the proper pronunciation of a name, or request permission to use the customer’s first name. Added to basic courtesies is the sense that salespeople are happy to take the time necessary to answer questions and/or deal with problems.

Whether products and services are sold by phone or on the floor, employees should be well-versed experts on whatever they’re selling. Again, large outfits have established high standards to emulate; for instance, the outdoor equipment chain with salespeople who can not only fit hiking boots to a T (or a toe), but also know how to clean, weatherproof and care for the leather, vibram, or nylon of which the boots are made. Every hour spent training salespeople in the product pays huge dividends for the company’s long-term success.

Conspicuous Image

To foster the image of an on-going, healthy business concern, business owners need to keep their image prominent before the public. Advertising can build image at the same time it attracts business. Anything from a display ad within the yellow pages listings, to a monthly “home-baked” newsletter, to the offering of free seminars, can portray the business as more than just the sum of its products. An example of image-making at its best comes from the owner of a natural foods store in a metrowest Boston town. She not only produces her own monthly newsletter (with product information and coupons, plus general health articles), but she also sponsors evening lectures on subjects such as acupuncture, aromatherapy, women’s health, and children’s nutrition. What’s more, she offers free tours of her in-house cookie “factory” to local schools. The samples the kids take home are the best cost-per-inch ad value imaginable!

For the less adventurous, there are plenty of conservative ways to make ads pay. Every Saturday for years, the sports section of a Los Angeles newspaper carried a one-inch ad for the “Best Hamburger in Town.” No catchy phrases, no dazzling graphics, but the ad was there — and there — and there again. The consistency sold the restaurant’s product and its image and eventually, the eatery became a 10 plus chain.

Community Involvement

To further promote the business — and its owner — as a rock-solid and permanent part of the local scene, there are opportunities just waiting to be tapped. Taking an active role in the Chamber of Commerce, trade or service associations, or sponsoring worthy local events all lead to great public relations. In addition to the more traditional public donations — providing kids’ sports team uniforms, taking out ads in yearbooks — the business can band together to join walkathons, or volunteer to man the phones for public TV or radio fundraisers. Doing “good” makes the business owner and the employees feel good about themselves.

“Feeling good” is a good point at which to conclude our journey to the heart of a business. Dollars and cents will always be important in establishing value, but it’s a kind of people-sense that will give the truest reading.

12 Ways to Increase the Value of Your Company

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1. Build a solid management team. A business with sales of $5 million and up needs a full complement of officers and directors. Such a team might include: a COO, a CFO, a sales manager and, depending on the type business, an IT director. It is also beneficial to create a Board of Directors with at least two outside members. This professionalizing of management can remove the stigma of “the one man band.” Not only will this build a stronger company, it will increase the value to a possible acquirer. Smaller firms should also build a strong management team, and creating an outside advisor group is also a good idea.

2. Loyal employees.  Happy and loyal employees make for a strong company.  Top management should have non-compete and/or confidentiality agreements.  Solid benefits plans for all employees should be in place. A company’s greatest asset is its employees and perhaps its biggest value-increaser.

3. Growth. Some smaller companies are kept small to maximize the owner’s benefits – the proverbial “cash cows.” However, if building value is the goal, then developing new products or services, building market share, expanding markets or opening new ones, is critical. This generally requires a financial investment, but building a strong growth rate also builds value.

4. Understanding your market. The value of a company may be contingent on its industry, its place in the industry and the direction of the industry itself. How big is the industry, is it headed up or down, who is the competition and how big is the company’s market share? Is it time to change direction or diversify?

5. Size counts. Companies with less than $5 million in sales and an EBITDA of less than $1 million can be perceived as small. Therefore, they may be dependent on continuing outside financing and lack the critical mass for both buying and selling power. These companies can be perceived as too small for acquisition or are penalized when it comes to value. However, over the past few years corporate buyers, as well as private equity firms, have seen the advantages of purchasing smaller firms. Obviously, companies with $10 million or more in sales and an EBITDA of $1 million or more are considered as solid and able to stand on their own.

6. Changing direction.  Small companies can be very adept at changing course and implementing change. They have to be able to change and move quickly to take advantage of new markets, to fill voids in existing markets and even to add or change products or services.

7. Documentation. Business plans, financial plans and personnel plans should all be in writing – and kept current. Terms of employment agreements should be spelled out and in writing. Business planning and company objectives, etc., should also be in writing and reviewed periodically. Contracts should be reviewed and maintained on a current basis.

8. Diversification. A major problem with many small companies is that their business is concentrated on one or two major customers or clients. Ideally, no customer or client should represent more than 10 percent of sales. Expanding to new markets, introducing new products, and finding new customers must be considered without deviating too far from the company’s core business.

9. Name and brand identity. Nothing beats the name Walt Disney, or Kleenex® or the soft drink called Coke® – they are household names. Small firms may not have the brand or name recognition of these companies, but they can work at it. This recognition is especially powerful in the consumer product area. But franchising has expanded this name or brand recognition to many different types of businesses.

10. Taking advantage of proprietary and other assets. Patents, brand names, copyrights, alliances, and joint ventures are all examples of not only proprietary assets, but, in many cases, valuable ones. Even equipment can be used in several different ways. Large landscape companies in cold climates put snowplows on their trucks, utilize their existing workforce and become a snowplowing company for their regular landscaping customers — office complexes, apartment and condo developments, etc.

11. “Lean and Mean.”  Many companies lease their real estate needs, outsource their payroll, have their manufacturing done offshore, have UPS handle all of their logistical needs. Since all non-core requirements are done by someone else,  the company can focus its efforts on what they do best.

12. Do it now! The owners of small firms, even large ones, have an attitude that says, “I don’t have time now, I’ll do it tomorrow” or “I’m too busy now putting our fires.” So the real challenges of building the business, and value, get sidetracked or put off indefinitely. Creating value is critical to the long-term (and short-term) success of the business.

Keep in mind that the best time to consider selling is when business is good, the business is running profitably, and many of the above “value-adders” are in place. By contacting your local professional intermediary you can explore which of the above will add the most value to your firm, so it will be ready to sell when you are.

What Is a Company Worth?

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This question can only be answered by addressing other related questions, specifically: Who’s asking and for what purpose?

From the perspective of the owner, prospective buyers, the IRS, lenders and divorce & bankruptcy courts, the value of a business for purposes of a sale, estate planning, orderly or forced liquidation, gifting, divorce, etc. can be vastly different.

Intrinsically tied to the various purposes of valuation are numerous definitions of “value.” Here are a few examples:

Investment Value – The value an acquirer places on a business based on a future return on investment determined by assessing past and current performance, future prospects, and other opportunities and risk factors involving the business.

Liquidation Value – The value derived from the sale of the assets of a business that is closed or expected to be closed following the sale.

Book Value – Book value is the difference between the total assets and total liabilities as accounted for on the company’s balance sheet.

Going Concern Value – Used to define the intangible value which may exist as a result of a business having such attributes as an established, trained and knowledgeable workforce, a loyal customer base, in-place operating systems, etc.

Fair Market Value
For the purpose of this article, the focus will be on transaction related valuations. Fair Market Value (“FMV”) is the most relevant definition of “value” and is of the most interest to business owners. The more knowledge business owners and prospective buyers have about the valuation process, the more likely they will come to an agreement on a purchase price.

FMV is the measure of value most used by business appraisers, as well as the Internal Revenue Service (IRS) and the courts. FMV is essentially defined as “the value for which a business would sell assuming the buyer is under no compulsion to buy and the seller is under no compulsion to sell, and both parties are aware of all of the relevant facts of the transaction.” IRS Revenue Rule 59-60 lists the following factors to consider in establishing estimates of FMV:

1. The nature and history of the business.
2. The general economic outlook and its relation to the specific industry of the business under review.
3. The earnings capacity of the business.
4. The financial condition of the business and the book value of the ownership interest.
5. The ability of the business to distribute earnings to owners.
6. Whether or not the business has goodwill and other intangible assets.
7. Previous sales of ownership interests in the business and the size of ownership interests to be valued.
8. The market price of ownership interests in similar businesses that are actively traded in a free and open market, either on an exchange or over-the-counter.

What is Goodwill?
An important element of value, when it exists, is goodwill. The IRS defines goodwill in its Revenue Rule 59-60, stating, “In the final analysis, goodwill is based upon earning capacity. The presence of goodwill and its value, therefore, rests upon the excess of net earnings over and above a fair return on the net tangible assets. While the element of goodwill may be based primarily on earnings, such factors as the prestige and renown of the business, the ownership of a trade or brand name, and a record of successful operation over a prolonged period in a particular locality, also may furnish support for the inclusion of intangible value. In some instances it may not be possible to make a separate appraisal of the tangible and intangible assets of the business. The enterprise has a value as an entity. Whatever intangible value there is, which is supportable by the facts, may be measured by the amount by which the appraised value for the tangible assets exceeds the net book value of such assets.”

Valuation Approaches and Methods
Exploring valuation techniques requires an understanding of the tools available. Which tools are utilized depends in part on the purpose of the valuation and the circumstances of the subject company. Generally there are several approaches to valuing a business. Within these approaches, there are several different methods. Listed below are the three major approaches along with some examples of specific methods that fall under each category.

• Income Approach
Discounted Cash Flow Method
Single Period Capitalization of Earnings Method
• Market Approach
Comparable Publicly Traded Company Analysis
Comparable Merger & Acquisition Analysis
• Asset-Based Approach
Adjusted Net Asset Method
Excess Earnings Method

All of the above methods and approaches are frequently used in business valuations.

Normalizing the Financial Statements
Before the approaches and methods above can be applied, it is necessary to analyze and normalize both the income statement and balance sheet of the business for the current and past periods selected to form the basis of the valuation.

• Normalizing the Income Statement

Normalizing the Income Statement generally entails adding back to earnings certain personal expenses, non-recurring and non-cash items. Examples of these “add-backs” could include depreciation, amortization, auto, boat and airplane expenses, one-time extraordinary expenses and other excess expenses such as owner’s salaries and family member’s salaries that are above fair market value, travel and entertainment, bonuses, etc. Owners usually tend to be extremely liberal when normalizing the income statement in order to bolster earnings, which can artificially inflate valuation. Each item must be carefully analyzed and scrutinized to insure that the normalization process is credible.

• Normalizing the Balance Sheet

Normalizing the Balance Sheet includes adjustments that eliminate non-operating assets and other assets and liabilities that are not included in the proposed transaction, and therefore the valuation. The book value of the assets will be adjusted up or down to reflect their fair market value. Inter-company charges will also be eliminated. Inventory may be adjusted upward or downward based on prior accounting procedures and/or obsolescence. Accounts receivable may also require an adjustment based on an analysis of collectibility.

Relevant Terminology:

EBIT – An acronym for earnings before interest and taxes

EBITDA – An acronym for earnings before interest, taxes, depreciation and amortization.

Capitalization Rate – Any divisor that is used to convert income into value. This is generally expressed as a percentage.

Discount Rate – The rate of return that is used to convert any future monetary gain into present value.

(Note: when determining FMV, the earnings stream selected to be capitalized or discounted should be normalized.)

Summary
Even with all the terminology and definitions discussed above, the answer to the original question has not yet completely been answered: What is the company worth?

The value driver of a business is the ability of the entity to generate future cash flow or earnings. Business appraisers will assign an appropriate capitalization rate (or multiple) to a selected earnings stream to derive an overall value for a business. The value of the net assets of the business will be compared to the cash flow valuation and may be adjusted upward or downward. For example: if the earnings based valuation is less than the net asset value, an upward adjustment may be in order. Conversely, if the net assets are negligible, a downward adjustment is more likely to occur.

Many appraisers typically use a common range of multiples to arrive at a “ballpark” indication of value (for example, 4 to 6 times EBITDA). While this approach is commonplace, an in-depth valuation of the subject company will produce a more accurate result. There are too many intangible factors to be considered to rely solely on the capitalization of earnings. Of course, the ultimate value of a company will be determined by the marketplace, which can greatly differ from a seller’s expectation, as well as the expectations of potential acquirers.

It is not uncommon for business owners to have an inflated sense of value of their company. This could be due to a variety of factors including emotional attachment to the business, unwillingness to accept the impact of the risk factors of the business, outside influence from previous market conditions, incorrect conclusion of normalized earnings, comparable transactions, etc. Conversely, acquirers often undervalue businesses. In their quest to “buy right” they often end up paying a lower multiple for a company with serious negative factors, while passing up on higher multiple opportunities, which, due to the quality, are actually better buys.

Valuation is a complex process. Owners and buyers will be well served if they rely on professional advisors such as their accountants, business appraisers, intermediaries or investment bankers.

Buying a Franchise: What It’s Worth to You

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If you are considering entering the world of franchising, an important consideration is assessing the value of the business. All of the following factors either affect or help determine valuations of typical franchise operations:

1. Franchise Agreements:

Typically, franchise agreements can cover a period of twenty years; sometimes with added options. In most situations where a franchise unit has fewer than ten years remaining on the agreement (and options, if any), the value would diminish proportionately.

2. Territory Exclusivity:

Many franchisors do not, as a matter of course, provide an “exclusive” to franchisees within a given territory. More commonly, however, the franchisor will offer a franchisee limited protection for five years, during which time only he or she will be allowed to expand operation to additional units. Even limited protection can be assigned some value; any current territorial rights may have additional — and significant — value.

3. Business Hours

Potential franchisees should consider operating hours when assessing the value of a business. Business in general, and franchise operations in particular, are staying open for increasingly longer periods — some operate 24 hours a day, seven days a week. Locations in certain areas — city centers, bus stations, train depots — may open for shorter hours and fewer days. Since most business owners/managers would prefer the less demanding hours of operation, a premium value will be placed on these units.

4. Location:

This is the most obvious variable. A franchise operation in a suburban or small-town setting has a higher value than one in an inner-city or high-crime-rate area, regardless of other similarities (rent, sales volume, etc.).

5. Cash Flow:

Surprisingly, profitability may not necessarily be the key factor in valuing a franchise operation. A demonstrated, well-documented cash flow can definitely add value to the unit; however, the smart buyer will also look at other variables, such as unusually low food costs or labor costs, sales history, and potential for growth or improvement under new management in determining the overall value. Extreme situations provide the obvious exceptions to importance of cash flow: where the cash flow is extraordinarily high, capitalization of earnings becomes a truer method of valuation; where the franchise is actually losing money due to inefficient management, there would be some reduction in value.

6. Leases:

Taking into consideration market variation, the typical rent will be set at approximately ten percent of retail sales. Modifications in value could result if the lease does not cover a period of at least ten years.

7. Remodeling:

Many franchise agreements will require units to be refurbished within a certain number of years (ten is typical), with the franchisee bearing the cost. Since these costs typically fall within a range from $75,000 to $150,000, potential franchisees should pay particular attention to where the operation stands on this timeline. For example, a unit due for remodeling in a year or less could be reduced in value by a fair percentage of the cost of the improvements. The total cost would not be deducted from the value, since these improvements would also be expected to improve business anywhere from five to twenty-five percent.

Why Use a Business Broker

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A professional business broker can be helpful in many ways. They can provide you with a selection of different and, in many cases, unique businesses, including many that you would not be able to find on your own. Approximately 90 percent of those who buy businesses end up with something completely different from the business that they first inquired about.

Business brokers are also an excellent source of information about small business and the business buying process. They are familiar with the market and can advise you about trends, pricing and what is happening locally. Your business broker will handle all of the details of the business sale and will do everything possible to guide you in the right direction, including, if necessary, consulting other professionals who may be able to assist you.

Your local professional business broker is the best person to talk to about your business needs and requirements.

Seize the Moment — Tips for Sellers (Option B)

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If you have made the decision to sell your business, the wisest first move is to contact a qualified business broker professional, who can . . .

  • Advise you on pricing and structuring the sale of your business.
  • Prepare the marketing strategy, using professional resources.
  • Determine the right buyer for your particular business.
  • Educate buyers in the business-buying process.
  • Keep you informed about market reaction.
  • Present offers and point out strengths and weaknesses.

When it comes time to sell, one of the best decisions a business owner can make is to continue managing his or her business efficiently (and profitably), while depending on the services of a business broker to forge the steps of the sale. The business broker professional is an invaluable advisor during the entire process, offering both objectivity and negotiation skills honed through years of experience in the buying and selling of businesses.

Financing Facts

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There still aren’t too many ways to finance the purchase of a business. Here are the primary methods:

Buyer Financing

Some buyers may have the cash available to purchase the business. Some may elect to use the equity in their residence, or other real estate. Others may have other assets that they can sell or borrow against.

Bank Financing

Banks may lend against a buyer’s assets as described above. They may also lend against the assets of the business, assuming there is sufficient value to support the loan. The business will also have to make sense to the bank, regardless of the asset value. In fairness to the banking system, many of the figures supplied by business owners have very little relationship to the actual earning power of the business.

Venture Capital Firms

These firms do not, as a practice, lend to small or even many mid-size businesses unless tremendous growth is anticipated. They also usually expect an equity position in the company.

SBA Loans

These have become more popular. There is now some competition among lenders for these loans. Many banks offer them, but the large non-bank companies seem to have the upper hand in both acceptance and service.

Other Sources

This category includes family, friends, relatives, credit cards and leasing companies. Some suppliers have been known to assist in the financing of a small business.

Seller Financing

This is, by far, the largest source of financing available for the purchase of a business. Many industry experts say that about 90 percent of small businesses sell with, or perhaps because of, the seller financing a good portion of the sale price. Buyers have much more confidence in the decision to purchase a business when the seller is willing to assist in the financing. The buyer has confidence that the seller believes the business will service the debt, in addition to providing a living wage.

The Advantages of Seller Financing

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Business owners who want to sell their business are often told by business brokers and intermediaries that they will have to consider financing the sale themselves. Many owners would like to receive all cash, but many also understand that there is very little outside financing available from banks or other sources. The only source left is the seller of the business.

Buyers usually feel that businesses should be able to pay for themselves. They are wary of sellers who demand all cash. Is the seller really saying that the business can’t support any debt or is he or she saying, “the business isn’t any good and I want my cash out of it now, just in case?” They are also wary of the seller who wants the carry-back note fully collateralized by the buyer. First, the buyer has probably used most of his or her assets to assemble the down payment and additional funds necessary to go into business. Most buyers are reluctant to use what little assets they may have left to secure the seller’s note. The buyer will ask, “what is the seller not telling me and/or why wouldn’t the business provide sufficient collateral?”

Here are some reasons why a seller might want to consider seller financing the sale of his or her business:

  • There is a greater chance that the business will sell with seller financing. In fact, in many cases, the business won’t sell for cash, unless the owner is willing to lower the price substantially.
  • The seller will usually receive a much higher price for the business by financing a portion of the sale price.
  • Most sellers are unaware of how much the interest on the sale increases their actual selling price. For example, a seller carry-back note at 8 percent carried over nine years will actually double the amount carried. $100,000 at 8 percent over a nine year period results in the seller receiving $200,000.
  • With interest rates currently the lowest in years, sellers usually get a higher rate from a buyer than they would get from any financial institution.
  • Sellers may also discover that, in many cases, the tax consequences of financing the sale themselves may be more advantageous than those for an all-cash sale.
  • Financing the sale tells the buyer that the seller has enough confidence that the business will, or can, pay for itself.

Certainly, the biggest concern the seller has is whether or not the new owner will be successful enough to pay off the loan the seller has agreed to provide as a condition of the sale. Here are some obvious, but important, factors that may indicate the stability of the buyer:

  • How long has the buyer lived in the same house or been a home owner?
  • What is the buyer’s work history?
  • How do the buyer’s personal references check out?
  • Does the buyer have a satisfactory banking relationship?

Advantages of Seller Financing for the Buyer

  • Lower interest
  • Longer term
  • No fees
  • Seller stays involved
  • Less paperwork
  • Easier to negotiate

Financing the Business Purchase

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Where can buyers turn for help with what is likely to be the largest single investment of their lives? For most small to mid-sized business acquisitions, here are the best ways to go:

Personal Equity

Typically, anywhere from 20 to 50 percent of cash needed to buy a business comes from the buyer and his or her family. Buyers who invest their own capital (usually an amount between $50,000 and $150,000) are positively influencing other investors or lenders to participate in financing.

Seller Financing

This is one of the simplest and best ways to finance the acquisition, with sellers financing 50 to 60 percent–or more–of the selling price, with an interest rate below current bank rates, and with a far longer amortization. Many sellers actively prefer to do the financing themselves, thereby increasing the chances for a successful sale and the best possible price.

Venture Capital

Venture capitalists are becoming increasingly interested in established, existing entities, although this type of financing is usually supplied only to larger businesses or startups with top management and a good upside potential. They will likely want majority control, will want to cash out in three to five years, and will expect to make at least 30 percent annual rate of return on their investment.

Small Business Administration

Similar to the terms of typical seller financing, SBA loans have long amortization periods. The buyer must provide strong proof of stability–and, if necessary, personal collateral, but SBA loans are becoming more popular and more “user friendly.”

Lending Institutions

Those seeking bank loans will have more success if they have a large net worth, liquid assets, or a reliable source of income. Although the terms are often attractive, the rate of rejection by banks for business acquisition loans can go higher than 80 percent.

Source of Small Business Financing (figures are approximate)

Commercial bank loans 37%
Earnings of business  27%
Credit cards  25%
Private loans  21%
Vendor credit  15%
Personal bank loans 13%
Leasing  10%
SBA-guaranteed loans 3%
Private stock  0.5%
Other 5%

Financing the Business Acquisition

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The epidemic of corporate downsizing in the US has made owning a business a more attractive proposition than ever before. As increasing numbers of prospective buyers embark on the process of becoming independent business owners, many of them voice a common concern: how do I finance the acquisition?

Prospective buyers are aware that the credit crunch prevents the traditional lending institution from being the likely solution to their needs. Where then, can buyers turn for help with what is likely to be the largest single investment of their lives? There are a variety of financing sources, and buyers will find one that fills their particular requirements. (Small businesses – those priced under $100,000 to $150,000 – will usually depend on seller financing as the chief source.) For many businesses, here are the best routes to follow:

Buyer’s Personal Equity

In most business acquisition situations, this is the place to begin. Typically, anywhere from 20 to 50 percent of cash needed to purchase a business comes from the buyer and his or her family. Buyers should decide how much capital they are able to risk, and the actual amount will vary, of course, depending on the specific business and the terms of the sale. But, on average, a buyer should be prepared to come up with something between $50,000 to $150,000 for the purchase of a small business.

The dream of buying a business by means of a highly-leveraged transaction (one requiring minimum cash) must remain a dream and not a reality for most buyers. The exceptions are those buyers who have special talents or skills sought after by investors, those whose business will directly benefit jobs that are of local public interest, or those whose businesses are expected to make unusually large profits.

One of the major reasons personal equity financing is a good starting point is that buyers who invest their own capital start the ball rolling – they are positively influencing other possible investors or lenders to participate.

Seller Financing

One of the simplest – and best – ways to finance the acquisition of a business is to work hand-in-hand with the seller. The seller\’s willingness to participate will be influenced by his or her own requirements: tax considerations as well as cash needs.

In some instances, sellers are virtually forced to finance the sale of their own business in order to keep the deal from falling through. Many sellers, however, actively prefer to do the financing themselves. Doing so not only can increase the chances for a successful sale, but can also be helpful in obtaining the best possible price.

The terms offered by sellers are usually more flexible and more agreeable to the buyer than those offered from a third-party lender. Sellers will typically finance 50 to 60 percent – or more – of the selling price, with an interest rate below current bank rates and with a far longer amortization. The terms will usually have scheduled payments similar to conventional loans.

As with buyer-equity financing, seller financing can make the business more attractive and viable to other lenders. In fact, sometimes outside lenders will usually have scheduled payments similar to conventional loans.

Venture Capital

Venture capitalists have become more eager players in the financing of large independent businesses. Previously known for going after the high-risk, high-profile brand-new business, they are becoming increasingly interested in established, existing entities.

This is not to say that outside equity investors are lining up outside the buyer\’s door, especially if the buyer is counting on a single investor to take on this kind of risk. Professional venture capitalists will be less daunted by risk; however, they will likely want majority control and will expect to make at least 30 percent annual rate of return on their investment.

Small Business Administration

Thanks to the US Small Business Administration Loan Guarantee Program, favorable financing terms are available to business buyers. Similar to the terms of typical seller financing, SBA loans have long amortization periods (ten years), and up to 70 percent financing (more than usually available with the seller-financed sale).

SBA loans are not, however, a given. The buyer seeking the loan must prove stability of the business and must also be prepared to offer collateral – machinery, equipment, or real estate. In addition, there must be evidence of a healthy cash flow in order to insure that loan payments can be made. In cases where there is adequate cash flow but insufficient collateral, the buyer may have to offer personal collateral, such as his or her house or other property.

Over the years, the SBA has become more in tune with small business financing. It now has a program for loans under $150,000 that requires only a minimum of paperwork and information. Another optimistic financing sign: more banks and lending institutions are now being approved as SBA lenders.

Lending Institutions

Banks and other lending agencies provide “unsecured” loans commensurate with the cash available for servicing the debt. (“Unsecured” is a misleading term, because banks and other lenders of this type will aim to secure their loans if the collateral exists.) Those seeking bank loans will have more success if they have a large net worth, liquid assets, or a reliable source of income. Unsecured loans are also easier to come by if the buyer is already a favored customer or one qualifying for the SBA loan program.

When a bank participates in financing a business sale, it will typically finance 50 to 75 percent of the real estate value, 75 to 90 percent of new equipment value, or 50 percent of inventory. The only intangible assets attractive to banks are accounts receivable, which they will finance from 80 to 90 percent.

Although the terms may sound attractive, most business buyers are unwise to look toward conventional lending institutions to finance their acquisition. By some estimates, the rate of rejection by banks for business acquisition loans can go higher than 80 percent.

With any of the acquisition financing options, buyers must be open to creative solutions, and they must be willing to take some risks. Whether the route finally chosen is personal, a seller, or third-party financing, the well-informed buyer can feel confident that there is a solution to that big acquisition question. Financing, in some form, does exist out there.

Friends and Family: A Financing Option

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The first job facing many prospective business owners is rounding up the cash necessary to make the purchase. They may find that banks have made borrowing difficult (or all but impossible), and that even SBA loans have requirements too stringent to meet. One viable option is obtaining financing from the seller; another is to seek help from family and friends.

Borrowing money from family members and/or friends is one of the most frequently-used methods of small business financing. The pluses are obvious–there is trust, familiarity, and a general comfort level when dealing with those you know. The drawbacks are self-evident as well: “doing business” with family and friends comes with cautionary notes of legendary proportions. Everybody knows that family ventures can be complex and stressful, stirring up “bad blood” and lingering ill will. However, by taking the right preventive steps, buyers can take advantage of friendly financial help.

1. Set up an informal meeting to introduce your ideas.

This is the time to “feel out” friends and relatives casually, being sure they understand that this is strictly a fact-finding (and fact-presenting) meeting. Anyone who is not interested or cannot afford to be involved has plenty of opportunity to say so without feeling obligated–or emotionally “blackmailed.”

2. Follow up with a professional business plan.

Those who have indicated interest should now be treated with utmost professionalism. A formal business plan, including detailed financials, and a carefully-drafted business contract should be presented at this subsequent gathering. Consult a business professional for help in establishing a schedule for repayment based on the appropriate interest rates. Nothing will inspire more confidence in lenders than the care taken with this vital paperwork.

3. Be clear about the structure of the business envisioned.

How much voice are investors to have in the business? This is a vital question. Be sure that all parties understand whether this is to be a simple investment or some sort of partnership, and put this agreement in writing.

4. Take care in identifying your borrowing “targets.”

Sometimes willing and eager family members can’t really afford to invest. If possible, try to spread the borrowing around so that no one person bears the crux of the loan. It may take more energy to get smaller amounts from a larger circle of people, but the safety factors for all concerned will more than compensate for the time spent.

5. Keep your investors involved.

Once the buyer becomes an owner and the new business is in operation, friends and family lenders are due more than their repayment. They will want to be informed and updated about the progress of the business. Keeping in touch is a cost-free way to return the vote of confidence your friendly investors have placed in you.

Venture Financing: The Hard Facts

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Government financing and venture capital financing account for less than one percent of all new business financing. Sixty-seven percent of all small to mid-sized businesses are financed by personal savings or friends; thirty-three percent are financed by lending institutions. The facts about venture capital financing are especially cold and hard…

  • Venture capital is limited to high-growth potential, high capital-absorbing businesses.
  • Venture capital benefits as few as 1000 businesses a year, and then…
  • The average investment is $2.3 million, divided between 3-4 venture capital funds, which take 40-50-60 percent or more of the business’s equity.
  • Venture capital investors expect the business to grow to $25-50 million within 5 years–at which time the business will go public or be sold.

Negotiating the Price Gap Between Buyers and Sellers

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Sellers generally desire all-cash transactions; however, oftentimes partial seller financing is necessary in typical middle market company transactions. Furthermore, sellers who demand all-cash deals typically receive a lower purchase price than they would have if the deal were structured differently.

Although buyers may be able to pay all-cash at closing, they often want to structure a deal where the seller has left some portion of the price on the table, either in the form of a note or an earnout. Deferring some of the owner’s remuneration from the transaction will provide leverage in the event that the owner has misrepresented the business. An earnout is a mechanism to provide payment based on future performance. Acquirers like to suggest that, if the business is as it is represented, there should be no problem with this type of payout. The owner’s retort is that he or she knows the business is sound under his or her management, but does not know whether the buyer will be as successful in operating the business.

Moreover, the owner has taken the business risk while owning the business; why would he or she continue to be at risk with someone else at the helm? Nevertheless, there are circumstances in which an earnout can be quite useful in recognizing full value and consummating a transaction. For example, suppose that a company had spent three years and vast sums developing a new product and had just launched the product at the time of a sale. A certain value could be arrived at for the current business, and an earnout could be structured to compensate the owner for the effort and expense of developing the new product if and when the sales of the new product materialize. Under this scenario everyone wins.

The terms of the deal are extremely important to both parties involved in the transaction. Many times the buyers and sellers, and their advisors, are in agreement with all the terms of the transaction, except for the price. Although the variance on price may seem to be a “deal killer,” the price gap can often be resolved so that both parties can move forward to complete the transaction.

Listed below are some suggestions on how to bridge the price gap.

  • If the real estate was originally included in the deal, the seller may chose to rent the premise to the acquirer rather than sell it outright. This will decrease the price of the transaction by the value of the real estate. The buyer might also choose to pay a higher rent in order to decrease the “goodwill” portion of the sale. The seller may choose to retain title to certain machinery and equipment and lease it back to the buyer.
  • The purchaser can acquire less than 100% of the company initially and have the option to buy the remaining interest in the future. For example, a buyer could purchase 70% of the seller’s stock with an option to acquire an additional 10% a year for three years based on a predetermined formula. The seller will enjoy 30% of the profits plus a multiple of the earnings at the end of the period. The buyer will be able to complete the transaction in a two-step process, making the purchase easier to accomplish. The seller may also have a “put” which will force the buyer to purchase the remaining 30% at some future date.
  • A subsidiary can be created for the fastest growing portion of the business being acquired. The buyer and seller can then share 50/50 in the part of the business that was “spun-off” until the original transaction is paid off.
  • A royalty can be structured based on revenue, gross margins, EBIT, or EBITDA. This is usually easier to structure than an earnout.
  • Certain assets, such as automobiles or non-business-related real estate, can be carved out of the sale to reduce the actual purchase price.

Although the above suggestions will not solve all of the pricing gap problems, they may lead the participants in the necessary direction to resolve them. The ability to structure successful transactions that satisfy both buyer and seller requires an immense amount of time, skill, experience and most of all – imagination.

Key Items Necessary for Selling a Business

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  • Three years of profit and loss statements
  • Federal taxes for the same three years
  • Current list of fixtures and equipment
  • The lease and related documents
  • Franchise agreement (if applicable)
  • List of encumbrances, loans, equipment leases, etc.
  • Approximate amount of inventory on hand
  • Names of outside advisors with contact information
  • Marketing materials, catalogs, promotional pieces, etc.
  • Operations Manual (if available)
  • Brief history of business

What Makes a Business Unique

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Most business owners think that their business is unique. There are obviously many different attributes that can make a business stand out from others. However, there are some key factors that make a business both unique and, at the same time, make it more valuable in the marketplace and more desirable by prospective purchasers. Just as importantly, these unique factors also need to be generally transferable to a new owner. Here are some key ones:

Intangible Assets
One example of an intangible asset could be a long-term lease for a great location that is transferable to a new owner. Other examples include a mailing list of current and past customers, a popular franchise relationship, a well-known product line such as Hallmark, or a well-established mailing program designed to attract new customers or clients. Trademarks and copyrights are some other examples of intangible assets.

Difficulty of Replication
For example, in most jurisdictions, liquor licenses are doled out by population or on some other limited basis. One can not just decide to rent some space and open a liquor store. Franchises often limit the number of units in a geographical area. Selling certain brand collectibles is a license not granted to just any store.

Proprietary Products, Services or Technology
A business owner may have developed, or have had developed, software unique to their business which is a key to its success. Or the proprietary item could be something as simple as a secret recipe for a food item, sauce or other food product unique to a restaurant.

Reputation
There is the pharmacy that is known all over town for delivering prescriptions or other medical needs. And there is the hardware store that will still sharpen knives or fix screens. Then there are the local businesses that have “just what you need” or that special something that makes them known all over town. While these characteristics make these businesses unique, it is up to a new owner to continue them.

When looking at businesses to buy, buyers should look beyond the numbers for the unique qualities that separate a particular business from the pack.