The indemnification clause requires the parties to indemnify one another for breaches of representations, warranties and covenants, and other types of claims that may arise after the closing, such as those related to tax, environmental, or employee issues. The indemnification clause, sometimes called “hold harmless,” functions similarly to an insurance policy and requires the breaching party to reimburse the other party for all expenses resulting from a breach. 

The value of the indemnification depends on the financial strength and creditworthiness of the party providing the indemnification. In most M&A transactions, 10% to 20% of the purchase price is withheld by a third party in an escrow account to fulfill any post-closing indemnification obligations, which mitigates any impact of a less-than-creditworthy seller.

Indemnification rights are more specific than the general legal rights included in most contracts. The indemnification provisions include specific rules governing the level of involvement the parties may have in defending suits or other claims, and other options that are rarely afforded to the parties under other general legal rights in most purchase agreements. 

Examples of potential disputes include:

• Inaccurate financial statements 
• Violations of post-closing covenants, such as non-competes or non-disclosure agreements
• Tax claims
• Loss of key employees
• Loss of key customers
• Working capital calculations
• Undisclosed pending litigation
• Undisclosed material liabilities, such as unpaid bills 
• Undocumented employees

Who Provides Indemnification

It’s important to consider who specifically is providing the indemnification. If there are multiple shareholders of the selling company, are all shareholders indemnifying the buyer, or only the majority shareholders? Or is the selling entity indemnifying the buyer? 

In most cases, the majority-selling shareholders are required to indemnify the buyer personally. To be obligated under the indemnification clause, a selling shareholder must sign the purchase agreement directly or through a “joinder.” This is often the case because the selling entity normally ceases to exist after the closing date. If it does exist, the proceeds from the sale are normally distributed to the shareholders, and the selling entity is left with few assets with which to fund a potential indemnification claim. 

It’s difficult for the buyer to have to chase down multiple shareholders, which is why escrows are so prevalent. If there are multiple selling shareholders, the sellers should also attempt to limit their liability to “several,” or separate liability, as opposed to “joint and several” liability.

“An entrepreneur is someone who will work 24 hours a day for themselves to avoid working one hour a day for someone else.”

– Chris Guillebeau, American Author and Entrepreneur

Selling your business will be one of the most stressful events in your life, period. Make no mistake about it – selling a business is not an easy task. Nor can you hire an expert and expect them to handle the entire process for you without an immense amount of effort on your part. Not only is the process stressful, it is also tremendously complex and filled with potential landmines and other setbacks.

When I began helping entrepreneurs sell their businesses over 20 years ago, I scoured the market for useful information on the topic. Once I started my career, I discovered that most of this knowledge did not deal with many of the real-world problems I encountered when helping my clients sell their businesses. Rather, it was theoretical knowledge or was directed at large, publicly traded companies. Many of the books available on the topic were a random collection of insights that were difficult to apply in the real world.

I wrote this book for owners of companies valued from $500,000 to $10 million – or companies with earnings before interest, taxes, depreciation, and amortization (EBITDA) of $200,000 to $3 million per year. This size range tends to be a no-man’s land for most business owners. That’s because most business brokers may not be equipped to deal with a million-dollar transaction, while the majority of M&A firms are accustomed to handling much larger transactions. Another challenge for businesses in this size range is that the potential buyer can be either an individual or a corporate buyer, such as a competitor, private equity firm, or other company. The issue here is that the marketing strategies, negotiating tactics, and processes can be significantly different for these two groups of buyers. 

Whether you are searching online for general guidance or browsing books for a useful, concise description of the sale process for companies in this size range, you will have difficulty finding valuable, actionable information. To be sure, there is a lot of theoretical intelligence out there that is specifically helpful for academics. However, if you own a small business with less than $10 million to $30 million in annual revenue, most of the advice in these books will not be useful to you. Additionally, most books on the topic are written by academics, accountants, attorneys, financial planners, or business appraisers who have theoretical knowledge but may not necessarily have real-world experience selling businesses. 

This book offers a solution. If you are looking for clear, concrete, and practical advice grounded in real-world experience, you’ve come to the right place. These pages walk you through the entire sales process and offer advice based on my decades of experience helping entrepreneurs successfully sell their businesses. 

How This Book Can Help You 

Selling a large, established $500 million company requires an entirely different process than selling a small to mid-sized business. This book is written for owners of both Main Street and lower middle-market businesses valued at $500,000 to $10 million, or approximately $1 million to $30 million in annual revenue or $200,000 to $3 million in EBITDA – these are the small companies in America that keep our economic engine running. They are the service companies, manufacturing businesses, professional service firms, technology companies, construction businesses, wholesale or distribution businesses, manufacturers, small professional practices, medical practices, and other small businesses with fewer than 500 employees. 

Through my years of experience devoted exclusively to helping people buy and sell businesses, I realized that most business owners do not want answers to technical questions such as how to allocate the purchase price between the various assets. Rather, they want straightforward answers to basic questions such as:

• How long will it take to sell my business?
• What is my business worth?
• Should I tell my employees I am considering selling my business?
• Do I need to prepare my business for sale, or can I put it on the market now without advanced preparation?
• Should I finance a portion of the price? What if the buyer defaults?
• Who is most likely to buy my business?
• Should I take my business off the market when I accept an offer?
• What should I do if the buyer refuses to sign a non-disclosure agreement?
• What documents do I need to prepare before I put my business on the market?
• Can I sell a portion of my company?
• Do I need a business appraisal?
• Can the buyer get a bank loan to buy my business?
• How do I find and hire a broker, M&A advisor, or investment banker?
• What should I look for when signing an agreement with a broker or M&A advisor?
• What is the difference between an offer and a letter of intent?
• How can I prepare for due diligence?
• Does my attorney need M&A experience?
• What is escrow? 

In this book, I offer practical advice that even the busiest entrepreneurs can apply in their hectic lives. I also want to note that I wrote this book not only for sellers, but for anyone involved in the M&A process, such as buyers, attorneys, accountants, and business appraisers. For the sake of clarity, however, I address sellers directly throughout the book, but I wrote this book with all of you in mind.

As the incomparable Mark Twain once said “Twenty years from now, you will be more disappointed by the things that you didn’t do than by the ones you did do, so throw off the bowlines, sail away from safe harbor, catch the trade winds in your sails. Explore, dream, discover.” 

Sincerely, 

Jacob Orosz

The composition of your customer base can drastically affect the value of your business. Many buyers specifically look at the strength and diversity of a business’s customers when calculating a value. In this section, I’ll list and describe the key components of a business’s customer base and how they can affect value. 

Customer Base

Does your business cater to a strong, stable customer base – Fortune 500 firms, for example – that exhibits the ability and willingness to pay for your product or service? The stronger your customer base, the higher the purchase price you’ll receive. 

Acquirers of business-to-business (B2B) companies place a high value on relationships with large, established customers. They assume that if your product is good enough to satisfy the needs of these companies, the next challenge will be to scale your business by building a strong sales team and infrastructure. 

Most acquirers view building an engaging product as riskier than scaling a company through sales and marketing efforts. National or Fortune 500 customers also hold a strategic value for certain buyers as these relationships can serve as an opportunity to cross-sell their entire product lines to your customer base.

Blue-chip customers are also valuable in the eyes of most buyers because it’s easier to upsell to an existing account than to establish a new one. For example: 

Intuit, the parent company of QuickBooks, acquired Credit Karma for $7 billion in 2020. By acquiring Credit Karma, Intuit could market its other products to Credit Karma’s 100 million registered users. It’s much easier for Intuit to attempt to upsell 100 million existing customers that already have a relationship with Credit Karma than it would be for Intuit to acquire 100 million new customers.

Potential acquirers may purchase your business solely for the existence of the relationships your company has with well-established customers. The cost to acquire blue-chip accounts is high, and the existence of these relationships can therefore have a tremendous impact on the value of your company.

Customer Acquisition

If there’s a strong product fit between your customer base and the acquirer’s product line, it may be a prudent investment for the buyer to purchase your company solely for the value of your customer base, especially if time and lost opportunity costs are critical factors in your industry.

But customer acquisition cost is a double-edged sword. 

A high customer acquisition cost is good because it means your customer relationships are more valuable. 

For example, if the average customer acquisition cost in your industry is $5,000 and you have 1,000 customers, then it would cost a company $5 million ($5,000 x 1,000 = $5 million) to replicate the value of your customer base, assuming there is no overlap between your customer base and theirs. 

On the flip side, a high customer acquisition cost can be a negative factor because it limits the scalability of your business. The higher the customer acquisition cost relative to the lifetime value of each customer, the more costly it is to scale a business. 

For example, a business with a customer acquisition cost of $50 and a lifetime value of $10,000 would be considered highly scalable, whereas a business with a customer acquisition cost of $1,000 and a lifetime value of $2,000 would not be considered highly scalable. 

It’s the ratio that matters – not the absolute numbers.

Customer Database

A customer database, such as a CRM, is also valuable to buyers. That’s because, as previously noted, the acquirer can market their products to your existing customer database. Selling a product to an existing customer, or upselling, is easier than establishing a relationship with a new customer. 

A robust CRM offers the buyer the ability to roll out their product suite to your customer base. The more information your database contains – such as demographics or other targeted information – the better, because it allows the acquirer to develop more targeted campaigns. 

In the example of Credit Karma, it would be valuable for Intuit to know which Credit Karma customers own a business. Intuit could then develop targeted email campaigns offering those customers a free trial of QuickBooks or other solutions for small businesses. Intuit could also create targeted campaigns based on the user’s credit score. For example, they could offer lines of credit for those with high credit scores, or credit-builder programs for those with low credit scores. 

Regardless, the more information your customer base contains that allows the acquirer to develop targeted campaigns, the more value the buyer will see in the database. Without this information, Intuit would most likely alienate Credit Karma’s customer base if they frequently blasted out non-targeted campaigns to their customers. It would be akin to Pfizer sending emails touting the benefits of Viagra to a group of nuns. 

Critical Mass of Customers

Larger companies prefer that you have a critical mass of customers. A broad and diverse customer base is a strong indication that the quality of your products and services is high, which presents a lower risk to the company.

Customer Concentration

Customer diversity is perhaps one of the most critical factors for buyers. How diverse is your customer base? Is the majority of your revenue generated from just a few customers or do you have a broad base, meaning you’re not dependent on any one customer? Low customer concentration reduces risk for the buyer. If customer concentration in your business is high, buyers may view this as too risky. 

For example, if a substantial percentage of your revenue – let’s say 50% – is generated from just your top three customers, buyers may be uninterested because your income would decline significantly if you lost one or more of those key clients. 

Ideally, no single customer should generate more than 5% to 10% of your total revenue. The higher the concentration of any one customer, the higher the risk to a buyer. This risk is also higher if you have a weak management team that won’t be available after the closing to ensure a smooth handoff. If the customer primarily deals with employees who will stay with the company post-closing, the relationship is less likely to be jeopardized during the transition process.

Customer diversity is one of the most critical factors for buyers when evaluating a business.

Close Relationships With Customers

Do you have any close, personal relationships with any customers that would be unlikely to be maintained once you no longer own the business? Does your business have strong relationships with customers? A buyer will consider the transfer of customers as excessively risky if you have close, personal ties with clients, and less so if those relationships are with your company, not you personally.

Repeat Customers

What’s your customer retention rate? Having many repeat customers reduces attrition for the buyer and improves scalability. A high degree of repeat business from your client base lessens the need to rely on a consistent stream of new customers, which reduces risk and greatly enhances the value and marketability of your business. A customer base that’s less loyal than average increases risk and attrition, reduces scalability, and increases the need to rely on a consistent stream of new customers. The net result is increased risk and reduced returns, which can negatively affect the value of your company. The reverse can also be said – a repeat customer base is a strong value driver for any company.

Customer Contracts

Does your business require contracts with customers? Long-term agreements with key customers reduce risk for the buyer. If such agreements are lacking, important clients may choose to shop elsewhere once they learn of the sale. In most cases, businesses don’t have contracts with their customers, and customers are free to come and go as they please. Long-term contracts are viewed as favorable by buyers and are a major value driver. 

One additional important area of concern is the assignability or transferability of contracts in the event of a sale. This can apply to customer and third-party contracts, such as leases with landlords or vendor agreements. Many contracts don’t explicitly address assignability. This is considered a risk factor if the sale is structured as an asset purchase, and also if the contracts have a “change of control” provision in the event of a stock sale.

The types of products and services you offer can also affect the value of your business. 

• Concentration: How concentrated are your products and services? Is 100% of your revenue generated from one product or service? If so, buyers will view this as risky unless your products and services are insulated from competitive pressure in the future.
• Products in Development: Do you have any products in development that can add significant value to your business? If so, the buyer will perceive more value. However, it’s wise to hold off on selling your business until the product has been launched and proven viable in the marketplace. Otherwise, you must be prepared to sell your company based on an earnout, in which a portion of the purchase price is contingent on the performance of the product once it’s launched.
• Degree of Specialization: Does your business offer specialized or value-added products and services, or do you sell a product that’s a commodity? Businesses that sell commodities and that have little to no competitive advantages, such as brand awareness, sell at low multiples. 
• Outlook: Is the overall outlook strong for your industry, such as in the semiconductor sector, or is the outlook poor, such as that for gas stations? The stronger the projections are for your industry, the higher the multiple you’ll receive for your business. Does your business produce a product or service that’s in high demand regardless of the economic climate, such as food products, or does your business provide a discretionary product or service, such as luxury consumer items? The stronger the demand for your products and services, the more your business will be worth. 
• Intellectual Property: Does your business produce any products that are protected by intellectual property, such as patents, trademarks, or trade secrets? Businesses such as Coca-Cola and pharmaceutical companies, whose products are protected by intellectual property, are worth more than those that are not.
• Product Warranties: Are there any limited or ongoing warranty obligations in place? Ongoing warranty obligations represent a form of risk to buyers, which reduces returns.

The nature of competition in your industry will also greatly impact multiples. For example, if competition is highly fragmented, the potential for a rollup exists. A rollup occurs when an acquirer raises funds to consolidate your industry by completing multiple acquisitions and rolling them up into one large entity. Multiples can become temporarily inflated in an industry if a company is attempting a rollup amid limited acquisition opportunities. 

If your industry is highly consolidated and organic growth opportunities are difficult to achieve, multiples can also become inflated as acquirers fight over potential acquisition targets. If competition in your industry is strong, multiples can become depressed. That’s especially the case when it comes to dealing with buyers from outside of your industry, such as private equity groups. Private equity firms are reluctant to invest in any industry in which competition is intense and the business has a weak competitive advantage or value proposition. Similarly, if competition is fierce in your industry and your competitors have a strong competitive advantage, they’re unlikely to acquire your business and pay a high multiple unless they’re buying your customer base or some other aspect of your business that’s difficult to replicate.

When examining competition in your industry, here are some important criteria that can affect the multiple you receive:

• Future Indirect Competition: What’s the threat of potential future indirect competition in your industry? Not only must you take into account the strength of the competition within your industry, but you also must consider the potential threat of competition outside your industry. Uber destroyed the taxi business. Airbnb is slowly encroaching on the hospitality industry. Netflix and YouTube are slowly killing off traditional media businesses. If a similar threat looms over your industry, it can weigh on the multiple you receive. 
• Technology: How is technology affecting your company and its industry? If technology is likely to destabilize your industry, multiples will become depressed unless your business possesses some unique competitive advantage that’s difficult to replicate.
• Competitive Advantage: Does your business have a sustainable competitive advantage? If your business has a stronger-than-average competitive advantage that’s difficult to replicate, it will become an attractive acquisition opportunity to both industry and financial buyers. For example, IKEA’s competitive advantage is difficult for competitors to imitate, so it’s likely to be viewed as a much more attractive acquisition opportunity than other companies in its industry.
• Barriers to Entry: Do barriers to entry enhance the value of companies in your industry? Any factors that limit the ability of outsiders to compete in your industry have the ability to drive up multiples – regulations that restrict new entrants, for instance. The same goes for any potential protections from excessive competition within your industry or niche.
• Brand Awareness: Is your brand name well respected in your industry? Brand awareness is a strong competitive advantage for consumer brands. Businesses with a well-known brand that have a loyal gang of customers sell at higher multiples than those that do not. Companies with strong brands such as Apple, McDonald’s, Coca-Cola, Visa, and Starbucks will always be valued at higher multiples than competitors whose brands are less widely known.
• Online Presence: For mid-sized companies, the extent to which your business has a highly visible and functional online presence and favorable reviews can significantly affect its value. Businesses with a poor online reputation will always be difficult to sell and will therefore change hands at a significantly depressed price, regardless of other factors.

When valuing a business, the primary consideration for most investors is the industry in which the business operates. This is usually the starting point of any valuation because multiples for similarly sized companies tend to cluster around a tight range in most industries. For example, multiples for retail businesses might be 4.0 to 5.0 times earnings before interest, taxes, depreciation, and amortization (EBITDA). In contrast, multiples for manufacturing businesses might be 6.0 to 7.0 times EBITDA.

Once you’ve determined the range of multiples for your industry, identify where in the industry your business is positioned. How do your company’s growth trends, margins, and profitability compare to others in your industry?

Here are the primary industry-related factors that can affect the value of your company:

• Barriers to Entry: How difficult would it be for a newcomer to enter your industry? The higher the barriers to entry, the higher the multiples generally are because the barriers limit new competitive threats. Buyers are more likely to be interested in an existing business if it’s more cost-effective to acquire it than replicate it from scratch – the classic buy vs. build decision. 
• Acquisition Activity: Have there been any recent acquisitions in your industry? The greater the acquisition activity in an industry, the more your business is likely worth. That’s because multiples tend to rise along with an increase in acquisitions. 
• Industry Trends: Is your industry seasonal, cyclical, or countercyclical? If your industry is cyclical, multiples will decrease along with declines in the overall economy. If your industry is countercyclical, businesses in your industry may become much more attractive when there’s a downturn in the overall economy due to a lack of other attractive investment opportunities. In a weak economy, for instance, discount retailers fare better than high-end brands, and fast food companies perform better than upscale restaurants. The appeal of countercyclical businesses can become especially apparent with private equity firms in a depressed economy if they have access to significant capital to invest when there are few alternative investments available.
• Industry Desirability: The multiples in an industry generally reflect the degree to which businesses in the industry are considered attractive investments. For example, the average EBITDA multiple for publicly traded firms in the airline industry tends to average around 8.0, whereas the average EBITDA multiple for the medical equipment industry has ranged from 20 to 25. Why? Because companies in the medical equipment industry offer the potential for higher rewards and are perceived as less risky than airlines. Travel is largely expendable; healthcare is not. Many businesses in the healthcare space are scalable; airlines are not.
• Industry Growth: The higher the growth potential of an industry, the higher the multiples generally are. If growth potential is limited, such as for retail businesses, multiples tend to be lower. Industries with strong growth potential, such as technology, are valued at high multiples. 
• Scalability: Scalability is the ability of a business to grow rapidly without increasing costs. The more scalable your business is, the more it will be worth. Industries with businesses that offer the ability to scale exponentially – software companies, for example – sell at high multiples. Industries that are less scalable – such as retailers – sell at much lower multiples. An industry that’s perceived as being more stable than the average industry reduces risk and drives up multiples, especially for financial buyers such as private equity firms. 
• Ability to Replicate: One of the most significant factors affecting your multiple is the degree to which your business can be replicated. This is the classic buy vs. build decision for acquirers. For example, if your business is difficult to replicate because you hold a number of patents, your company will sell at a much higher multiple than if your business is easy to mimic. If your business is easy to replicate, a buyer may believe it’s more cost-effective to build a business from scratch than acquire your business. 
• Regulations: Are there any regulatory threats on the horizon in your industry? Is regulation minimal or stable? Regulations can play to your advantage if they result in barriers to entry that may limit competition. Heavily regulated industries – such as petroleum and coal products manufacturing – are influenced more by external factors than most industries. Risk is higher as a result, and multiples are lower in many highly regulated industries than in other sectors.

When valuing a business, the primary consideration for most investors is the industry in which the business operates.

“The intellect is always fooled by the heart.”

– François de La Rochefoucauld, French Writer

In a recent survey, Consumer Reports found that a “modern and updated kitchen” still rules when it comes to features favored by home buyers. And just as there are any number of factors that can affect the value of a house – a finished basement, for instance, or freshly painted high-traffic areas – there are many factors that can affect the value of your business. In this chapter, I’ll discuss the top ones. 

To be sure, the more profitable your business is, the more valuable it is. But there are many other factors at play, chiefly the buyer’s perception of risk and return.

Risk vs. Return

The primary reason a buyer may be willing to pay a premium price for your business centers on their perception of risk and return. Any factor that reduces the perceived risk associated with owning your business or that enhances the prospect that your business will generate significant returns will improve its value. Buyers will compare the risk and return of buying your business with the risk and return involved in alternative investments or other corporate development opportunities. As you review the factors outlined in this chapter, consider how they impact the buyer’s perception of the potential risk or returns associated with your business.

Collection of Factors

Many so-called experts believe the attractiveness of a business can be boiled down to 9 or 10 simple components, but the reality is much more complicated. In fact, many buyers consider dozens of factors when assessing a business and later focus on just a handful that represent the greatest risks or the opportunity for outsized returns. 

Despite the complexity of individual businesses, I’ve compiled a list of major factors that can affect the value of any business. While this list is by no means all-inclusive – in reality, there are hundreds of factors that can impact the value of your business – it’s representative of that larger detail. It’s unlikely that every factor below will be relevant to your company. But reviewing these items will help you see where your business is strongest and assist you in identifying those areas for improvement that represent the greatest opportunity for value creation. Familiarizing yourself with these considerations will help you understand and prioritize the universe of variables that may come into play when preparing to successfully exit your business.

Prioritizing Factors

Even if your business is otherwise pristine, all it takes is just one major deal killer – such as high customer concentration or the lack of a management team – to turn off a potential buyer. When considering all the factors that can potentially affect the value of your business, first scan all the possibilities and then zero in on the few elements that can have the greatest impact. An experienced M&A advisor will understand the type of buyer most likely to acquire your business and the handful of factors that category of buyer will focus on the most.

Absent their input, the considerations presented here are a valuable starting point.

What Can Impact Value vs. What You Can Do About It

Not all of the factors I cover here are actionable. For example, while interest rates can affect the value of your business, there’s nothing you can do about them. Likewise, while the industry you operate in can affect the multiple you receive, there’s little you can do to influence the dynamics of your sector as a whole. 

In this chapter, I explain the factors that can impact the value of your business but stop short of telling you what you can do about them. In the next chapter, I will walk you through many of these same factors and lay out specific actions you can take to enhance value, such as creating a strong management team or mitigating the effects of close personal relationships with key customers. But first, let’s examine the variables that can impact the value of your business, organized into the following major subjects: 

• Industry
• Competition
• Products and Services
• Customers
• Operations
• Staff
• Finance
• Legal
• Economic Factors
• Negotiating Skills
• Timing

The primary reason a buyer may be willing to pay a premium price for your business centers on their perception of risk and return.

As a business owner, one of the most important questions you’ll ask yourself is: What’s my business worth? To answer this question, most business owners pay a professional to value their business. Before you do the same, be sure you consider the following: 

• What type of valuation is best for your situation?
• How should the methods used to value your business change based on the type of buyer most likely to buy your business and the size of your business?
• Should you have an appraiser, a broker, or a CPA value your business? 
• How much does a business valuation or appraisal cost? 

Each of these questions will impact who you choose to value your business and the end value they arrive at for you. Next, I’ll describe each of these factors in more detail. 

The Process for Valuing a Business

While there aren’t universally standard steps to valuing a business, and the method can change depending on who you hire and the type of valuation you’re looking for, here’s a general outline of the process most professionals use to value a business: 

1. Data Gathering: Most appraisals start with an analysis of three to five years of your profit and loss statements, balance sheets, federal income tax returns, and a company questionnaire. While this stage of the process is most likely the most exciting part for CPAs, the data-gathering process is the most time-consuming part of the undertaking for you. This is because it involves gathering a large amount of financial and operating information on your company. 
2. Analyze and Normalize Financials: Once the appraiser has this information, they’ll normalize and analyze your financial statements by inputting them into a spreadsheet. This step also involves making adjustments to your financial statements to calculate EBITDA so your business can be compared with others in your industry. 
3. Additional Questions: The appraiser will need to communicate with you during this process since your involvement is key to the accuracy of the appraisal. 
4. Compile the Report: Once this step is complete, the appraiser will compile the report based on the information you’ve provided, as well as information the appraiser has already obtained about your industry.

Choosing the Right Type of Valuation

When considering whether you should have your business appraised, you have several options available to you. The various types of business valuations don’t have standard definitions, but most reports fall into one of three main categories: 

1. Verbal opinion of value
2. Written report for non-legal purposes, such as a business sale
3. Self-contained or formal appraisal

Verbal Opinion of Value

A verbal or oral opinion of value is suitable for any business owner who doesn’t need a written report. This type of valuation usually involves the appraiser, broker, or CPA reviewing your financial statements and offering a verbal estimate of value. Some M&A intermediaries offer this service for free, while most experienced experts will charge a fee. These types of reports are useful if you’re in the exploratory stages of selling your business and would like a ballpark idea of what your business is worth before committing more time, money, and effort to the process. A formal report isn’t essential for most businesses. 

Written Report for Non-Legal Purposes

This is sometimes called a Restricted Appraisal Report. These reports don’t comply with appraisal standards and can’t be used for legal purposes. Written reports can range from a couple of pages to 50 or more pages. I generally refer to these reports as a “business valuation, not for legal purposes.” The format of these reports varies considerably because they aren’t standardized. Some are simple and straightforward, while others are long, formal, and full of technical jargon that have little practical application in the real world. A “calculation of value” is the industry’s attempt to offer a simplified report for business owners. Costs for these reports can range from free to tens of thousands of dollars. These reports are most useful for business owners looking to sell a business. 

Self-Contained Appraisal

This type of report, also known as a formal appraisal, is required for any legal purpose, such as divorce, tax matters, or bankruptcy. These reports are often hundreds of pages in length and are of little use for a business owner looking to sell a business. Prices vary widely but usually run at least $5,000 or more. The format of self-contained appraisals is more standardized and, therefore, more consistent. Unfortunately, because of this standardization, self-contained reports are complicated, filled with legal jargon and formulas, and take more time and money to prepare. This standardization often means that not only are these reports too esoteric to be useful in the real world, but they’re prepared by business appraisers and CPAs, many of whom have never actually sold a business. This leads to the question – would you pay an appraiser thousands of dollars to value your business if they’ve never sold a business before? I wouldn’t. And generally, you don’t need this type of appraisal unless it’s being used for legal purposes.

Would you pay an appraiser thousands of dollars to determine the value of your business if that person had never personally sold a business before?

Choosing an Appraiser Who Will Use the Right Methods 

To complicate matters further, not only are there different types of valuations, but there are different methods that appraisers use. Different types and sizes of businesses use different benchmarks, and the value of a business can change based on the methods that are used. Here’s a more detailed explanation of why appraisal methods vary:

Methods for Small vs. Mid-Market Businesses vs. Large Businesses

The methods used to value a small business are different from those used to value larger businesses. Unfortunately, most valuation software doesn’t make this distinction, and you sometimes end up with a report that isn’t suitable for your business. When obtaining a business appraisal, ask the appraiser the industry and size of businesses they sell and value on a regular basis, and the methods they most commonly use to value a business. 

The Right Standard of Value for Appraising Your Business

Most business appraisals use fair market value (FMV) as the standard of value. FMV doesn’t consider the strategic value of a business to the buyer. Therefore, any business appraisal using FMV as the standard of value for a middle-market company is unlikely to represent what your business may actually sell for. Ask your appraiser what standards of value they will use to appraise your business.

How Buyer Types Affect Your Valuation

The task of valuing your business is complicated by the fact that there are different types of buyers. Some buyers, such as private equity firms, are looking to buy a business as an investment to be run by a management team. Others may consider your business as a strategic addition to a similar business they already own, in which case they may be able to reap synergistic benefits. Your business’s size and type will determine the type of buyer interested in your business, which will, in turn, determine the multiple the buyer is likely to pay. It stands to reason that whoever appraises your business should be intimately familiar with who’s likely to buy it.

Choosing the Right Appraiser 

When choosing an appraiser, your options include M&A firms, CPAs, and business appraisers. Who’s right for your situation? And how much does a valuation cost? Do you need to pay $10,000 for an appraisal, or should you trust a free valuation? The following are the advantages and disadvantages for your three primary options for having your business appraised: 

• M&A Firms: Many merger and acquisition firms, as well as other intermediaries, offer valuation services to their clients. These firms will provide a simplified valuation report and focus on the value of your business solely in the context of a sale. A major advantage of M&A firms is that they have experience buying and selling companies and are well qualified to advise you on the value of your business in the actual marketplace, as opposed to the theoretical legal world. They’re also usually well-versed in both strategic and other corporate buyers. Additionally, the value of most middle-market companies is established through an auction process, and M&A advisors are experts in using private auctions to sell a company. They can advise you on the relationship between the price you may achieve through an organized auction process and the baseline value shown in a valuation report.
• CPAs: Accountants and CPAs sometimes offer valuation services to their clients. Some CPAs are also licensed business appraisers. While accountants have a strong grasp of the numbers, few have sold a business before and aren’t an ideal choice to prepare a valuation for M&A purposes. On the other hand, larger accounting firms have dedicated M&A professionals on staff and may be more qualified to do so if they have experience selling businesses.
• Business Appraisers: Business appraisers are the most qualified professional to value a business for legal purposes. Unfortunately, most lack real-world experience selling companies and shouldn’t be used to value your business for a sale. 

The different appraisers might seem overwhelming at first. Regardless, the decision should be made within the context of your goals.

• The Best Appraiser for Legal Purposes: When obtaining an appraisal for legal purposes, select a business appraiser or a CPA who is a licensed appraiser.
• The Best Appraiser for Selling Your Business: M&A intermediaries with real-world experience selling companies are ideal when the purpose of your valuation is to sell your business or weigh your exit options. When selling your company, you don’t need an appraisal that’s designed for legal purposes, or that can be used in court. As a result, your advisor can produce a shorter report that’s limited to the valuation methods that buyers use in the real world, which will save you time and money.

The Cost of a Valuation – Research Based on 44 Companies

I contacted a random sample of 44 M&A intermediaries, investment bankers, business appraisers, and CPAs to see what they would charge for appraising a middle-market manufacturing company. Not surprisingly, their fees ranged widely, from “complimentary” to as much as $40,000. The more knowledgeable and experienced an expert is, the less likely they are to offer anything for free. After all, how much does someone value advice if they’re willing to give it away for free? Fortunately, free appraisals aren’t common in the middle market. Most M&A advisors selling businesses valued between $5 million and $100 million don’t offer any form of a free valuation. 

Can you expect to get what you pay for? Since there’s no standard format for valuing companies that are for sale, you can expect that a free appraisal won’t be nearly as comprehensive as a $40k valuation. Still, depending on your circumstances, you may find that an appraisal on the lower end of the price spectrum could suit your needs. Consider this your first round of comparative shopping.

M&A Firms

• Range:
  • $1,500 t0 $2,500 for a limited report
  • $5,000 to $15,000 for a full report
• Average: $7,000

Out of the 24 M&A firms I contacted, almost half didn’t recommend an appraisal at all. Several recommended going straight to an auction process, thus bypassing an appraisal, while a couple recommended a third-party appraisal. One of the firms offered a free valuation for prospective clients, another asked for a 5% retainer based on the valuation, and a third charged an hourly rate of $350.

Investment Bankers

• Range:
  • $12,000 to $17,000
• Average: $14,500

Of the two investment bankers I surveyed, only one provided concrete pricing ranging from $12,000 to $17,000 for their process, which takes four to five weeks. They didn’t suggest setting a price for the company, as they recommended an auction process with no price. They also advised us to pursue the strategic value rather than the fair market value. The other investment banker didn’t provide pricing because their costs vary based on a number of factors. They also mentioned attempting to achieve strategic value. 

Business Appraisers

• Range: 
  • $2,000 to $10,000 for a limited, short, or verbal report
  • $3,500 to $30,000 for a full report
• Average: $11,000 

Nearly half of the business appraisers I spoke with offered a limited or verbal report with options to upgrade at a higher price. These limited reports ranged in price from $2,000 to $10,000. Only one of the 12 business appraisers discussed standards of value based on the purpose of valuation, while two said they could prepare reports specifically for legal purposes.

CPA and Accounting Firms

• Range: 
  • $2,000 to $3,000 for a verbal report
  • $5,000 to $15,000 for a calculation or full report
• Average: $8,000

Two of the four accounting firms I contacted could provide reports specifically geared toward business evaluations. One proposed a low-priced verbal opinion for $2,000 to $3,000. Another firm suggested preparing an 80-to-100-page report specifically for tax and other compliance purposes.

Financial Advisory Companies

• Range: 
  • $10,000 to $40,000
• Average: $22,500

As you can see, the two financial advisory companies surveyed offered the highest costs with a $40,000 appraisal. Another firm supplied valuations for business sales on an hourly basis, and charged $10,000 or more for appraisals for legal purposes.

Conclusion

Here’s the bottom line – businesses are measured by the bottom line. Yes, a business’s potential can enhance its value – especially if that potential is close to being realized – but don’t expect the buyer to pay a lot for a promise that has yet to be entered into the ledger. The primary value driver of your business is profitability that can be demonstrated.

And, yes, there are other variables that buyers may consider when purchasing a business, but the majority exclusively look for one thing, and one thing only – profit. When valuing your business, focus on the two methods most buyers use to value a business:

1. Multiple of EBITDA
2. Comparable Sales

To increase the value of your business, focus on increasing your EBITDA or increasing your multiple.

The issue of who you’re dealing with matters, too. As a business owner, you understand the value of knowing your customer. You wouldn’t be here if you weren’t adept at identifying the audience for your product or service and knowing how to reach them with the right prices. The same holds true when it comes to selling your company. It’s essential that you and your appraiser are familiar with the various types of business buyers and their motivations. Some buyers are looking to acquire a business as an investment that will be operated by a manager. Others might be attracted to your business for synergistic reasons. The difference matters when determining the multiple the buyer may pay.

Do buyers of businesses pay for potential, or do they base their valuation strictly on the cash flow your business generates? Here I’ll explain what buyers want and why.

I’ll start by establishing some truths:

• The closer potential is to being realized, validated, and revenue-generating, the more the buyer will pay for it.
• Buyers prefer a proven business with revenue and cash flow where potential has been realized as opposed to “unrealized” potential.
• Every business has unrealized potential. The closer the potential in your business is to being realized, the higher the likelihood you can be paid for it.
• Ideas in their rough form are worth little to buyers. As Steve Jobs said, “Ideas are worth nothing unless executed. Execution is worth millions.”

Here are some examples of potential:

• Selling to a New Customer Group: Acme Corporation believes they could dramatically grow their business by selling their existing products to a new customer group. The idea is just an idea at this point, and they haven’t yet sold any products to this customer group.
• Creating a New Product or Service: Wayne Enterprises thinks it can substantially increase revenues by introducing a new product to the marketplace. The product hasn’t started development yet, hasn’t been user tested and validated, and hasn’t generated any revenue.
• Creating a New Product Idea: Ralph has an amazing business idea for a product that will cure cancer. He has a business plan, but no progress has been made beyond creating the idea. The idea hasn’t been validated, and no sales have been made.
• Creating a New Business Idea: Kate started a business that looks great on the surface. She’s spent over a million dollars building the business, but it generates little revenue and is currently breaking even. Kate believes her business has significant potential, but the business hasn’t generated any profits yet.

These are examples you may see as potential opportunities, but when selling a business, you’ll soon discover that most buyers will be willing to pay little for these types of potential. Under what circumstances are buyers willing to pay for potential? If potential exists in your business, what can you do to get paid for this potential? 

Here are some general characteristics of potential that buyers won’t pay for:

• The idea is only a rough idea. There are no plans or data to back it up, and little has been executed. Implementation hasn’t begun, and the idea hasn’t been validated.
• The business, division, product, service, or idea hasn’t yet generated revenue.

If there’s no proof the idea will generate revenue, it may be a good idea, but it’s still just an idea. If no revenue has been generated, most buyers won’t be willing to pay anything for it. Nonetheless, such a plan may be the icing on the cake for the buyer to decide to move forward after their due diligence investigation.

What are buyers willing to pay for?

Buyers want:

• Future revenue with a high degree of certainty. In fact, you’ll achieve a higher valuation if you wait until the revenue from the contract is recognized on your financials before you attempt to sell your company.
• A new product that’s been developed and has generated revenue. The stronger the validation, the more buyers will be willing to pay. It’s even better if you have a track record of developing successful products.
• Synergies – but buyers won’t pay for synergies unless they have to. Generally, only larger companies pay for synergies and only in an auction in which they’re competing with others to acquire your business. 

Don’t venture capitalists buy ideas? Yes, but with a catch. 

An idea isn’t all they’re buying. They’re also investing in a team that will execute that idea and turn it into reality. Venture capitalists don’t buy a business outright. They normally make a minority investment in a business in which the ownership team will remain on to execute the idea. 

So venture capitalists aren’t buying an idea. Rather, they’re investing long-term in a business and a team that will stay in place to follow through on the proposition. In earlier rounds, investors focus more on the strength of the team than the actual idea. If you expect to create a visionary idea and then sell that idea to a third party to execute, think again because you’ll get paid little for selling an idea that someone else will execute.

Here’s my practical advice on ideas and potential:

• If you have unrealized potential, point it out to a buyer. But the less polished and un-validated the opportunity, the less you can expect to get paid for it.
• Treat ideas as icing on the cake. Use potential to motivate the buyer to purchase your business, but don’t expect to get paid if the idea hasn’t generated revenue.
• To better demonstrate the potential, crystallize it into a one-to-two-page business plan. Outline your assumptions and back them up with hard data. Better yet, run a series of experiments to validate your assumptions in the real world.
• If you believe a buyer may pay for synergies, consult with an M&A advisor. An M&A advisor may be able to determine if synergies exist and conduct a private auction in which multiple buyers compete to acquire your company, thereby driving up the price.

Keep in mind that while you may see potential in your business, buyers won’t see this as a primary reason for purchasing your company. What buyers want is actual revenue and profitability, so the more you can demonstrate the revenue-generating possibilities of your business’s opportunities for growth, the more interested they will be in buying your company. 

The two primary methods to value a middle-market business include:

1. Multiple of EBITDA: Multiply the earnings before interest, taxes, depreciation, and amortization (EBITDA) of the business by a multiple. Common multiples for mid-sized businesses in the middle market are four to eight times EBITDA. 
2. Comparable Sales Approach: This involves researching prices of similar businesses that have sold and then adjusting the value based on any differences between your company and the comparable company.

Profit is the #1 criteria buyers look for when buying a business and the #1 factor that buyers use to value a business. 

Method 1: Multiple of EBITDA

Here’s how you can value your business using the multiple-of-EBITDA method:

Step 1: Determine your EBITDA for the previous 12 months or your latest fiscal year. This is called “recasting” or “normalizing” your financial statements. It involves adding the following back to the net profit of your business – depreciation, amortization, owner’s salary, non-cash expenses, non-recurring expenses, and other perks.

Step 2: Multiply your business’s EBITDA by the multiple.

Example: $5 million EBITDA x 6.0 multiple = $30 million value of business

Common Multiples

Here are common multiples for mid-sized businesses:

• Construction Businesses: 3 to 7 times EBITDA
• Food Businesses: 4 to 7 times EBITDA
• Manufacturing Businesses: 4 to 8 or more times EBITDA
• Retail Businesses: 4 to 6 times EBITDA
• Service Businesses: 4 to 7 times EBITDA
• Wholesale Businesses: 4 to 6 times EBITDA

Multiples vary with the current economic climate and market conditions and also with the desirability of the business. The multiple varies based primarily on the industry in which a business operates in addition to several other factors. 

How do you determine the appropriate multiple? The best source is experience such as the expertise you can gain from an investment banker with significant experience in the industry. Other than that, several databases are available that provide pricing information on businesses. This information can help paint a picture, though the picture will be incomplete, at best. Some of these databases require subscriptions costing up to tens of thousands of dollars per year. If you’re in the dark, I recommend reaching out to an M&A advisor or investment banker to ask if they have the current multiples for your industry.

Larger businesses always sell at higher multiples. To demonstrate:

• Business A: EBITDA of $1 million per year = 4.0 multiple, or a value of $4 million.
• Business B: EBITDA of $5 million per year = 5.0 multiple, or a value of $25 million.
• Business C: EBITDA of $100 million per year = 8.0 multiple, or a value of $800 million.

The relationship between EBITDA and multiples is direct. As the EBITDA of a business increases, so does its multiple. Larger businesses are seen as more valuable by sophisticated investors because they’re viewed as more stable, have more professional management teams, and are less dependent on the owner for the business to operate. There’s a simple, clear relationship between the size of a company and its multiple that’s demonstrated in the transactional databases and widely accepted by both investment bankers and buyers.

Method 2: Comparable Sales Approach

The comparable sales approach is a method for valuing your business based on the prices of similar businesses that have sold, then making adjustments to account for any differences between your company (i.e., the subject company) and the comparable company.

This approach is often difficult to use because pricing information on privately held businesses is difficult to obtain. The best source of comparable transactions is from an M&A intermediary or business appraiser who has access to these private databases. Several databases are available that contain comparable business sales. However, the information is sparse or incomplete, so you can’t rely on this data entirely. Collectively, these databases contain approximately 100,000 transactions.

Other Factors to Consider

Beyond valuing your business by EBITDA or comparable sales, there are other factors to take into consideration.

Value Enhancement

Remember, there are only two ways to directly increase the value of your business:

1. Increase EBITDA:
   • Reduce expenses.
   • Increase revenues.
2. Increase the Multiple:
   • Reduce the perception of risk.
   • Improve the perception of potential returns.

Your multiple is a reflection of how risky a buyer perceives your business to be, and how much opportunity your business presents. To increase your multiple – and your valuation – take steps to reduce the risks associated with your business, and present a growth plan to the buyer that demonstrates the growth potential in your business. Buyers will pay higher multiples for companies that represent less risk and that have more growth potential.

Accounting for Synergies

The valuation methods mentioned above don’t take into account the possible synergies that might be achieved. There are five broad types of synergies: 

• Cost savings
• Revenue enhancement
• Process improvements
• Financial engineering
• Tax benefits

The value of synergies is impossible to calculate without knowing who the buyer is and having access to their financial statements. The value of synergies is different for every buyer; therefore, the value of your business can differ substantially depending on the buyer. If you expect to sell your business to a strategic buyer, the best you can do is to estimate the baseline value (i.e., fair market value), and then attempt to maximize the price as much as possible by negotiating with multiple buyers.

What’s Included in the Price

The price should include all tangible and intangible assets used in your business to generate the cash flow, or EBITDA, that your business produces. This includes all of the equipment and assets required to operate your business on a daily basis, and the amount of working capital required to sustain your current revenue.

Working capital is defined as:

• Current Assets: Accounts receivable, inventory, and prepaid expenses, minus 
• Current Liabilities: Accounts payable, short-term debt, and accrued expenses 

Working capital is customarily included in the value of nearly all middle-market companies.

The value of your business can differ substantially depending on who the buyer is.

“Before anything else, preparation is the key to success.”

– Alexander Graham Bell, Inventor

Pricing a business is based primarily on its profitability. Profit is the #1 criteria buyers look for when acquiring a business and the #1 factor buyers use to value a business. There are other variables that buyers may consider, but the majority primarily look for one thing – profit. Most valuation models are therefore based on some multiple of profit, or EBITDA, a business generates.

Why is there such a wide range of values for businesses? The simple answer is because a valuation is one person’s opinion. An opinion of value can vary based on who performs the appraisal, what they’re looking for, and the methods they use. Let’s explore the many reasons behind why businesses can have a wide range of potential values. 

Concept 1: Information is Limited

Comparable Transactions Are Often Unreliable

The ideal way to value your business is to determine what similar businesses have sold for. Unlike residential real estate transactions – where it’s not difficult to find recent sales of homes like yours – there have probably been few, if any, recent sales of businesses highly similar to yours. While information is readily available on public companies, there are vast differences between valuing private and public companies. The market for businesses is fragmented, making it difficult to obtain relevant comparable transactions, and information is limited. The market for mid-sized businesses is inefficient, and intelligence is scarce, to say the least.

All Businesses Are Unique

Additionally, all businesses are unique. Even if you’re able to find a somewhat similar comparable transaction in your industry, the business won’t be the same as yours in terms of risk, growth rate, location, sales volume, number of employees, and a host of other critical factors that can affect the price.

Availability of Accurate Information

The information available in transaction databases for small and mid-market transactions is often submitted without being verified, and only pieces of the story are provided, such as high-level financial details. Critical transaction information may be missing from the database, such as the terms provided, how EBITDA was calculated, whether the parties are related, and other relevant information. This makes it challenging to adjust transactions to make them truly comparable.

Even in the unlikely event that you can find the recent sale of a company that closely resembles yours, you may not be able to access accurate numbers on the business and the transaction. Unlike real estate sales, which often leave a public paper trail, business sales numbers are private. Access to accurate information can be hard to come by, especially because rumor and exaggeration often obscure the facts.

Not only is information limited or biased, it can also be incomplete or inaccurate. Appraisers must rely on information from ownership or management, which can be biased, or on accounting and financial details, which are often missing pertinent data. As a result, an appraiser’s opinion of value will continue to evolve as they acquire new findings, or as their understanding of existing information changes.

Beware of Incomplete Information

Watch out for incomplete sales information, such as hearsay. Attend any business event with others in your field, and you’re sure to hear that so-and-so sold their business for such-and-such dollars. 

At a business lunch, for example, you may learn that Emma received $10 million for her business. Even assuming this number has some truth to it, and it may not, you may not be told other noteworthy details. For example, the reports of the sale price may not mention that Emma agreed to work for the buyer for three years, which was included in the purchase price, or that the price included the real estate, or that Emma received only 15% of the purchase price upfront with the rest to be paid over five years, or that 80% of the price was based on an earnout. 

Value Is Only Determined in a Sale

A key task in selling any business is figuring out how much it’s worth. If you expect precision in pricing your business, you’ll be disappointed. No pricing formula or expert can accurately provide a sales figure that’s exactly “right.” So, while you need to price your business sensibly, you won’t know how much it’s really worth until the day a buyer writes you a check.

Price does not equal value. The actual value is only determined when a business is sold. Just because your company was valued at $100 million doesn’t mean it’s worth $100 million until someone actually pays you $100 million. Just because your friend’s company was valued at a six multiple doesn’t mean your company is also worth a six multiple because you’re both in the same industry and have similar-sized businesses. Just because your uncle received an offer on his business for $100 million, which works out to 70% of revenue, doesn’t mean your business is worth $35 million just because it generates $50 million in revenue.

A comparable transaction must come from an actual transaction – not an appraisal, the asking price from a similar business, or other hypothetical non-transactions. 

Price does not equal value. The actual value is only determined when a business is sold. 

Concept 2: Predicting the Future Is Difficult

Market Variability Is Hard To Predict

The essence of valuation is predicting how other investors will behave, such as anticipating the price they’ll pay for a business. Even the world’s most respected mutual and hedge fund managers, with billion-dollar budgets and thousands of employees, whose sole objective is to predict the future value of publicly traded companies, can’t consistently beat the markets. 

In 2007, Warren Buffett bet $1 million that the S&P 500 would outperform a collection of hand-picked hedge funds. Buffett wasn’t betting against the “average” hedge fund. Far from it. Buffett allowed the opposing party to hand-select from among the best-managed funds in the world. Protégé Partners took him up on his offer and meticulously selected five hedge funds. What were the results at the end of the decade-long bet? The results were calamitous for the hedge funds. From 2007 to 2017, the S&P 500 gained over 125%, while the five hedge funds gained a paltry 36% in comparison. The bet was open to anyone in the industry that wished to participate, but only one stepped forward. And despite their ability to actively monitor the funds with the assistance of hundreds of analysts, their performance was crushed by a passive investment in an index fund that required no work and a staff of exactly zero.

What’s the lesson here? The market is impossible to predict, even for those with nearly unlimited resources who professionally manage billions of dollars. Fear and greed drive human behavior, and even the world’s best investors can’t accurately predict movements in the markets with any consistency. Even Warren Buffett, considered by many to be the greatest investor of all time, admits he can’t predict the price of a stock in the short term or even predict how the economy will do in the mid-to-long term. From the tulip bulb craze in Holland in the 1630s to the dot-com bubble in 1999, humans’ irrational behavior has proven impossible to forecast accurately. Predicting the behavior of a single individual is difficult enough, let alone predicting the impact of fear, greed, and herd behavior. Changes in the macroeconomic environment can have an enormous impact on the value of a business, and such changes have proven impossible to foresee.

Values Change Based on Markets

Because the marketplace for the sale of mid-sized businesses is inefficient, values can also vary widely over time. Therefore, current market conditions can significantly affect the final selling price of your business.

Estimating Future Cash Flow Is a Challenge

The fundamental premise of most methods of valuing a business is placing a value on expected cash flows. After all, a buyer is buying future cash flows, not historical ones.

Most projections prepared by owners of mid-sized businesses are based on assumptions that are impossible to substantiate. History isn’t an accurate representation of what’s expected to happen in the near future for any business, especially in a volatile or unpredictable economic environment. Assessing future cash flows for a business is especially difficult if there’s a lack of consistent, historical financial projections that have been met. Estimating potential growth rates is inherently difficult for any business, even one with well-documented and predictable growth, let alone a business with inconsistent financial results.

Not only must future cash flows of a business be predicted, but the potential risk of receiving the revenue must be assessed as well. Stuff happens. The presence of risk must be built into any financial model, even though risk is impossible to predict with precision.

When valuing a business, one must estimate the future cash flows as well as its potential for growth, and the associated risk. Such an estimate is subjective at best, even if it’s based on strong, historical financial results, and even more so if historical financial information is limited. The degree to which a business’s value is tied to future results – and the great degree of risk associated with estimating future cash flow upon which a business’s value is based – must always be considered when reviewing any business appraisal. 

The fundamental premise of most methods of valuing a business is placing a value on future expected cash flows.

The Impact of the Future Is Unpredictable

Future value depends on factors beyond our immediate control, but the impact of these factors can’t be predicted. For proof of this, look no further than the coronavirus pandemic, which no one saw coming and which threw most sectors of the economy into a tizzy. Price depends on demand, which itself depends on a wide variety of factors, from interest rates to constantly evolving consumer trends to the political landscape, and more. 

The economy impacts some types of industries to a great degree, especially those selling a discretionary product or service or companies that operate in a cyclical market. The impact of a protracted recession can be disastrous for cyclical businesses. Other industries, such as finance or healthcare, are susceptible to the impact of external factors such as governmental regulations, and one can only conjecture about their likelihood and potential impact. Our lawmakers – some with motives that are questionable – wield power that can determine the fate of many industries, which introduces an additional layer of guesswork for any business operating in such sectors.

Even the world’s most widely esteemed economists can’t predict the future trajectory of the broad economy, let alone the outlook for specific industries or businesses within those industries. Such a requirement introduces a level of uncertainty in any appraisal, so the best one can do is to make an educated guess based on a limited amount of information. These limitations on the ability to predict such uncertainties must be considered when weighing the merits of any valuation.

Concept 3: Buyers Have Different Criteria

Perceptions of Risk Are Subjective

The group of potential buyers for a business is diverse, thereby greatly expanding the likelihood of a wide range of opinions. For example, a lower mid-market business may have the following potential buyers – wealthy individuals, direct competitors, indirect competitors, financial buyers, and smaller publicly traded companies. 

The views, perspectives, expectations, and tolerance for risk among a diverse group of buyers can vary greatly, resulting in a wide range of possible values. The tolerance for risk also varies widely from buyer to buyer. Their opinion of value varies significantly as the price a buyer can afford to pay is a direct function of their assessment of the risk of the potential investment. A buyer’s assessment of risk may also be limited by their ability to acquire accurate information on the business and industry. The value of a business is ultimately determined by a buyer’s perception of risk, which can’t be accurately predicted or measured. 

Any valuation should first explore the potential universe of buyers, and then calculate a range of potential values those buyers may pay.

Lost Opportunity Cost Varies

The lost opportunity cost of an acquisition for any corporate buyer is the cost of not completing another transaction or other form of corporate development. Some examples of lost opportunity costs include not launching a promising new product when you had the chance, not forming a joint venture to strengthen your core operations, or not expanding distribution channels to sell more products. Because the lost opportunity cost varies from buyer to buyer, the value of a business will also vary from buyer to buyer, and such a variation adds another layer of complexity to any business appraisal.

Synergies Are Impossible To Calculate

The financial benefit of potential synergies is also impossible to accurately anticipate or assess. When selling a mid-sized business, the potential universe of buyers normally includes direct or indirect competitors who would stand to benefit from adding your offerings into their mix. Often, competitors bring synergies to the table in the form of potential increased revenue or decreased expenses. To properly value a business sold to a synergistic buyer, one must calculate the amount of the synergies so they can be analyzed and valued. 

As an example, if a company with an EBITDA of $5 million per year is purchased by a competitor that brings an additional $1 million in increased EBITDA in the form of synergies to the table, the valuation could look like this:

Before Synergies: $5 million EBITDA x 6.0 multiple = $30 million value

After Synergies: $6 million EBITDA x 6.0 multiple = $36 million value

Implicit in this valuation is that we know the amount of the potential synergies and, therefore, the post-sale EBITDA, which forms the basis of the valuation. In most cases, this information can’t be obtained by the seller. Buyers rarely will provide you with access to their financial models, let alone their reasons for the acquisition. As a result, you may not understand the buyer’s true motives for a transaction. Sellers are rarely privy to a buyer’s financial models, projections, or other analyses that can be used to calculate the amount of the synergies. The best you can do is to reverse-engineer the buyer’s potential synergies, estimate their value, and then negotiate the highest purchase price possible, ideally with multiple buyers in the form of a private auction. 

A valuation based on synergies is, at best, an educated guess and normally only serves as a baseline upon which the company may be valued. Any excess of the baseline value can only be achieved and determined in the actual marketplace through a competitive marketing process.

Buyers Don’t Always Follow Valuations

Keep in mind that an appraiser is making an educated guess as to what a hypothetical buyer might pay for your business. That’s why estimating the value of a mid-sized business is difficult – you’re speculating on how a diverse group of investors will think and behave. This is an inherently onerous task, regardless of one’s expertise and knowledge.

Concept 4: Valuation Methods Are Subjective

Appraisers Lack Real-World Experience

Most business appraisers lack an essential requirement – experience. Few have ever sold a company in the real world, yet despite that, their job is to make an educated guess as to what a hypothetical buyer will pay for a business. While most appraisals are commissioned for tax or legal purposes, those intended for selling a business should be prepared by a professional with real-world experience in the marketplace, such as an investment banker or M&A advisor.

Compensation Can Impact Objectivity

M&A advisors’ form of compensation may also affect their opinion. If their estimate is too low, a potential client may go elsewhere. As a result, an advisor may pad their opinion to avoid losing a client and then later backtrack on the valuation in an attempt to bring the owner back into the “real world.” Interests should be aligned whenever possible, and the true beneficiary of any valuation should always be questioned. 

Most business appraisers lack an essential requirement – experience.

Cognitive Bias Clouds Rational Judgment 

Humans are biased, and analysts are no different. Not only must an appraiser deal with an enormous amount of uncertainty, but they must also cope with their own preconceived opinions and notions, which are often subconscious and therefore undetectable.

Here’s a list of cognitive biases and potential examples that may surface when valuing a business:

• Confirmation Bias: The appraiser seeks information to confirm their bias. For example, they may have a long-term belief that the range of multiples for radio stations is 8 to 10 times EBITDA, and they may ignore information that doesn’t support this bias. They may form an initial opinion regarding the value of a business and then fiddle with the valuation to ensure it aligns with their initial expectations.
• Recency Bias: The analyst may assign more weight to companies they have appraised or sold recently and forget about data or transactions that aren’t recent.
• Anchoring Bias: The appraiser first learns through another appraiser, who’s widely considered a leader in the field, that multiples in the aerospace industry are in the range of 9 to 10 times EBITDA. This becomes the “anchor,” and the advisor then seeks information to confirm this anchor, ignoring factors that conflict with the anchor.
• Availability Bias: The appraiser may place too much emphasis on data that’s readily available and not perform an exhaustive search for information that’s less available.
• Conservatism Bias: The appraiser may cling to their long-held belief that multiples never exceed 6.0 if EBITDA is below $5 million, and then consciously ignore information that doesn’t support this personal belief.
• Contrast Effect: The investment banker may hear of a transaction at a 10.0 multiple in an industry in which they’re valuing a business, so they push up their estimate to a 6.0 multiple from 5.0. After all, an increase in the multiple by a factor of one “isn’t a big deal” if a larger company in a related industry sold at a much higher multiple.

In preparing any valuation, an advisor should attempt to be aware of their biases and make efforts to mitigate the impact of their biases on their opinion. Readers of appraisals should also be aware of the potential for biases in any valuation and be cognizant of the impact such biases can have on the appraisal.

Concept 5: Significant Time and Effort Are Required

Software Isn’t Designed for M&A Valuations

Most software to appraise businesses is designed for legal or tax purposes. The methods used in the courtroom are different from those buyers use in the real world. Most software is inadequate for addressing a variety of situations and must be designed to handle the highest level of complexity the appraiser might encounter. An appraiser can be faced with having to arbitrarily input information into a program simply because it’s required by the software, despite it being irrelevant to the business’s stage of growth or industry. For example, many appraisal software programs analyze key financial ratios, such as debt to equity. These ratios may be irrelevant for a small manufacturing company in which the transaction is structured as an asset sale.

To avoid this arbitrary information, many investment bankers use their own spreadsheets of factors suited to the client and business they’re valuing. For owners considering a sale, an M&A advisor’s oral opinion can sometimes be more valuable than a written appraisal. 

At Morgan & Westfield, for example, we combine a financial assessment of the business with an exit strategy and an in-depth consultation with the owner to develop a full understanding of the business. We then explain our opinion of value in detail during a phone call with the owner. We can best assess and communicate our opinion of value if we aren’t encumbered by the built-in limitations of external software. 

If you’re considering paying for a written appraisal, ask for a sample report. Be sure you can understand it and that the information is relevant before you pay for a valuation.

Valuations Take Time and Effort

Properly valuing a business takes a great deal of time, especially when it comes to understanding and predicting future cash flows. The more sweat equity that’s invested in preparing the appraisal and predicting cash flows, the more accurate the valuation will likely be. But most business owners understandably don’t want to pay tens of thousands of dollars for an advisor to spend hundreds of hours developing an understanding of their business. As a result, many valuations, particularly oral valuations, are predicated on input from the owner or management team, who have inherently biased views.

Even if sufficient time is spent understanding the business and the sub-sector, how accurately can future cash flow be predicted for a business? The best one can do is to make an educated guess. A business is highly dependent on the aptitude and drive of the entrepreneur and predicting the long-term drive of one individual is difficult, to say the least. 

The value of any appraisal is in direct relation to the skill and experience of the appraiser and the amount of time they spend understanding your business. As a business owner, you should be aware of such limitations and accept that you’re paying for a professional’s opinion, and the accuracy of such an opinion is related to the amount of time and effort spent by the appraiser.

Concept 6: Fair Market Value vs. Strategic Value

Two standards of value a buyer might use to value a company are fair market value and strategic value. Next, I’ll describe how each of these methods might drastically change how a buyer may value your business.

Fair Market Value

Most business appraisals use fair market value (FMV) as the standard of value. The real-world understanding of “fair market value” is as follows:

The highest price a business might reasonably be expected to bring if sold using normal methods and in the ordinary course of business in a market not exposed to any undue stresses. That market is composed of willing buyers and sellers dealing at arm’s length and under no compulsion to buy or sell, with both parties having reasonable knowledge of the relevant facts.

Explicit in the definition of fair market value is the following:

• Amount (i.e., Price): The prevailing standard in business transactions is the highest price, whereas in real estate transactions, the standard is the “most probable price.”
• Willing: The definition implies that the parties are willing and able, have sufficient motivation, and are acting in their best interests.
• Compulsion: FMV assumes the parties are “under no compulsion” to complete a transaction and that they’re dealing with one another at arm’s length, not influenced by special motivations.
• Knowledge: Fair market value assumes the parties are well-informed and possess reasonable knowledge of the industry, marketplace, and the opportunities and weaknesses of the subject business.

Strategic Value

Strategic value, also called investment value, is the worth of a business to a specific buyer. It can represent an amount in excess of FMV to a specific buyer of a business, usually a strategic buyer. The primary downside to strategic value is that you can’t measure it until you know who the buyer is. That’s because every buyer will extract a different amount of value from your business based on the synergies they bring to the table.

For companies likely to be sold to a strategic buyer, a valuation will only serve to establish a “floor,” or a minimum price, or fair market value at which the company may sell. It’s possible your business may sell for more if it’s purchased by a strategic buyer. 

It’s impossible to quantify the synergies until you identify the buyer, and many times you can never quantify the synergies, as most buyers hold these in confidence throughout the process to maintain their negotiating leverage. For mid-sized businesses, the purpose of the valuation is only to establish a minimum floor price or fair market value. The true value, or strategic value, can only be determined in the actual marketplace by establishing a competitive auction process among buyers.

Concept 7: Business Valuation Is a Range Concept 

Business valuation is not an exact science. Various buyers will value each business differently, and the same goes for appraisers. All this goes to say that the value of a business should never be a single hard number, but rather a range of values. 

A Valuation Is Based on a Professional’s Opinion

When obtaining a valuation, you’re paying for a professional’s opinion. This is a subjective point of view from an independent professional and can change based on any new information they obtain. This represents the professional’s opinion as to what a hypothetical buyer is likely to pay for your business, not necessarily what your company will actually sell for in the real marketplace. 

Valuation Is Essentially Mind Reading

In reality, the appraiser is attempting to predict how a diverse audience with different preferences, views, and perspectives will behave. Making this prediction is inherently difficult, which is why the range of possible values for a business is wider than for other investments such as real estate. 

Identifying Value Drivers

A key part of an appraiser’s value is not in giving you a single number but rather in identifying those factors that will heavily influence the value of your business. For example, your business may have a strong management team or valuable lineup of proprietary recipes. These factors are called value drivers. Knowing what these factors are will help you maximize your business’s value.

Concept 8: Transaction Structure Affects Value

In most transactions, some portion of the purchase price is contingent. It follows that the terms of the sale – such as the amount of the down payment, repayment period, and interest rate – can all affect how much a buyer will be willing to pay. Regardless of the terms, you should walk away from any transaction if the cash you receive at closing doesn’t meet the minimum you’re willing to accept for your business.

Concept 9: Your Personal Needs Affect Value

Poor health or financial pressures may force you to sell. If, for these or other understandable reasons, you need to sell quickly, you’ll probably have to accept less than the optimal sale price. Similarly, if you’re unable or unwilling to work for the buyer, even for a short time after the closing, that fact may diminish the value of the business in the buyer’s eyes. Many buyers prefer to have you stay on board during the entire transition period.

Conclusion

Valuing a business is a challenging task, even for the most seasoned advisor. Unless you’ve got a crystal ball, the best you can hope to do is to make an educated guess about what the future will bring while trying to stay unbiased. Although such an assessment of value may be tenuous, it’s nonetheless the starting point of the M&A process and a critical component of a successful exit strategy for any entrepreneur. A valuation of your business serves as a baseline from which to develop your exit strategy – the ultimate value can only be determined through a carefully executed sale.

“Money flows in the direction of value.”

– Uche Ugo, International Brand Consultant

Valuing a business is an inherently difficult undertaking, but it’s a critical step in planning the sale of your company. In this chapter, I explore why that’s the case and why the ranges of potential values for businesses are much wider than for other assets. You’re about to gain a greater understanding of the challenges you may face when valuing your business and learn what factors can affect the potential range of values for your company.

The essence of valuing a business is predicting its future cash flows and then placing a price tag on those cash flows based on their present value.

Ensure Cash Flow is Accurate: When calculating ROI or determining a multiple, be sure to use an accurate cash flow figure, which is usually going to be EBITDA. 

Account for Differences: The rate of return and multiples are only useful when comparing two investments that share similar criteria. Many business owners compare the returns on investment in their business to the returns of real estate or publicly held companies. But these comparisons aren’t often accurate because these different asset classes represent varying levels of risk. For example, ROI wouldn’t be suitable when comparing investments with the following differences in criteria:

When comparing two investments, they should share the following similar criteria: 

• Time Frame
• Leverage
• Potential
• Risk

If they don’t, adjustments should be made to account for the differences. 

Conclusion

Multiples are the foundation of nearly every business valuation in the middle market. But while the math of calculating a multiple is simple, don’t let the apparent simplicity fool you. Just like a tennis racket or golf club is easy to swing, doing it properly is much more difficult. Understanding what multiples are and how they’re used is foundational to understanding how to value your business.

When it comes to selling your business, ROI isn’t the most relevant or useful metric for valuing your business. The primary advantage of using ROI is that it’s a quick-and-easy “back of the envelope” method. Sophisticated investors can calculate the ROI on a potential investment in their head in a few seconds, helping them determine if an investment is worth spending time on before pursuing it. 

Consider the following example:

A friend pitches you an investment idea in their company and asks to borrow $200,000 and then repay you $300,000 in 10 years. You can quickly calculate the following in your head:

Return = $100,000 ($300k – $200k)

ROI = 50% ($100k/$200k)

Annualized ROI = 10% ($100k/10 years – not compounded)

Few sophisticated investors would consider this investment after spending a few seconds calculating the potential return. Why would they consider a risky investment in a startup at a 10% ROI when returns on public stocks historically yield 8% to 10% and represent a much lower risk?

The ROI can also be used in the reverse direction to calculate the amount of the required repayment based on the desired returns. If the stock market yields 8%, and you consider this investment four to five times riskier than large, public stocks, you would require a 32% to 40% annualized ROI to account for the risk of the investment. If you invested $200,000, you would need to receive approximately $1 million in just five years to account for the risk. 

Here’s how I performed this calculation in my head:

1. First, I determined how risky the investment was so I could calculate the desired ROI. Given the high failure rate of startups and the cost and overhead of managing a small investment in a startup, I would need to receive a return of at least four to five times the historical returns generated by public stocks. I assumed an 8% return on public stocks and multiplied this by four to five to arrive at a return of 32% to 40%. This high rate of return accounts for the fact that startups have about a 50% failure rate.
2. After determining risk, I used the “rule of 72” to determine that the investment would double twice in four years. The rule of 72 is a formula that calculates how long it will take for an investment to double in value based on its rate of return. To use the rule of 72, you divide the interest rate by 72 to determine how long an investment will take to double. For example, at 12% interest, an investment will double in six years (72/12 = 6). An investment would double every two years at a 36% rate of return.
3. With these two calculations, I was able to determine that this took the initial investment of $200,000 to $400,000 in year two and to $800,000 in year four. I then added 30% of $800,000 ($240,000), to the $800,000 to arrive at $1 million.

The entire calculation took about 10 seconds to do in my head. This is the primary advantage of using ROI and multiples. They’re quick and easy to calculate. I might perform a calculation like this a dozen times in a typical lunch meeting with a private equity partner. It would be odd to pull out my phone every time to calculate returns and interrupt the flow of the conversation, so any seasoned professional learns to perform these calculations in their head, all without breaking eye contact. This skill is commonplace for anyone in M&A, venture capital, or private equity. 

Watch Shark Tank and count how many times the judges calculate potential returns on investments in one episode. This is exactly how ROI and multiples are used in the real world – as quick, crude rules of thumb.

Here’s a second example to illustrate how ROI is used in the real world:

Suppose a business owner wants $10 million for their business, and they net $2 million per year. So far, we have a 20% ROI. Easy enough. But now, suppose that the business is a local distributor, and the buyer must purchase $5 million in inventory, which isn’t included in the price. The ROI is now 13.33% ($2 million/$15 million = 13.33%). At this point, I wouldn’t be terribly interested, but I would want to dig deeper. I would want to consider the impact of leverage, how risky the business is, and the potential that exists in the business.

If the inventory can be financed at 6% interest, the annual interest on the inventory would be $300,000 ($5,000,000 x 6% = $300,000). We now have an EBITDA after debt service of $1.7 million, or an ROI of 17%. 

If revenues, gross margins, or profitability declined in recent years, I would consider this business risky, and an ROI of 17% wouldn’t suffice, given that returns on public stocks are often 8% to 10%.

But if the owner claimed the EBITDA was $2 million, I would need to closely examine how the owner calculated EBITDA. What exactly did they include in their calculations? Were they aggressive in their calculations? Did they include their salary? Did they miss any potential adjustments? Is the business growing?

I would also want to consider other factors, such as the impact of leverage on financing the acquisition, the amount of annual capital expenditures (CapEx), the need to inject additional working capital, and the stability and predictability of cash flows.

All of these considerations and more are critical when you evaluate the opportunity and costs of a particular business.

The primary advantage of using the ROI is that it’s a quick-and-easy “back of the envelope” method of calculating the value of a business. 

As shown above, multiples aren’t a perfect valuation method. In fact, multiples ignore several important variables, which are described below. 

The Effects of Capital Appreciation

In most cases, the majority of an entrepreneur’s net worth is in the form of capital appreciation in their business. Therefore, when calculating ROI, it’s critical to consider the effects of capital appreciation or growth in the value of the business. In most scenarios, the value of a business grows in relation to, but not directly proportional to, growth in its earnings. There may also be a gradual growth in the multiple, which is called “multiple expansion.” The idea is that the higher the EBITDA, the higher the multiple. Here are a few common scenarios that demonstrate the role of capital appreciation:

Keep in mind that a 20% growth rate isn’t sustainable for long. But this illustrates the incredible effects of capital appreciation on ROI.

The following illustrates the impact of including cumulative EBITDA from the business when calculating ROI:

Unless you can project the future value of a business, you can’t accurately calculate the actual returns. You can estimate or project returns, but it’s just that – an estimate.

When attempting to calculate the returns of a business, it’s critical to consider the impact of growth on the value of a business. Obviously, this impact will be less for low-growth companies, such as retail, and greater for high-growth businesses, such as those in tech. Regardless, such a calculation will be a crude estimate, at best.

Calculating the potential return on businesses is inherently more difficult than calculating returns on other investments, such as real estate, due to the difficulty of projecting the future earnings, and therefore the value of a business. 

Multiples Ignore the Effects of Leverage 

Multiples don’t take into account the impact of leverage, or financing, on returns. Here are several scenarios that illustrate the impact of leverage on ROI:

As the charts above illustrate:

• ROI increases as leverage increases.
• Returns are highly dependent on current interest rates.
• When interest rates rise, returns decrease.
• The greater the leverage, the higher the debt service, which increases risk.

Here are the primary benefits of using multiples:

• Universally Used: Multiples are simple to calculate and are universally used. Due to their broad use, multiples allow you to quickly evaluate and rank potential investments. 
• Simplicity: Multiples are easy to use and are simpler and faster than, for example, calculating the internal rate of return. 
• Facilitates Easy Comparison: Multiples make comparing an investment’s returns to other investments – such as real estate, stocks, bonds, or other businesses – quick and easy. 

There are several primary disadvantages of using multiples. Multiples don’t account for: 

• Time: Multiples don’t account for the impact of time. To do so, use the internal rate of return.
• Leverage: Multiples don’t account for the effect of leverage on cash flows and, therefore, returns. To calculate the impact of leverage, either use “cash-on-cash return” or IRR. As leverage increases, the potential for gains or losses increases, as well as risk. Also, the higher the interest rates, the greater the amount of debt service and the lower the returns. In other words, returns are higher when interest rates are lower if leverage is used, but lower interest rates tend to drive up the price of businesses, thereby offsetting the impact of higher returns. 
• Capital Appreciation: Multiples don’t consider the effect of capital appreciation. In most cases, only the ongoing cash flow, or EBITDA, is considered and not the impact of growth on the value of a business. 
• Potential: Multiples don’t consider the value of potential. If you’re comparing two investments with similar rates of return, but one investment is highly scalable and has higher potential, such as a software business, then, obviously, that investment may be more attractive. So, future earnings, and therefore potential, use discounted cash flow.
• Risk: Multiples don’t consider the impact of risk on potential returns. If you’re comparing two investments – real estate versus a small business, for example – and the returns are similar, but one investment is less risky, such as real estate, the less risky investment will be considered more attractive. 
• Inflation: Multiples must be used carefully when comparing investments in time periods with significantly different inflation rates. To do so, use the real rate of return.

A multiple is a helpful tool, but you should use them with caution. Being aware of their limitations and their intended goals is important when using multiples to compare investments. 

Multiples, and therefore ROI, are useful tools for quickly comparing investments within or across asset classes. Here’s a comparison of returns on various asset classes.

*If held until the maturity date.

Multiples have several purposes. Let’s explore the two primary ones.

To Compare Investments

One of the primary purposes of multiples is to easily facilitate comparisons with other investments. Investors attempt to maximize their returns and will always seek out investments that generate the highest returns relative to the amount of risk. Using a simple metric to calculate potential returns on various investments simplifies this process.

Quick Valuation Method

Multiples are also used as a quick calculation before other more thorough measures of return are employed, such as the internal rate of return (IRR) or discounted cash flow (DCF). Multiples allow you to quickly evaluate and rank potential investments before deciding which ones to pursue. Multiples can differ dramatically from business to business and from buyer to buyer for the same company, which is one of the reasons the range of values can be so broad for a business.

For example, if a business is priced at $10 million and generates $1,000,000 in EBITDA, you can run some quick calculations and determine that other investments may be more attractive than one that only offers a 10% ROI. Few investors would invest in a business that offers a 10% ROI when other lower risk, absentee investments are available, such as real estate or stocks. The exception is if the business offers some unique advantage that’s difficult for the acquirer to replicate and the buyer can take advantage of these synergies and earn a higher return. Multiples are a handy tool to use before deciding to dig deeper into the merits of an investment. 

The purpose of calculating the ROI and multiples is to facilitate comparison with other investments. 

The following chart shows typical returns for Main Street and mid-market businesses and their corresponding multiples.

“Valuing a business is part art and part science.”

– Warren Buffett, American Investor and Philanthropist

Buyers buy businesses so they can receive a return on the investment (ROI) they make in the business. ROI is calculated by dividing the return by the amount of the investment. Here’s an example: 

$100,000 return/$1,000,000 investment = 10% return on investment 

In the real estate world, a capitalization rate is the rate of return a real estate investment generates. Typical cap rates for real estate range from 4% to 10%. This would correspond to an 10.0 to 25.0 multiple.

In the business world, ROI is the inverse of a multiple. If the multiple is 4.0, the ROI is 25%. For example:

$1 million EBITDA x 5.0 multiple = $5 million purchase price, or

$1 million EBITDA/$5 million purchase price = 20% ROI

Multiples are used in the business world because they’re simpler to calculate, and returns are significantly higher on businesses than other investments. Common multiples for most mid-sized businesses are 4 to 8 times EBITDA. This equates to a 12.5% to 25% ROI for the buyer, not taking into account the impact of any synergies. Because returns are higher, it’s easier to calculate a multiple than a cap rate.

For example, if a business generates $2 million in EBITDA, it’s much simpler to apply a 6 multiple than to calculate a cap rate of 16.66%. You can calculate the value of a business in your head when using a multiple, but when calculating a cap rate you’ll usually need to perform the calculation using a computer or calculator – or, in a pinch, the back of a napkin.

Calculating a multiple is quick and easy, enabling buyers to readily compare the potential returns on different investments. 

The return on investment is the inverse of the multiple.

Now that I’ve explained how to normalize your financial statements, let’s go into more detail about the primary measure of cash flow that nearly all valuations are based on – EBITDA. It’s critical that you fully understand what EBITDA is and why it’s the most common metric used to value businesses in the middle market. 

EBITDA

With the notable exception of tech businesses, EBITDA is the most common measure of earnings for mid-sized companies and allows a buyer to quickly compare two companies for valuation purposes. Once you know the EBITDA of a business, you simply apply a multiple to arrive at the value. 

Here’s the strict definition of EBITDA:

EBITDA = Earnings (or Net Income) Before Interest (I) + Taxes (T) + Depreciation (D) + Amortization (A)

EBITDA measures the profitability from the core operations of a business before the impact of debt (interest), taxes, and non-cash expenses (depreciation and amortization). It eliminates the impact of financing (interest) and accounting decisions (depreciation and amortization), which can vary from business to business.

Here’s a description of each component of EBITDA:

• Earnings (E): This is the net income of the business after all operating expenses such as insurance, rent, and payroll have been paid.
• Before (B): Referring to “Earnings Before …”
• Interest (I): This includes interest from all debt financing, such as bank loans. Different companies have different capital structures and varying levels of debt, resulting in different interest payments. This results in varying net incomes. EBITDA allows you to easily compare two businesses while ignoring the capital structure of each business, which may change after the acquisition. In other words, EBITDA includes interest payments because interest payments discontinue post-acquisition in most cases, with a few rare exceptions.
• Taxes (T): This includes city, county, state, and federal income taxes. Income taxes vary based on a number of factors and are likely to change post-acquisition. As a result, EBITDA includes taxes in its calculation. Note: Only income taxes are added back; don’t add back sales or excise tax when calculating EBITDA.
• Depreciation (D): Depreciation is a non-cash expense. Methods of depreciation vary by company. Actual cash flow is based on real capital expenditures (CapEx), not depreciation; therefore, depreciation is also added back when calculating EBITDA.
• Amortization (A): Amortization is a non-cash expense and is the “write-down” of intangible assets, such as patents or trademarks.

Why EBITDA?

There’s one primary reason buyers use EBITDA – to compare two businesses with one another quickly. Here are several additional reasons EBITDA is so commonly used:

• EBITDA facilitates comparisons: EBITDA is an approximate measure of the cash flow available to the buyer. The goal of calculating EBITDA is to facilitate an apples-to-apples comparison between businesses. EBITDA allows one to make comparisons across companies, whether they’re in the same industry or not. 
• EBITDA is a rough estimate of free cash flow: EBITDA is an estimate of the amount of cash flow available to pay back interest or debt and fund the purchase of new equipment, such as “capital expenditures.” Once EBITDA is calculated, buyers will dig deeper into a multitude of other factors to calculate other measures of cash flow and the multiple, such as the growth rate of the company, its gross margins, customer concentration, and dozens of additional financial and non-financial factors. 
• EBITDA is primarily used as a measure of earnings: EBITDA is useful when a buyer is initially evaluating a company as an acquisition target. Once a buyer digs deeper, they’ll use other more specific measures of earnings to assess your company and will make adjustments to account for interest payments and capital expenditures. 
• EBITDA is used in most valuation methods: For example, EBITDA is used to calculate the value of a business in several income-based valuation methods. It’s also used when evaluating comparable transactions to compare multiples among similar businesses that have recently sold.

Benefits of EBITDA 

There are both advantages and disadvantages to using EBITDA to value your business. The following are the benefits:

• Common Use: EBITDA is the most commonly used measure of earnings by buyers, sellers, investment bankers, M&A advisors, and many others to value companies in the middle market.
• Straightforward Calculations: EBITDA is simple to calculate and less prone to error, which facilitates more accurate comparisons.
• Eliminates Non-Operating Variables: EBITDA eliminates variables that may not impact the buyer post-acquisition, such as interest or taxes. It also removes non-cash expenses, such as depreciation and amortization, so buyers can make their own estimates regarding the amount of these expenses. They can then deduct the amount from cash flow based on when the money is actually expended, not when it’s deducted for tax purposes.
• Allows Comparison: Because EBITDA is commonly used and straightforward to calculate, it allows one to easily compare a business’s earnings with other businesses. This comparison also facilitates the use of comparable transactions to value a business.

Downsides of EBITDA

EBITDA is fallible and can present these shortcomings, as well:

• Rule of Thumb: EBITDA is a simple rule of thumb. Expect buyers to dig deeper into your financials than just calculating EBITDA. EBITDA isn’t a magic bullet – just because your business has a high EBITDA doesn’t necessarily mean it will be an attractive acquisition candidate to a buyer.
• Not an Accurate Measure of Cash Flow: EBITDA is not a wholly accurate measure of cash flow for a buyer post-acquisition for the following reasons:
  • Depreciation: Adding back depreciation for companies with significant depreciation and ongoing capital expenditures results in an inflated measure of earnings. EBITDA is misleading for companies with significant ongoing capital expenditures. 
  • Amortization: The same can be said for amortization, as in the case of companies with significant amortizable intellectual property, such as pharmaceutical companies. 
  • Working Capital: EBITDA ignores working capital needs by not accounting for working capital injections that might be required by the buyer, especially in the case of high-growth companies.
  • Taxes: EBITDA also ignores the impact of income taxes. Theoretically, a company in a non-taxable state such as South Dakota may be worth more than a company operating in a state with corporate income taxes. 

Deciding on the Base Year

An important consideration is determining which year the valuation should be based on. A valuation is normally based on the last full year’s EBITDA or the most recent twelve months – also called trailing twelve months (TTM). In other cases, a weighted average may be used if results are inconsistent from year to year and business cycles are longer and unpredictable. Some value may also be placed on projected current-year EBITDA if the growth rate is consistent and predictable. Some buyers may attempt to use an average of the last three years’ EBITDA, which can pull down your valuation if your business is growing from year to year.

If you want to increase the value of your business – focus first on increasing the EBITDA of your business and then on increasing your revenue.

How To Increase the Value of Your Business

While you shouldn’t ignore other factors, one of your most important objectives should be to increase EBITDA. Every dollar increase in EBITDA increases the value of your business by its multiple. 

For example, let’s say your business is likely to sell at a 5.0 multiple. If you increase your EBITDA by $1 million per year, you will have increased the value of your business by $5 million ($1 million x 5.0 multiple = $5 million).

There are only two direct ways to increase EBITDA:

1. Increase Revenue: 
   • The easiest way to increase revenue is to increase your prices because 100% of your price increase will fall to the bottom line, less any direct sales costs. For example, if your company currently generates $10 million per year in revenue, and you increase pricing by 5%, your EBITDA will increase by $500,000 per year ($10 million x 5% = $500,000), less any direct sales costs such as commissions. If your current EBITDA is $2 million, your EBITDA will increase by 25% (to $2.5 million from $2 million). In essence, a 5% rise in prices can increase your EBITDA by 25%. 
   • Other methods for increasing revenue primarily include creating new products or services or selling more of your existing products and services. But be careful before engaging in risky product development or marketing campaigns if you plan on selling in the next few years. Conservative buyers generally won’t allow you to make adjustments for any unsuccessful marketing campaigns or product launches when calculating EBITDA. I recommend sticking to low-risk methods of increasing your revenue if you plan to sell in the next three years, such as increasing your budget in predictable marketing campaigns with measurable returns. Avoid high-risk sales or marketing strategies such as hiring a new sales manager or launching a new marketing campaign in which you have no experience. These strategies can drain cash flow, decreasing EBITDA and therefore decreasing the value of your business.
2. Decrease Expenses: Decreasing your expenses is often easier than increasing revenue. Doing so also has the advantage of immediately impacting EBITDA and is less risky than attempting to increase revenue. The only caveat here is to not reduce expenses the buyer would view as unfavorable – for example, standard insurance premiums should be maintained, as should normal inventory levels.

Another alternative for increasing the value of your business is to increase its growth rate, so “projected EBITDA” is used to value your business instead of the “current year’s EBITDA.” The value of your business is normally based on its most recent 12-month EBITDA (TTM). But, if you’ve demonstrated strong, consistent growth, you may be able to negotiate a price based on some measure of projected EBITDA.

Conclusion

The starting point for all business valuations is first to normalize your financial statements to calculate EBITDA. Nearly all valuations in the middle market are based on EBITDA. But when it comes time to adjust your financial statements, there are several tips you should keep in mind. If you’re planning to sell your business in the near future, remember to:

• Minimize the number of adjustments several years before the sale.
• Ensure all adjustments are thoroughly documented.
• Be conservative when making adjustments.

The number one method for increasing the value of your business is to increase its EBITDA. The second method is to increase revenue. So, if you want to increase the value of your business – focus first on increasing the EBITDA of your business and then on increasing your revenue.

If you’re like most business owners, you’ve operated your company in a manner to minimize taxes. You may have given yourself and your family members as many perks and benefits as possible, kept non-working family members on the payroll, and written off other expenses through your business – all of which contribute to decreased earnings and, therefore, a lower tax burden. These, and other common practices, are designed to keep your profits and your taxes low, perhaps artificially so.

All well and good. But when the time comes to value your business, these expenses must be removed before you can accurately value it. Financial statements form the basis of all business valuations and must be “normalized” or “adjusted” before you can get a true reading. The process of normalizing or adjusting your financial statements involves making numerous adjustments so that the actual earning capacity of your business can be properly measured. 

Common adjustments include the following:

• Your salary and perks
• Family members’ salaries and perks
• Expenses or income that won’t recur or continue after the sale
• Personal expenses, such as personal auto, insurance, cell phone, child care, medical, and travel expenses
• Depreciation
• Amortization
• Investment or other non-operating expenses or income
• Interest payments on any business loans
• Other one-time or non-recurring expenses
• Non-operating revenue

Removing owner-specific perks, benefits, and expenses is necessary to determine your business’s actual earning capacity. Adjusting your financials in this manner allows you and potential buyers to compare your business with other businesses using EBITDA, which is the most common metric for valuing companies in the middle market.

Adjusting your financial statements is one of the most important steps in valuing your business. Many buyers compare potential acquisition targets using EBITDA. By comparing the EBITDA of one company with another, buyers can easily understand a business’s value based on the business’s generated profits rather than its taxable income. This normalization helps facilitate a more accurate comparison between companies.

Let’s get ready to do some normalizing …

Adjusting your financial statements is one of the most important steps in valuing your business. 

Definitions of Adjustments 

Here are descriptions of the different types of adjustments that can be made when calculating EBITDA. 

• Discretionary Expenses: Expenses paid for by your business that are a personal benefit to you are discretionary. To qualify, the expense must personally benefit you and not your business or your employees. These expenses must be paid for by your business and be documented as an expense on your profit and loss statements. 
• Extraordinary Expenses: Expenses your business paid for that are exceptional, unlikely to recur, and are documented as extraordinary are known as extraordinary expenses. Examples include expenses associated with natural disasters, relocation of your business, or a lawsuit. Examples that don’t qualify include a marketing campaign that failed or headhunter fees to replace a manager who resigned.
• Non-Operating Revenue and Expenses: These are expenses or revenue unrelated to your core business operations. Examples of non-operating revenue include interest earned on investments, revenue from the sale of a large asset such as the sale of equipment that’s no longer used in your business, or an insurance settlement. Examples of non-operating expenses include interest payments on debt and payments to settle lawsuits.

Sample Adjustments

The following adjustments are generally allowable and can be adjusted when calculating EBITDA:

• Accounting: Any accounting fees incurred that are unrelated to your business or are for personal matters
• Amortization: All amortization (the ‘A’ in EBITDA)
• Barter Fees: Any barter-related fees, expenses, and income 
• Cost of Goods: Expenses for anything purchased for personal use that wasn’t used for your business
• Depreciation: All depreciation (the ‘D’ in EBITDA)
• Entertainment: All personal entertainment and related expenses
• Interest: All interest expenses (the ‘I’ in EBITDA)
• Legal: Any personal legal fees
• Meals: Any personal meal expenses
• Medical: Any personal medical expenses
• One-Time Expenses: Any capital investments in new equipment, one-time start-up expenses for new product lines, build-outs, major repairs, or one-time legal fees
• Payroll: Any salaries for non-working family members
• Personal Vehicles: Any automotive expenses, payments, fuel, insurance, and repairs for personal use
• Repairs: Any repairs for your personal home or other personal property
• Supplies: Personal groceries and other supplies
• Taxes: All corporate income taxes (the ‘T’ in EBITDA)
• Telephone: Personal cell phone expenses
• Travel: Any expenses related to personal or nonessential travel.

The following expenses can be partially adjusted:

• Charitable Contributions: Owners often make charitable contributions with the expectation of receiving business in return. For example, an owner of a company might sponsor a local sports team and hand out free products at events or make cash contributions. Doing so is often expected to generate publicity and exposure for the business, but directly measuring the results is difficult. You can adjust any personal contributions made that aren’t related to your business or in which your business didn’t receive any exposure, such as a private donation to your church, but you should leave in any charitable contributions that were expected to benefit your business.
• Continuing Education: Some educational expenses are considered discretionary and shouldn’t be removed just because they were optional. These expenses should be removed only if they were personal in nature and weren’t related to the business. For example, if continuing education is the norm in your business or if it’s directly related to your business, leave it in.
• Dues and Subscriptions: Any personal fees such as country club dues that had no expectation of benefitting your business can be removed. All business-related dues should be left in.
• Retirement Contributions: You can remove your 401(k) and IRA contributions for yourself and any family members, but don’t remove any fees related to retirement plans that benefit your employees.

The following expenses should be normalized to market rates:

• Bad Debt: You should ideally establish a reserve for bad debt, or an allowance for doubtful accounts. If you don’t, adjust any bad debt that’s excessive based on your prior years. You can normalize this, but you shouldn’t remove it completely. If you had bad debt in the past in your business, you’re likely to have it again. This should be normalized based on your prior years by deducting an even amount each year (i.e., establishing a reserve for bad debt), or by spreading a large bad debt expense over several years.
• Personal Insurance: Any personal insurance expenses such as health insurance, dental insurance, and life insurance, should be adjusted to what might be considered reasonable for a president of a company of your size. Most buyers in the middle market will hire someone to continue running the company, and personal insurance expenses are often included in the compensation package.
• Rent: If you own the property and lease it back to your business, the rent should be normalized to current market rental rates based on the cost to rent the property in the open market, not based on your cost of ownership.
• Underpaid Employees: Salaries for underpaid employees, such as family members working in your business, should be normalized to market value.
• Unpaid Family Members: Salaries for working family members should be adjusted based on the actual cost in the marketplace. Salaries for non-working family members should be added back.
• Your Salary: Your salary should be normalized to market rates. For most middle-market business owners, this equates to a salary of $200,000 to $500,000 per year, plus benefits.

The following expenses shouldn’t be removed and can’t be adjusted. You can identify these as expenses that can be reduced or limited, but they shouldn’t be adjusted when calculating EBITDA:

• Advertising: Owners often attempt to remove fees related to advertising because the advertising campaign wasn’t effective and didn’t bring in any business. But developing successful advertising campaigns always involves risk. This is a routine business expense and can’t be removed just because the campaign was unsuccessful. A new owner must continue to advertise and market the business, and many campaigns are unsuccessful.
• Entertainment and Meals: Dining with clients is critical to building relationships. These expenses shouldn’t be removed just because they were optional.
• Membership: Membership fees in country clubs and other clubs that are optional should be identified but not adjusted. 

Tips for Making Adjustments

Making adjustments is an integral part of the valuation process. Properly adjusted financials allow for the accurate comparison of different businesses. When making adjustments, it’s important to remember that buyers will examine them and may raise questions if any adjustments appear to be inaccurate, or the buyer may simply walk away without discussing their concerns. Here are several tips to ensure the adjustments you make will be accepted by buyers.

Be Thorough

All adjustments should be concise and verifiable. The more thorough and accurate the documentation is regarding your expenses, the better. If you’re aggressive or inaccurate with one adjustment, most buyers will question the credibility of everything else you say from that point on. The more detail you provide and the more documentation there is to back up your adjustments, the more likely you’ll sell your business quickly and for the best price possible. That’s why I recommend hiring a third party to review your adjustments and assist you in calculating your EBITDA. 

If you’re aggressive or inaccurate with one adjustment, most buyers will question the credibility of everything else you say from that point on.

Be Conservative

When making adjustments, buyers will have the opportunity to review the backup documentation for the adjustments you made to your financial statements during the due diligence period. If you’re aggressive in the adjustments you make, it’s possible the buyer won’t accept all of them. On the other hand, if you’re conservative in the adjustments you make, it’s less likely the buyer will dispute the legitimacy of any of them. Some adjustments are in gray areas – for example, you may have adjusted out $10,000 in country club dues. But a buyer may reason that you have golfed with a few clients before and may not necessarily have landed or retained these clients if you didn’t give them the opportunity to beat you on that last dog-leg par four.

While buyers may not necessarily voice the fact that they aren’t accepting your adjustments, any aggressive adjustments you make can cause more concern than necessary and as a result, they may begin to question other areas of your business more stringently. 

While the buyer won’t necessarily approve or reject every adjustment you make, if more than a few are questionable, the buyer is likely to downgrade their valuation if you overestimate EBITDA.

When selling a business, always be conservative when making adjustments to your financials. If you’re conservative, the buyer will assume you’ve been conservative regarding other issues as well, and the buyer may feel the need to verify fewer of your representations during due diligence. On the other hand, if your adjustments are aggressive, the buyer may feel the need to perform more thorough due diligence.

Value is a function of risk. The lower the risk, the higher the value. A buyer who’s dealing with a conservative seller will view the transaction as less risky and may be willing to pay a higher multiple than if the buyer were dealing with an aggressive seller who may represent more risk. Keep in mind that when I say “aggressive” in the context of selling a business, I’m referring to the representations you’re making. 

An example of an aggressive representation is, “I can definitely grow revenue by 20% per year for the next five years.” 

An example of a conservative representation would be, “I have grown revenue by 18% to 22% during the previous three consecutive years, and I hope this trend will continue. But I’m always aware that the economic and competitive landscape can change at a moment’s notice, and my estimates are just that – estimates.”

If your stance is aggressive, the buyer may also propose much more thorough reps and warranties in the purchase agreement to protect themselves after the closing. This could include language in which you warrant that any claims you made were true to the best of your knowledge. If your representations later prove to be untrue, your representations will come back to bite you, even after the closing. The buyer can sue you or even offset losses from your representations against future payments via a setoff against any future payments, such as a promissory note or earnout. If you want to sleep soundly at night after you sell your business, make conservative statements.

Value is a function of risk. The lower the risk, the higher the value. 

Minimize Adjustments

The fewer adjustments there are, the cleaner your financials will look when selling your business. Look at your profit and loss statement. How many total adjustments do you have? Don’t focus on the total in dollars (for example, $936,950 in adjustments) but instead look at the total number of adjustments (as in, 14 adjustments in the most recent year). Remember – the fewer adjustments, the better. 

When a buyer first looks at your profit and loss statement, they’ll immediately notice the total number of adjustments you make. If your adjusted profit and loss statement is clean, with minimal adjustments, the buyer will assume that due diligence will be faster, less expensive and that this transaction will represent less risk for them. On the other hand, if your financial statements include dozens of adjustments and there are other inconsistencies they notice at the outset, many buyers will walk away at this point because they won’t want to invest the time and effort in trying to unravel the situation.

Don’t include any small adjustments that don’t meaningfully impact EBITDA. It’s generally a good idea to avoid making any single adjustment less than $5,000 to $10,000, although the amount depends on the size of your business. Your goal should be to reduce the total number of individual adjustments, not the total amount of adjustments. Small adjustments don’t impact EBITDA enough to impact the valuation substantially, and generally aren’t worth making. A financial statement with fewer adjustments looks “cleaner” to a buyer and may justify a higher valuation because the buyer may perceive that fewer adjustments must be verified during due diligence.

If you minimize adjustments, buyers will assume you’ll be easier to deal with than other business owners and that you’re running your business in an upright, above-board fashion. Collectively, these strategies build trust, which reduces risk for the buyer and maximizes value for you. It may even lessen the burden of due diligence. The ideal scenario is to eliminate adjustments altogether at least two to three years prior to a sale. This will increase the value of your business and reduce the burden of due diligence. 

Always be conservative when making adjustments to your financials.

Impact of Adjustments on Valuation

If you want to maximize the purchase price, there’s one simple trick you can employ. Be conservative regarding your adjustments, but be aggressive regarding the multiple you choose when valuing your business. 

Here’s an example:

You can often justify this higher multiple in Business B if you can demonstrate to the buyer that your business represents less risk. The strategies above don’t prevent you from keeping “potential adjustments” in your back pocket – just don’t show them to the buyer until you need to. If the buyer is performing due diligence and uncovers a few problem areas, they may attempt to renegotiate the purchase price. This is the perfect time to sit down and have a talk with the buyer. Walk them through the expenses you decided not to adjust. Tell the buyer you wanted to be as conservative as possible and point out each expense you didn’t make but could have. By doing so, you’re offsetting a potential renegotiation of the purchase price and reassuring the buyer that you’ve been conservative in the representations you’ve made.

If you want to maximize the purchase price, be conservative regarding your adjustments, but be aggressive regarding the multiple.

How to Easily Produce a Detailed List of Adjustments

The best way to prepare a list of your adjustments is to export a “general ledger” from your accounting software to Microsoft Excel or a similar program. Once exported, mark each adjustment with an “X” or highlight the entire row. By doing this, you’ll have a spreadsheet that clearly identifies all your adjustments that you can give to the buyer when they perform due diligence. Simply show buyers this report, and the buyer will be able to tie each adjustment to the specific entries in your accounting software. Remember that the buyer may request the source documents, such as receipts for the transactions, so also be prepared to produce detailed invoices or receipts if necessary.

“Profit is not a cause, but a result.”

– Peter F. Drucker, Management Consultant and Author

Here’s the bottom line – before you value your business, you must make sure your financials accurately reflect the actual earning capacity of your business. You do this by making numerous adjustments to your financial statements to calculate your business’s cash flow. This process is called normalizing, recasting, or adjusting your financial statements. The resulting cash flow after the adjustments have been made is called earnings before interest, taxes, depreciation, and amortization (EBITDA).

In this chapter, I talk about the importance of normalizing your financial statements, walk you through how the normalization process works, and share common adjustments that can and can’t be made when calculating EBITDA. Don’t skip this chapter – understanding how EBITDA is calculated is critical to the valuation process because this is the number one measure of cash flow all buyers use to value businesses in the middle market. A thorough understanding of EBITDA is the foundation on which to value any mid-sized business.

Now that we’ve covered what all buyers look for, let’s cover the extent to which the two main buyer groups value each of the factors already discussed.

There are two broad categories of buyers – financial and corporate buyers. Each group has different criteria and goals for buying a business and will place a different value on the factors previously outlined. It’s crucial that you understand the two general types of buyers in the business world and which type is most likely to acquire your company. Only then can you determine what changes to focus on to drive up the value of your business and receive the highest possible price from that specific buyer group. 

When preparing to sell your business, you should start by understanding the type of buyer most likely to acquire your company. By understanding these two buyer types and their criteria, you can best position your business to be as attractive as possible to the category of buyer most suited to it. This serves to maximize the price you receive and saves you from the wasted effort of making improvements to your business that a buyer may not desire.

Here are both types in more detail and what each buyer group looks for.

Buyer Type 1: Financial Buyers

Financial buyers primarily consist of private equity firms. These buyers are likely to consider businesses in a variety of industries, including the service, technology, retail, wholesale, and manufacturing sectors. They often have general criteria they’re seeking in a business, such as the level of cash flow or limitations on customer concentration, but they don’t usually limit their search to specific industries. While there are different subsegments of financial buyers and private equity that place a varying level of importance on various criteria, I’ve summarized the primary factors that nearly all financial buyers look for below.

Profitability

Financial buyers evaluate a business based on the income it can generate for them; hence their name – financial buyers. This kind of buyer is looking for an income stream and will often consider a business in any industry that meets their general investment criteria. Financial buyers are highly numbers-driven. That’s why they’re called financial buyers.

If your business is likely to be sold to a financial buyer, prioritize profitability over other factors until your EBITDA exceeds $5 million per year. If your business generates less than $2 million in EBITDA, it’s usually more beneficial to invest in sales and marketing to increase the revenue or profitability of your business than to invest in building a management team or infrastructure. To be sure, improving other value drivers helps, but most financial buyers prefer more cash flow over added infrastructure.

Since this sort of buyer is focused heavily on the numbers in the business, they’re often looking for the highest return on their investment, technically called the internal rate of return, or IRR for short. They scour the market for businesses selling at the lowest multiple, which is calculated by dividing the asking price by your EBITDA. They’re likely considering dozens of types of businesses in addition to yours.

Financial buyers are highly numbers-driven and evaluate a business based on the income it can generate for them.

Management Team

Financial buyers rarely become involved in the operations of a business. Remember, they are financial buyers, and they don’t become actively involved in the operations of the companies they acquire. Most private equity firms require that the management team and owner remain to continue operating the business after the closing, in addition to requiring significant infrastructure to ensure the business can scale. If this isn’t the case, they will bring in an external president to run the company, although this adds an additional element of risk for the investor. 

General partners in private equity firms focus their time on acquiring companies and don’t become actively involved in the management of their investments. So, either existing management must remain to operate the business, or the private equity firm must hire a management team to run the business after the closing. The only exception to this rule is when the private equity firm owns a portfolio company that competes directly with yours, and they plan to integrate your business with that company. 

In most cases, if you aren’t willing to stay to run the company and you lack a strong management team that can run your business without you, your business will be unsalable to most private equity firms.

Infrastructure

Some private equity firms specialize in lower middle-market businesses, which tend to have less infrastructure than larger companies. These businesses offer private equity firms more opportunity for value creation by implementing what is known as the “private equity toolkit.” This consists of a number of tools the private equity firm implements to build infrastructure into your company to improve its scalability and manageability. Other firms seek companies that already have significant infrastructure in place and shy away from any companies that lack this framework. 

In most cases, a strong management team is more important to private equity firms than strong infrastructure. While most private equity firms require significant infrastructure, the need will vary depending on the firm and its market focus. 

Private equity firms specializing in the lower middle market are skilled and experienced at installing systems and other infrastructure in businesses to enable them to quickly grow. After all, that’s one of the primary tools private equity firms use to scale a company. They often view installing infrastructure as less risky than building a new management team. Most partners at private equity firms have experience professionalizing dozens of middle-market companies. 

Companies generating nine-figures (greater than $100 million) tend to already have significant infrastructure in place, are run professionally, and don’t benefit as much from the private equity toolkit as do companies in the lower middle market. On the other hand, private equity firms that operate in the middle and upper-middle markets tend to use different tools, such as financial engineering, to create value more than PE firms operating in the lower-middle market.

Financial buyers target an internal rate of return of 20% to 30% per year, which means they aim to double or triple their investment in 3 to 5 years before selling the business again to another buyer. You might hear this referred to as a 2x or 3x MOIC, or multiple of invested capital. Generating these kinds of returns is often possible only with systems and infrastructure in place, and installing these systems and infrastructure costs time, money, and risk for the financial buyer. If your business doesn’t have this infrastructure in place, it will still be salable to a PE firm, but you won’t receive top dollar for it. 

While infrastructure is essential to financial buyers because they won’t be involved in the day-to-day operations, it’s less important than a strong management team. If you want to sell your business for the maximum amount possible, focus on building a business that’s scalable from day one. 

Ability to Replicate

The more attributes your business has that are difficult to replicate, the more value PE firms will see in it. Most PE firms will attempt to rapidly grow your business for three to five years after they acquire it before selling it to a strategic buyer, or another private equity firm. Often, the only way the private equity firm can maximize the selling price when they exit your business is if your business has attributes that are difficult to replicate in the marketplace. 

If your business is no different from other businesses out there, it’s replaceable, and the buyer will have no reason to buy your particular operation. To maximize the price when selling to financial buyers, spell out why your business is unique compared with other businesses to avoid having your business reduced to a set of numbers.

Growth Plan

Financial buyers primarily value a business based solely on its numbers without taking into account the impact of any synergies. They are experts at scaling companies through creating strategic relationships, building strong management teams, and developing efficient sales and marketing programs. 

Your growth plan should lay out how the PE firm can grow your business in the coming years. Showing a plan to increase EBITDA will specifically appeal to them since it’s the primary metric they use to value businesses. Remember that most private equity firms target an IRR of 20% to 30% per year, which means they must generate an ROIC of two to three times if they exit the investment in three to five years. Laying out a plan for how they can do just that with your business will appeal to all private equity firms. Making plans that quickly plateau will greatly diminish your credibility. 

Learn More

I have interviewed many partners at private equity firms and strategic buyers for my podcast, M&A Talk. If you’d like to learn more about how private equity firms think and the types of businesses they like to acquire, you can listen to the following M&A Talk episodes at morganandwestfield.com/resources/podcast:

• The Basics of Private Equity with Jeff Hooke
• M&A Perspective as a Corporate Acquirer and PE Firm with Joan De la Paz Hellmer
• The Private Equity Toolkit with Michael Roher
• The Basics of Independent Sponsors with John Koeppel
• Behind the Scenes of Private Equity with Jim Evanger & Brent Paris

Buyer Type 2: Corporate Buyers

Corporate buyers primarily consist of direct and indirect competitors and strategic buyers, and each group varies in what they specifically look for in a business. Strategic buyers look to capitalize on synergies that can be obtained by acquiring your business that they might not be able to replicate on their own, such as valuable intellectual property or long-term customer contracts. Corporate buyers that are direct or indirect competitors often look to acquire not for synergies but as an alternative to organic growth. Despite those differences, much of what corporate buyers look for is similar. I’ll explain each factor here. 

Every corporate buyer prefers to build if they can – because it’s much cheaper.

Profitability

While EBITDA is important to corporate buyers, it’s less important to them than to private equity firms. Financial buyers are fully numbers-driven, while corporate buyers will consider many other attributes of your business. To be sure, corporate buyers place a lot of weight on the EBITDA the business generates, but there are many other factors they also consider.

Management Team

The same can be said of your management team when it comes to corporate buyers. While corporate buyers value a strong management team, most are in the same or a similar industry and are willing to tolerate a less-than-ideal management team, especially if they plan on integrating your business with theirs. If the buyer will be fully integrating your company with theirs, they will require less bench strength than if they were to keep your business operating on a stand-alone basis after the closing.

Infrastructure

The degree to which corporate buyers require scalability and infrastructure in your business depends on if they plan to merge your business with theirs or if they want to run your business as a separate entity after the closing. Here’s a breakdown of each: 

• Integrated: Corporate buyers who will be integrating your company with theirs require less infrastructure in your business than if it will be run as an independent business after the closing. In these cases, the buyer already has existing infrastructure and doesn’t require your business to have as much infrastructure than if it were to continue to run as a stand-alone entity. For example, the acquirer may provide legal, accounting, and human resources services to its business units or divisions and may therefore not require that these functions be highly streamlined in your business.
• Stand-Alone: Corporate buyers who will keep your business as a stand-alone entity will require more infrastructure than if they were integrating your business with theirs. They may not be interested in acquiring your business unless your company has adequate infrastructure in place and can continue to operate on a stand-alone basis without your involvement. In some cases, this type of buyer may promote a manager at their corporate office to run your company as president. Still, your business should have a management team and systems in place to ensure that operations continue to run smoothly during the transition process.

Ability to Replicate

All corporate buyers carefully weigh the “buy vs. build” decision. To buy is to make acquisitions, or to grow inorganically. To build is to pursue growth organically, such as through sales and marketing programs or by introducing new products. Every corporate buyer prefers to build if they can – because it’s much cheaper. So if they can replicate, or build your business from scratch, they will. If they can’t replicate your business, only then will they consider acquiring you.

All competitors will examine the extent to which they can replicate attributes of your business, or generate a similar level of organic growth. It may be possible to replicate your business by starting a comparable business from scratch, acquiring another similar company, or launching a new product line that is close to what your company offers.

The more difficult it is for a competitor to replicate your business, the higher the multiple you’ll receive. The degree to which a buyer can reproduce your business depends on your industry and your competitive advantage, and how difficult that advantage is to copy. While other factors may influence the price, the degree to which your business can be easily replicated is one of the most important factors these buyers consider when evaluating your company.

Certain industries have low barriers to entry, while others have high barriers to entry. Industries with high barriers to entry receive higher multiples because businesses in these industries are often difficult to replicate. Competitors also compare the cost of investing in your business with the cost of other corporate development options such as joint ventures, partnerships, or strategic alliances. 

Corporate buyers are usually in the market for a business with a competitive advantage that’s sustainable and not easily replicated. Your business must have a competitive differentiation or other attributes that a buyer can’t easily reproduce. 

If your business is easy to replicate, the buyer will do just that. They will build instead of buy. If your business is likely to be sold to a corporate buyer, then focus on building a business that possesses attributes that are difficult for the buyer to replicate.

Growth Plan

Corporate buyers have longer holding periods than financial buyers and often have no defined exit plan. They typically expect to fully integrate your company into theirs and hold it indefinitely. Make sure your growth plan highlights the difficult-to-replicate value in your business. Show how you could leverage that value in your growth plan. Focus on aspects such as intellectual property or long-term customer contracts in order to make buying your business more appealing than organic growth. 

Conclusion

When preparing to sell your business, it’s important to understand the different buyer types, their criteria, and how you can position your business to be as attractive as possible. Know the different types of buyers and the degree to which they require systems, a management team, and other attributes before you invest time in building them. Each type of buyer has a different set of preferences regarding the type of infrastructure, systems, and other elements they desire in a business. 

Many buyers will consider a profitable business that lacks infrastructure. But few buyers will consider an unprofitable business that has significant infrastructure in place. Always prioritize profitability over infrastructure until your EBITDA exceeds several million dollars per year.

For most businesses, developing a management team is the most critical factor other than profitability in building a salable business. For other businesses, creating systems or increasing cash flow may create more value. There’s no cookie-cutter formula. Knowing the potential types of buyers for your business can help you maximize your sale price and properly market your business for sale to the right audience when the time comes, setting it apart from other companies like it.

Before diving into the features specific buyer groups look for, I’ll list and describe the primary factors all buyers will consider when looking to acquire any company. After we cover these, I’ll review the two major types of buyers and the degree to which each buyer group seeks each of these attributes.

Factor 1: Profitability

The most important factor all buyers look for in a business is profitability. If your margins are lower than industry benchmarks, don’t waste your time or money focusing on other value drivers. Instead, invest in improving profitability. Only when your profitability is healthy should you focus on improving other value drivers, such as building a management team or infrastructure. 

Many buyers will consider a profitable business that lacks other key attributes, even in the middle market. But few buyers will consider a business that doesn’t generate a significant profit, even if it possesses many other valuable attributes. As a rule, always prioritize profitability over every other value driver.

In most industries, few buyers will give your business a second look if it isn’t generating a significant amount of profit. The primary exceptions are businesses in highly scalable industries, such as technology and healthcare. If your business isn’t generating substantial profit, don’t waste your money building infrastructure or a management team that won’t increase your profitability. Invest your money in sales and marketing instead. Only when your business is highly profitable should you invest in other optimizations.

The most important factor buyers look for in a business is profitability.

Factor 2: Management Team

Most buyers desire a company with a strong management team as opposed to a business that’s dependent on a few key people. Unfortunately, building a professional management team requires a new set of skills for most entrepreneurs. When you first started your business, you likely performed most of the key tasks yourself. But once you reached a certain point in your business, you probably built a management team that handled many of the key decisions in your business.

Starting a business requires a different set of skills than growing a business. And different sets of skills are required at different stages of growth. The skills required to grow your business from zero to $1 million in revenue aren’t the same skills needed to grow your business to $50 million or $500 million in revenue. 

Building a team requires both recruiting and management skills. You have to learn how to find and hire good people and then how to get the best results from those people. What position or positions would add the most value to your company? What does your company need most? Would a CFO, COO, VP of Marketing, VP of Sales, or VP of Human Resources help? Should you hire an external president? Take the time to develop a formal management team. Not only will your business be easier to sell, it will also sell faster, and as a result, your revenues and profits will likely increase.

Understand the different types of buyers and the degree to which they require infrastructure before you invest in building systems and a management team.

Factor 3: Infrastructure

Buyers in the middle market look for a business that has infrastructure and that’s scalable, or that has the potential to grow quickly. Buyers love a business that has significant infrastructure in which the owner hasn’t tapped its full potential. This usually involves an owner who’s burned out or hasn’t built effective sales and marketing systems but has the infrastructure and operational systems in place to quickly scale once sales and marketing are ramped up. To sell your business for the maximum amount, focus on building a business that’s as scalable as possible. You can greatly improve scalability and manageability by developing systems to streamline, automate, and document your processes, which will increase your business’s value.

Factor 4: Ability to Replicate

Buyers in the middle market also look for businesses that possess attributes that are difficult to replicate. If your business has low barriers to entry and is a “me too” product or service, this may turn many buyers off, especially if they feel they can easily replicate what your business has to offer them. 

But there’s one major exception to this rule. In industries that are viewed as a zero-sum game in which further organic growth is difficult to achieve, companies regularly acquire competitors as an alternative to organic growth. But again, this is still difficult to replicate. For example, companies in the pest control and commercial cleaning industries regularly acquire competitors, even if no competitive advantage exists.

The following is a list of differentiating factors that can make your business difficult to replicate and therefore increase its value:

• Advantageous contracts with suppliers, vendors, or other third parties
• A website with high search engine rankings
• Cost advantages that are difficult to replicate
• Custom software
• Customer loyalty
• Experienced management team
• First movers in industries with network effects
• Government regulations that restrict competition due to high barriers to entry
• High switching costs for customers
• Intellectual property, such as patents or trade secrets
• Licensing requirements that prevent competitors from entering the market
• Long-term contracts with customers
• Prime location with a long-term lease, for retail operations
• Proprietary technology
• Recurring revenue
• Repeat customer base
• Significant barriers to entry
• Stable customer base
• Strong distributor or supplier agreements

One of the main aspects buyers look for is a strong competitive advantage. A competitive advantage should be summarized in an objective statement and should be difficult for competitors to copy. Your business must have a competitive differentiation that a buyer can’t easily reproduce if you want top dollar for your business. Superior customer service isn’t a competitive advantage. Rather, a competitive advantage is one that’s difficult to replicate, such as proprietary technology, economies of scale, patents, well-known trademarks, and brand name recognition, to name a few. 

When planning to sell your company, consider the extent to which buyers may view your business as easy to replicate. To make your company as attractive as possible, build a business that’s difficult to replicate.

Factor 5: A Growth Plan

Regardless of who’s most likely to buy your business, if you want to maximize its value, you should create a plan that outlines its potential growth opportunities. Most buyers will ask why you’re selling when you’re at a supposed inflection point in your business. Your answer will either maximize or destroy your positioning. There should be plenty of runway left for the buyer. Ideally, you should be in the process of executing your growth plan so you can backup the assumptions in your plan with current data.

Prepare a short business plan with simplified financial projections. Highlight the major ways you can grow your business and include a short, bulleted list for each growth opportunity. Here are some tips for preparing projections:

• Don’t lump all revenue streams together. Break your revenue down by type.
• Include three sets of assumptions – low, medium, and high. Av0id hockey stick business plans – scenarios that show steep increases following periods of flat performances – they diminish your credibility. Prepare your projections in a spreadsheet so the buyer can play with the numbers to determine the impact of any potential changes in the variables, which is called a sensitivity analysis. 
• Document and provide backup documentation for each key assumption. What’s the basis for forecasting each source of revenue? What’s the basis for forecasting costs? Are they based on a percentage of revenue, are they fixed costs subject to inflation, or is there another variable? What are the assumptions behind capital expenditures over the coming years?

Build a business that’s unique or difficult to replicate. 

“Business is all about perspective.”

– Jacob Orosz, President of Morgan & Westfiel

Your business is one of your most valuable assets. When preparing your business for sale, it’s critical to know what buyers of businesses want – and then build exactly that. 

To maximize value and dramatically increase salability, you need to create a business that’s desired by buyers. Understanding what buyers are looking for is essential when deciding which action steps to prioritize to maximize your sales price.

You’ve decided to double down. What options do you have to finance the growth?

Raising money can come in the form of debt from banks or equity from investors. This section will focus on selling equity as opposed to debt. There are two primary non-bank sources for raising money – private equity firms and other investors, such as venture capital or angel investors. In most cases, this money will be raised by private equity firms, and this is suitable only for high-growth opportunities that offer the possibility of a 30% to 40% annual return for the investor. 

Option 1: Growth Equity

Growth equity is an investment made by a private equity firm in your company in which you sell a partial interest. For example, you may sell 20%, 40%, or 60% of your company. The sale can take the form of either a majority or minority interest, and you must remain on to operate the company. 

Private equity groups and corporate venture firms make these investments only in promising companies in which significant opportunity exists. Their objective is to make an investment in a portion of your company today and then sell this portion at a significant gain in three to seven years.

This is most commonly funded by financial buyers, such as private equity firms and family offices, in which they purchase a minority position in your business. Private equity firms have a limited time horizon and are counting on you to grow your company and achieve a second exit in three to seven years. Minority investments are also made by corporations, but this is less common than those made by financial buyers. This situation is best for business owners who want to receive the support of a sophisticated investor with deep pockets who’s willing to inject some growth capital into the business. An additional benefit is that the buyer will likely have deep capabilities and resources from which you can benefit, such as wider distribution channels or the brand name of a larger company.

Growth equity is ideal if you:

• Have a business with a strong competitive advantage and need the expertise or capital funding of a third party to capitalize on an opportunity.
• Are willing to stay to operate your company until it’s sold.
• Want to avoid investing more of your own capital in your company.

Option 2: Raising Funds From Angels and Venture Capitalists

The mechanics of the investment look similar to growth equity – you sell a portion of your company in the form of equity to an outside investor. But the types of companies that are suitable for this arrangement are different from those that are suitable for growth equity.

Raising money from a VC is a grueling process that can take up to a year, and you may have to give up control of your company along the way. VCs only invest in ultra-high-growth opportunities that have the potential of developing into nine-figure businesses of $100 million, and more. Less than 3% of those seeking venture capital obtain an investment, and most VC-backed investments fail. 

In summary, raising VC money is a risky, high-stakes game reserved for scalable businesses that can produce outsized returns. On the other hand, growth equity is best for stable businesses with predictable growth and cash flow. Think of it this way – growth equity is for more stable, lower growth, lower risk businesses, whereas venture capital is for risky, high-growth businesses. 

Learn More

On my podcast M&A Talk, I’ve interviewed several entrepreneurs who have raised venture capital and successfully exited their business. Several of these entrepreneurs had exits in the hundreds of millions of dollars, but the path was far from easy. Check out episodes such as Lessons Learned from $0 to $441 Million with Gustavo Ruiz Moya, Business Strategy Exit Basics with Wendy Dickinson, and Jeff Wald, Founder of WorkMarket, on a $100 Million+ Exit, and more at morganandwestfield.com/resources.

Conclusion

One of the first things you should consider when deciding whether to sell your company is if suitable alternatives exist to an outright sale. Selling your business doesn’t have to be an all-or-nothing proposition. Rather, several potential options exist. But before you explore those options, consider how committed you are to your business. Exploring your level of commitment requires being emotionally honest with yourself. If you decide you’re truly committed to your business and would like to double down, then do just that. But entrepreneurs often lack the capital to fuel the growth of their business. If this is you, growth equity from a private equity firm might be a suitable option. 

Should you sell your business or double down? The answer depends on both you and the state of your industry. You must look both inward to yourself – and outward to your industry – for the answer. In the section that follows, I show you how to look both ways and create a framework to help you decide how to navigate this difficult decision. For this framework, I’ve separated my advice for each section into three topics – your business, your industry, and your competition. Each of these topics is important to examine internally and externally to ensure you make the most reasoned decision. 

Look Outward – To the State of Your Industry

Knowledge is collecting information – wisdom is simplifying it. First, collect the necessary data, then step back to simplify it.

Step 1: Collect Information

Start by gathering information. Remember to withhold your judgment when you’re in the information-gathering stage. Stick solely to the task at hand – gather data without the need to weigh the facts or assess their impact. Once you’ve compiled the necessary information, you’ll have the opportunity to analyze and synthesize it.

Start by asking yourself the following questions about your business, industry, and competition:

• Your Business
  • Are your revenues stable, declining, or increasing?
  • Are your gross margins stable, declining, or increasing?
  • Is your net profit stable, declining, or increasing?
  • Is your value proposition still competitive?
  • Are you gaining or losing competition?
• Your Industry
  • Is your industry fragmented and run by small, independent businesses? Or is it slowly consolidating?
  • Is your industry growing, or is it in decline?
• Your Competition
  • Are your competitors stealing your market share? Is your market share slowly eroding?
  • How strong are your competitors? 
  • Are there any new competitors in your industry that are backed by institutional money, such as venture capital?
  • Have any competitors introduced a new value proposition that has the potential to change your industry and make your business obsolete?
  • Will you continue to remain competitive if you only innovate incrementally, or are dramatic changes needed to stay competitive?

Step 2: Simplify Information

Once you’ve gathered this information, analyze it at a high level. Be honest with yourself in assessing the state of your industry – don’t let your heart fool your intellect. Synthesize your information and look for trends in the following categories:

• Your Business: Is your business growing and staying competitive, or are you in a slow decline?
  • If your business is in decline, ask yourself why. Is it due to your inabilities, such as lack of skills, or unwillingness, such as lack of motivation? Is your competition simply stronger than you? If you lack the skills or motivation to compete and your competition is intense, it might be time to sell. 
  • If your business is strong and your value proposition is still relevant, it might be worth doubling down.
• Your Industry: Is your industry growing or in decline? Are competitors slowly consolidating?
  • If your industry is in decline or your competitors are consolidating, it’s time to sell, especially if you lack the ability or motivation to reinvent your value proposition.
  • If your industry is growing and competition isn’t actively growing stronger or consolidating, doubling down might be your best option.
• Your Competition: Is your competition strong and likely to put you out of business?
  • If your competition is getting stronger by the day and you lack the skills or motivation to compete, selling might be your best option.
  • Lack of direct competition might be a reason to double down and extract more value from a business.

Knowledge is collecting information – wisdom is simplifying it. 

Look Inward – To Yourself

“I’d rather regret something I’ve done than something I wish I had done.”

– Lucille Ball, American Actor

Once you’ve examined your business and industry, it’s time to look inward. While analyzing your business involves your mind, looking to yourself involves your heart. As American essayist Anaïs Nin once said, “We do not see things as they are, we see them as we are.” 

Give careful thought to each of the following three areas. 

Step 1: Assess Your Skills

Do you have the skills to continue to compete in your industry? If not, are you sufficiently motivated to acquire these skills? Is your competition so formidable that you won’t be able to acquire the skills fast enough to compete? This last situation is most common in innovative industries that require a high degree of technical knowledge, such as software. If that’s the case, it’s time to sell.

In circumstances in which you lack the skills to compete, and you’re having trouble keeping up with the competition, you have two choices: 

1. Double Down: Carve out a niche for yourself in the industry or raise money to enable yourself to compete.
2. Exit the Race: Sell your business.

Step 2: Assess Your Motivation

Do you have the energy and motivation to commit to your business? If your industry is highly competitive and the sharks are slowly eating away at your market share, you must have an unusually high degree of motivation to remain competitive. On the other hand, if competition is weak, you’ll likely be able to get by with an average amount of energy and motivation.

Are you burned out? If so, why? Are you burned out because you haven’t had a break in 10 years, or are you burned out because you hate your industry? As they say, only dead fish swim with the stream. So if you’re burned out and the competition in your industry is getting stronger by the day, you must realistically assess your ability to compete – and swim against the stream.

While analyzing your business and industry involves your mind, looking to yourself involves your heart. 

Step 3: Consider Your Dreams

Do you love your business? Do you really love your business? Knowing what you know now, would you get into your business again if you had to start all over? What are your dreams for 5, 10, or 20 years from now? Are you ready, emotionally and financially, to retire?

The answers to these questions first require that you know yourself. What makes you happy? What gets you excited? What does your ideal day look like? Does your business align with your dreams, or is your heart elsewhere? If your heart is elsewhere, perhaps it’s time to exit gracefully. If you aren’t sure, your objective is simple – get to know yourself.

Many entrepreneurs are so busy that they have little time to truly get to know themselves. Introspection requires a significant amount of time and exploration through journaling, talking to others, and reading. Many business owners don’t have the time it takes to fully explore themselves. 

One of the best methods for learning more about yourself is traveling. We travel not only to see the world, but to also see ourselves. Travel helps us see what’s possible. As French social philosopher and activist Simone Weil said, “Attachment is the great fabricator of illusions; reality can be obtained only by someone who is detached.” Travel is a powerful tonic for detaching us from our illusions and allows us to gain perspective so we can more clearly see the reality before us.

The better you know yourself, the easier it will be to make your decision. If you feel you don’t know yourself enough to be confident in your decision, take a break to self-reflect before making one of the most critical decisions of your life. 

Signs You Should Double Down

Now that you’ve taken a deep dive into both your industry and yourself, it’s time to weigh the results of your exploration and make a decision. Below are guideposts to help you decide if you should double down or sell.

These are signs you should double down based on your gathered information:

• Your Business: You’ve realistically determined that your business will remain competitive. Your business continues to grow and your competitive advantages will remain attractive, even with only incremental innovation.
• Your Industry: Your industry is growing, and you’re optimistic about the prospects for your business. And your industry isn’t quickly consolidating – independent operators will continue to be successful in the long run.
• Your Competition: The competition in your industry isn’t strong, and it’s unlikely your competitors will put you out of business anytime in the near future. There haven’t been any new entrants backed by institutional funding, such as venture capital, or wildly attractive value propositions that have been introduced recently.

Beyond your business, industry, and competition, there are several additional signs you should double down: 

• Financial Variables
  • Net Worth: Your net worth isn’t concentrated in your business. Your retirement isn’t dependent on the sale of your business.
  • Reinvestment: You can afford to reinvest cash back into your business if doing so is required to remain competitive.
• You
  • Skills: You have the skills and ability to remain competitive.
  • Motivation: You love your business – you have the drive, motivation, and energy to continue.
  • Dreams: Doubling down on your business aligns with your dreams.

Signs You Should Sell

Let’s re-examine each of these same categories for signs you should sell:

• Your Business: Your revenue is declining, and your value proposition is slowly eroding. Incremental innovation won’t be sufficient to survive. If you don’t double down, your business will likely fail. 
• Your Industry: Your industry is in decline. Or, there’s an acquisition frenzy in your industry – and large competitors are quickly gobbling up smaller ones to fight to become the dominant player. Note that acquisitions in your industry can be an ideal time to sell because many buyers come out of the woodwork and aggressively protect their turf. But in many industries, there’s a limited window of opportunity – critical mass must be established as quickly as possible in a “winner takes all” market. If your business is in such a market, and you lack the capital, skills, or motivation to compete, it’s time to sell. 
• Your Competition: The competition is strong. If you don’t compete, you’ll be out of business soon. Several new venture-backed competitors have entered the market with enticing value propositions. Good ideas are often being pursued by dozens of competitors simultaneously, frequently without them having knowledge of one another. If so, carefully scan your industry to see if any such competitors are quickly gaining market share. If they are, sell before a competitor dominates the market and your business or your product becomes obsolete. Smaller, agile competitors can also quickly out-innovate you. Be on the constant lookout for competition that has the potential to unseat you.
• Your Financial Situation
  • Net Worth: If your net worth is concentrated in your business and your retirement depends on the sale of your business, these are both signs you should sell. If you’re uncomfortable with how much of your personal wealth is tied up in your business, selling might be a good option.
  • Reinvestment: If you can’t afford to reinvest cash back into your business and doing so is required for you to remain competitive, it’s probably time to sell.
• You
  • Reason for Sale: You have other hobbies, passions, or businesses to pursue. Your business isn’t your life, and your life isn’t your business.
  • Skills: You lack the skills or ability for your business to remain competitive.
  • Motivation: You’re burned out – you don’t have the drive, motivation, or energy to compete.
  • Dreams: You hate your business, and it doesn’t align with your dreams.

Be Flexible if the Industry or Economy Changes

Once you’ve decided to sell, you may have to adjust your timing based on market or industry cycles instead of establishing a definitive time frame. For example, if you decide to sell once your business hits $100 million in revenue, you should be prepared to unload it at any time if an acquisition frenzy starts in your industry and multiples quickly rise. 

The sale process can take from 6 to 12 months, or more. In most cases, you’ll need to assist with the transition for one to two years. If this is the case in your industry, then it may be necessary to begin the exit process several years before you want to fully exit your business.

You should also be prepared to change your game plan if you obtain new information about your industry or discover new truths about yourself. Remember the English proverb – “Time trieth truth” – truths may be slowly revealed to you at the most unexpected of times. So be prepared for the unexpected.

Once you’ve decided to sell, you may have to adjust your time frame based on market cycles instead of establishing a definitive time frame. 

“Whenever you see a successful business, someone once made a courageous decision.”

– Peter F. Drucker, Management Consultant and Author

Should you sell your business, or should you double down? Or should you explore other alternatives? If you sell now, you may be leaving money on the table. But if you maintain the status quo, your competition will eat you for lunch. At the same time, if you double down, a large payout glimmers in the distance. 

You may be at a point in your life when you prefer to diversify your wealth instead of concentrating it. You may feel it’s risky if too much of your net worth is concentrated in one illiquid source – your business. If a competitor puts you out of business, you could lose the majority of your net worth.

Or, you may want to double down, but you don’t have the capital to invest in your business. The problem is, if you’re in a competitive industry, you must put cash back into your company to stay in the game. Instead of taking money out, you need to put money back in, which is perhaps the exact opposite of what you want to do at this stage in your life.

As a result, you face a critical decision. Do you sell now and get out while you can, or double down and risk losing a substantial portion of your net worth?

It’s a decision that will determine the fate of the rest of your life. Unfortunately, these critical life decisions are often made as a response to an acute event. Or they may be made in a frame of mind that’s sometimes fleeting. As Marcel Proust, a 19th-century French novelist said, “All our final decisions are made in a state of mind that is not going to last.” As a successful entrepreneur, you’ve learned to temper your optimism with realism. But what should prevail now – your optimism or realism?

In this chapter, I offer a framework for helping you decide whether you should sell your business or double down. If you decide to recommit, I’ll provide several potential options for raising capital other than traditional bank financing. 

Selling a business isn’t always an all-or-nothing proposition. Just ask Jack Welch.

General Electric CEO Jack Welch was well-known for divesting businesses as a way of “pruning” the company to give way to the growth of the remaining business units within GE. In his first four years as GE’s CEO, he divested over a hundred business units accounting for approximately 20% of GE’s assets. Welch eliminated over 100,000 jobs through layoffs, forced retirements, and divestitures. During Welch’s 20-year reign, GE’s profits grew to $15 billion from $1.5 billion, while the market valuation increased to $400 billion from $14 billion. 

Many owners have a significant portion of their personal wealth concentrated in their business. You may consider selling a division of your business, which can enable you to generate liquidity while still maintaining control of the remaining portion of your business. It also allows you to focus your talents on a division with the most significant potential, that you most enjoy, or that offers you the greatest opportunity for work-life balance.

Publicly owned companies, which are usually under intense pressure to meet projected quarterly earnings, commonly sell non-core divisions. And so can you, even if you’re no Jack Welch. 

Why Businesses Make Divestitures

A divestiture is a strategy of focusing on the core competencies of your company by spinning off non-core divisions. In other words, you can divest divisions that aren’t part of your core operations to allow your entire company to focus on what it does best. 

Sometimes, poor management decisions lead to a need to divest non-performing business units. For large companies, selling a weak division is a straightforward management decision.

Selling non-core divisions could also be a way to raise funds. A divestiture generates cash upon a sale, creating an opportunity to invest those funds into more promising divisions or ventures that can yield higher returns. A company’s individual components are sometimes worth more than the company as a whole. Therefore, breaking up the company and selling the pieces can often yield more in the aggregate than if it were sold in its entirety.

Learn More

If you’d like to learn more about what goes on behind the scenes in deciding to sell a business unit, listen to Advice From a $5 Billion Business on Selling Your Company With Russell Iorio on the M&A Talk podcast at morganandwestfield.com/resources. I discussed this decision-making process with Russell, the former Senior VP of Corporate Development at Leggett & Platt, a $5 billion diversified manufacturer with 15 business units in 18 countries, where he was in charge of divesting the company’s business units. 

Selling a segment or division of your business allows you to focus your talents on a division with the most significant potential, that you most enjoy, or that offers you the greatest opportunity for work-life balance.

Deciding To Sell a Division

You don’t need to sell your entire company should you decide to retire or cash out. With proper strategic planning, you can often sell just a piece of your business, allowing you to generate additional funds for your retirement or provide you with growth capital to invest back into the company.

In deciding whether to sell your whole company or only a portion of it, first examine the overall value of your business and then determine the individual value of each division. Once you’ve performed this analysis, you may realize that it would be prudent to sell your business in pieces to extract the most value.

You have two primary options in selling a portion of your business:

1. Selling a Percentage: Selling a piece of your entire company is usually structured as a percentage of your stock. With this strategy, the business owner typically just wants to take some cash off the table. 
2. Selling a Division: This structure involves selling a division, unit, or category of your business. Many companies are acquired for strategic purposes. A buyer may see tremendous value in one division of your company while seeing little value in your other units. If you encounter such a buyer, you may consider a spin-off of one of your divisions. 

Selling a Division Is a Strategic Decision

Selling a portion of your business doesn’t necessarily mean giving up something – it only means letting go of a “part” to enable the “whole” to thrive. The cost of keeping a non-performing or non-core division could be much higher than the returns that could be generated by selling that division. This strategic decision could free up your time and energy, allowing you to focus on your core operations, potentially increasing the overall value of your business in the process.

A common example I encounter is a business that originally started as a single retail location and gradually evolved to a business with multiple retail outlets on a national basis and a significant online presence. Splitting the business into two divisions – an online division and a brick-and-mortar division – may make the company easier to sell and potentially maximize its value. Many buyers have a strong preference for online-based businesses and a strong aversion to brick-and-mortar businesses, or vice versa. Selling the divisions separately solves this problem.

Splitting your company may make it easier to sell, increase its value, and ultimately increase the final selling price. Value is directly related to risk. The higher the risk, the lower the value – and the lower the risk, the higher the value. By splitting the business into two, you potentially reduce the level of risk for the buyer. 

Many companies develop additional product lines as a part of their overall corporate growth strategy. In the process, many business owners create product lines they later regret pursuing. The product line may not fit with the overall operations or may make the business owner lose focus on their core business. In such instances, selling the product line can be a wise course of action.

Many buyers search for strategic acquisitions and have specific criteria regarding which businesses they’ll consider. They may be interested in just one component of your business and may not pursue your company as a whole because your other divisions don’t align with their strategy.

Popular divestitures in the past include the decision of Hewlett-Packard CEO Meg Whitman to spin off and merge HP’s non-core software assets with Micro Focus, a British company. This transaction was valued at about $8.8 billion, significantly less than the $11 billion it spent to acquire the division five years earlier. 

Even middle-market owners can benefit from splitting their companies into separate divisions and selling them individually. For instance, some businesses require special licensing, so breaking the business into two divisions may be prudent, as some companies may only be interested in divisions that don’t require special licenses.

Regardless, the decision should first be considered from a strategic standpoint, and you should ask yourself if selling a division will help you accomplish your long-term objectives. Only after you’ve considered the strategic elements of the decision should you consider the tactical components, or the “how to’s,” which I address next.

Operational and Legal Implications 

The decision should first be considered from a strategic standpoint – ask yourself if selling a division will help you accomplish your long-term objectives. 

When deciding to sell a division, there are two important aspects to take into consideration – operational and legal. Let’s examine them both.

Operational Implications

You must first be sure that your business can be divided in two, from an operational standpoint, before considering the legal implications of doing so. Some divisions are so intertwined that it’s impossible to separate them, or doing so could prove too costly. Businesses that are most conducive to being sold as divisions can be easily split in two from an operational standpoint.

When determining if your business can be split in two, consider the following questions:

• Do you have a separate website, phone number, and facility for each division? 
• Can costs be accurately allocated between divisions? 
• Do you have employees who share duties for each division? If so, which division would they remain with? 

Consider the answers to these questions as early as possible to determine how practical it is to separate the divisions from an operational standpoint. In many cases, significant work needs to be done to separate divisions so they can be operated independently.

Few buyers will be willing to take the risk of creating a separate website, hiring new employees, and completing the dozens of other tasks that are required unless you’re selling a division that can easily be integrated into another company, such as a product line. 

If the division is likely to be run as a stand-alone entity by the buyer, it’s ideal to run it as a stand-alone business with a separate profit and loss statement for at least one year before beginning the sale process. Doing so will make the business easier to sell and will simplify the process of separately valuing each division. The more integrated the division is with your primary operations prior to putting it on the market, the more difficult it will be to sell.

Legal Implications

From a legal standpoint, there are two general transaction structures when selling a division – asset sale or a stock sale. Here are your options for structuring the transaction from a legal perspective:

• One Entity: If your business, including the division you wish to sell, is legally structured as one entity, such as a corporation or LLC, your only option is to structure the sale of one of the divisions as an asset sale. In an asset sale, your entity sells the individual assets of the division to the buyer via an asset purchase agreement (APA), and the assets are listed and transferred separately in a bill of sale. 
• Separate Entities: If each division is a separate entity, the sale can be structured either as an asset sale or a stock sale. For example, if “Division A” is “Acme Incorporated” and “Division B” is “Summit Incorporated,” you can structure the transaction either as a stock sale via a stock purchase agreement (SPA) or as an asset sale via an asset purchase agreement. In a stock sale, you sell the shares of the entity that owns the division and its assets. Because the entity owns the assets, there’s no need to transfer the assets separately.
• Selling a Percentage: You also have the option of selling a percentage of your company, but this defeats the purpose of focusing on your core competency because you’ll still own both divisions post-closing. 

Regardless, the decision to sell a division should begin with a consideration of your long-term goals. If you wish to focus on your core division, selling a percentage of your entity, or stock, is likely not for you. If, on the other hand, you want to diversify your risk and divest the division so each division operates as a separate legal entity, then you can structure the sale as a stock or asset sale.

Valuing a Division

The asking price for a division is determined using the same methods used to value a business as a whole. In essence, you’re selling an income stream (i.e., EBITDA). To properly value the income stream, you must first measure it. And here’s where it gets tricky. 

If the two segments are closely interwoven, it may be difficult to calculate the income for each division separately unless the divisions are being run as stand-alone units. 

If the divisions aren’t being run as stand-alone units, a pro forma must be prepared for each division. But, be aware that any errors in the pro forma will be magnified by the multiplier. For example, if you overstate income by $1 million, and your business is valued at a 6.0 multiple, then your business will be overvalued by $6 million ($1 million x 6.0 = $6 million).

Preparing a pro forma for a division can be tricky due to the difficulty of properly allocating expenses between divisions. While revenue may be easier to allocate than expenses, the impact on revenue of any inter-division transactions must also be considered. When allocating expenses, you must also decide how to allocate fixed expenses. For example, if your facility costs are currently $100,000 per month for both divisions, what would a reasonable rent be for each division separately? The same idea goes for allocating other forms of corporate overhead as well, such as salaries, insurance, professional fees, advertising, and marketing.

Assigning Weights to Each Division

An alternate method, if you can make it work, is to value the business as a whole and then assign weights to each division based on the revenue that each division generates. For example, if your company generates $20 million in revenue and is valued at $10 million, and “Division A” generates $12 million in revenue (60% of total revenue) and “Division B” generates $8 million in revenue (40% of total revenue), Division A would be worth $8 million ($10 million x 60%). 

While this may seem to be a reasonable computation, some buyers may not be willing to accept such a calculation. That’s because you’re likely to understate the amount of fixed expenses and therefore overstate income or margins, meaning profitability may differ significantly between divisions. Such a calculation would only be reasonable if the two divisions have similar margins and expenses, such as two similar product lines.

Ideally, the divisions can be valued based on the income each division generates. But doing so involves numerous assumptions that are prone to error. A back-of-the-envelope method for obtaining a ballpark valuation for each division isn’t difficult, but such ballpark estimates are unlikely to suffice for most buyers. A ballpark estimate should only be used for internal planning purposes. Or for valuing ballparks.

The asking price for a division is determined using the same methods used to value a business as a whole. In essence, you’re selling a cash flow stream. 

Questions to Consider

The decision to sell a division or segment of your business is a strategic one and should be based on your long-term objectives. Consider the following questions when deciding if selling your company as a whole or in parts makes better sense:

• Would I be happier if I simplified operations and focused solely on my core business?
• Have I spread myself too thin? If so, would selling a division improve my focus?
• Knowing what I know now, would I start both divisions again?
• Which division is the most profitable?
• Which segment of the business is most suited to my skills and strengths?
• How hard would it be to sell each segment separately?
• Is it practical to sell each segment separately?
• What’s the potential value of each division?
• What’s my number one bottleneck now? 
• Do I need growth capital to significantly grow my business? If so, would selling one of the divisions free up my capital and energy to focus on my core competence?
• If I sold one of my divisions, could I reinvest the money in the remaining division and significantly boost revenue and income?

Once you consider these questions and the operational and legal implications, you can determine the best way to move forward. Business owners sell portions of their companies for many reasons. It’s a fairly common practice and can free up cash for you to use as you see fit.

But you may decide it makes more sense to sell your business as a whole. This is where an M&A advisor, or investment banker, can help you evaluate the host of different factors that come into play, including how much stake you want to have in the future of the company. Also, having your business valued as a whole and in pieces can help you decide what makes the most financial sense in the long run. Either way, an M&A advisor or investment banker should be able to assist you with selling your business in a way that aligns with your long-term objectives, so don’t hesitate to seek professional advice. Remember that selling a portion of your business doesn’t mean giving up something – it only means letting go of a “part” to let the “whole” thrive. After all, the cost of keeping a non-performing or non-core division could be much higher than the returns.

Conclusion

Planning your exit starts with weighing your exit options. Your exit options can be broadly categorized into the following three areas:

• Involuntary
• Inside
• Outside

If you’re reading this book, I assume you want to maximize the price. If so, an outside exit option is the only guaranteed way to do just that. 

Finally, examine if it’s sensible to break your company into pieces and sell them individually. In some cases, doing so can yield a higher value. If you’re unsure, consult with an M&A advisor to help you determine the most prudent course of action that will help you maximize not only your price, but also your level of well-being and happiness.

A management buyout (MBO) is common in the middle market. Often, your management team may have aspirations to become business owners. Your team may be a source of potential leads to buyers, or they may cause conflicts and hold-ups if not handled properly.

Your management team is familiar with your business operations, strengths, customers, competition, and unique advantages in the market. Your current managers, or people in their networks, may have distinct insider knowledge that allows them to quickly pull the trigger, which can be one of the most efficient sales experiences any seller can hope for.

Unfortunately, members of your management team may not have the financial resources necessary to acquire your business and invest in its growth. The adjustment necessary to go from being an employee to being an owner can be difficult for even the most aspiring entrepreneur. 

To sell to your management team or an employee, be prepared to finance all or part of the sale or arrange for a bank to finance the transaction. Private equity firms also commonly finance these MBO transactions.

Disclosing to your management team that your business is for sale may cause some disruptions. Employees may fear the upcoming change and leave their positions or even attempt to undermine the sale. 

During negotiations, the dynamic shifts from an employer-employee relationship to a business owner’s relationship with a business owner. If you begin serious discussions with the wrong person, this can cause tension in the work environment throughout the negotiations and transfer of ownership, especially if discretion isn’t maintained and confidentiality isn’t respected. 

If you have a strong management team that may be interested in acquiring your business, I recommend consulting with an investment banker to determine the extent to which financing may be available to fund the transaction.

Employee Stock Ownership Plans

Employee stock ownership plans (ESOP) are programs in which employees can buy shares of a company under specific terms. An ESOP is technically a defined contribution plan as defined by IRS code, and meets the IRS’s definitions of a qualified retirement plan. ESOPs are complex and expensive to establish – the words IRS and simple never belong in the same sentence. They often require the specialized knowledge of accountants, tax advisers, and lawyers for ongoing re-examination and re-certification to keep the plan compliant with all regulations.

ESOPs are one way to integrate employee ownership in a company, often positively affecting the employees’ commitment, dedication, and productivity. In most cases, selling to one or more employees has significant tax advantages.

Although the process varies, the ESOP typically purchases stock at its inception, using a bank loan. Employees can receive shares as compensation, similar to a 401(k), with the potential for the ESOP shares to vest immediately or over time, as with a pension plan. As employees reach retirement age, they will have options to diversify their ESOP holdings away from company stock or cash out. 

An ESOP structure may make sense for your business, but these normally yield the lowest sales price and are often used only as a last resort. An ESOP is generally only a wise course of action for middle-market business owners who either care greatly about their employees and would like to reward their hard work, or for those who own businesses that are excessively difficult to sell on the open market.

Involuntary Exit Options

Involuntary exits can result from:

• Death
• Disability
• Divorce
• Other unplanned events. 

Your plan should anticipate such occurrences, however unlikely they may seem, and include steps to avoid or mitigate potential adverse effects. By following the advice outlined in this book, you’ll be in a better position to withstand the effects of a sudden event that forces you to exit your business without warning.

Inside Exit Options

Inside options include:

• Selling to your children or other family members
• Selling to your employees
• Selling to a co-owner

Inside exits require a professional who has experience dealing with family businesses, as they often involve emotional elements that must be navigated and addressed discreetly, gracefully, and without bias. These options greatly benefit from tax planning because if the money used to buy the company is generated from the business, it may be taxed twice. Inside exits also tend to realize a much lower value than outside exits. Due to these complexities, most business owners avoid inside exits and pursue an outside option instead. Fortunately, most M&A advisors specialize in outside exit options. If you’re considering selling your business and want to maximize your price, you generally shouldn’t pursue an inside exit if you want to maximize your proceeds.

Inside exits require a professional who has experience dealing with family businesses.

Outside Exit Options

Outside exit options include:

• Selling to another company or competitor
• Selling to a financial buyer, such as a private equity firm

Outside exits tend to realize the most value. This is also the area where M&A advisors and investment bankers specialize. The majority of this book is focused on outside exit options. Outside exit options will nearly always yield you the highest price. If maximizing the price is your goal, focus on outside exit options and hire an M&A advisor or investment banker to conduct a private auction to sell your company.