Of all the misconceptions by business owners, the ones surrounding their company’s value are both the most common and often wildly inaccurate.
Asset vs Stock sale – About 90% of small business sales are asset transactions. Only about 10% close as a transfer of stock ownership. That will double the tax estimate from 20% capital gains to a 40% ordinary income rate. Businesses transfer debt-free. So if an owner owes anything on his credit line, that comes off the top from the proceeds, but the tax is also still payable and also comes off the top. The problem is exacerbated when a planner, not taking this into consideration, assumes that the owner has and knows the net value of his business.
Business Valuation – Business valuation is both an art and a science. There are many factors that go into developing the value of a business. They fall into two main groups, tangible factors and intangible factors. Each value is weighed based on how it affects the business performance, and what can be expected of the subject business going forward. Remember, a buyer is buying the ability to make money from the existing business.
Tangible factors – Tangible factors are easier to value. This is where the science of the valuation takes place. Tangible factors can be looked up or calculated. They include cash in the bank (if that is part of the deal), accounts receivable (assuming they are collectable) and inventory (assuming it is saleable). Other tangible factors include revenue produced over time, buildings owned by the business that are included in the sale, cash flow, obligations to employees (such as retirement plans, etc). Also included in this value are items that would decrease value such as losses, poor margins, or debt that will be assumed in the transaction.
Intangible factors – The discussion of intangible factors is where the art of business valuation becomes part of the equation. These factors include efficiency of the operations systems. Will the buyer have to come in and make an investment in the company to get it running more efficiently? Competition and product will also play a part in the value. If the product or service a company sells is changing due to technology, or is something that is no longer popular to own, the projected sales may be assumed to be decreasing, which would affect the value. The experience of the management team will also affect the value. After the owners of the company depart, does the existing management know how to take the company forward? And, there are factors such as customer base and satisfaction, competition, market share, industry position, vendor relations and location.
The Multiples – The multiples paid for businesses depend on the type of buyers they attract. Commonly, those that sell for less than $2,000,000 are considered “Main Street.” Their target buyers are individuals who are purchasing an income. They intend to work in the business, and to earn a regular paycheck by running it. Main Street pricing is typically between 2.1 and 2.8 times SDE (seller’s discretionary income) and based on simple arithmetic. The closer you come to 3 times SDE, the less a buyer is able to pay both the bank and himself. For larger companies, those that attract financial and industry acquirers, the multiples are higher, but the multiplier is lower. Those buyers anticipate paying for professional management, so the owner’s compensation is less of a consideration. They look at EBITDA (earnings before interest, taxes, depreciation and amortization) to calculate available cash after all the expenses of running the business are paid. These numbers are based on actual sales data and industry surveys. Sellers often confuse the terms revenue and income, or apply EBITDA multiples to SDE. They are greatly disappointed and angry when legitimate offers fall far below their expectations. Just because your planner or your banker didn’t challenge your valuation estimate doesn’t make it fact.
Engage a Valuation Professional to ensure you really know the value of your business and then take the valuation to your Accountant for tax modeling. Whether you are ready to sell or not, you should start with benchmarking your business. Benchmarking provides a means to compare your firm against other businesses, and identify areas where you can improve your performance. Email me now at DanYoung@b2bcfo.com to schedule a free business assessment. You will receive a complimentary benchmarking report for your business.
(Excerpted from the Awake at 2 o’clock? Business Ownership Blog)
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