Tina: I am a buyer, how do I know if I am paying too little or too much for a business? How can I protect myself from paying too much?
Michael: There are many factors that go into what a buyer pays, and conversely, what a seller accepts for a business. For example, the motivations of the buyer and seller, as well as the negotiating strength of each party are crucial factors. Are there other buyers making offers? How badly does the seller want to exit the business? Is the seller in need of cash or is he/she in financial distress? Is there a health issuer requiring the seller to move quickly? Is there seller (or other) financing? Just like consumers will spend more with a credit card, business buyers may pay more when seller or bank financing is involved.
It is crucial that a buyer has an expert to guide him. A valuation professional can give you an opinion of value based on what comparable businesses have sold for and by using other accepted valuation procedures. The expert can also guide the buyer in their negotiations, initial and counter offers and proposed deal structure. As an example, I recently advised a client looking to buy a parts reseller. Before I got involved, my client wanted to start at $175,000. I cautioned him that the company only had 2 years’ history and had been in the hands of the current owner for only a few months.
In addition, I advised my client that the seller’s financial presentation was biased towards the seller (i.e., inflated adjustments). In the end, my client’s 2nd offer was for $160,000, and the discussions ended there, as the seller wanted much more and my client did not see much value beyond $180,000. He saved himself tens of thousands of dollars by having professional advice. In conclusion, it is part art and part science as to what is the “right price.” You will get a return many times over the fee that you pay an advisor to help you navigate through the process.
Most businesses with more than one shareholder should have a buy-sell agreement and all businesses should have a continuity plan in the event of the death or incapacitation of the main owner/shareholder.
Tina: If I also own the real estate, is it necessary to have my business and real estate appraised separately?
Michael: Yes, the real estate is typically a separate transaction. If bank or other financing is involved, the lender will require an appraisal. This approach will also give clarity as to what you are paying for the business, since the price will not be bundled with the real estate transaction. In many cases, the Real Estate may be legally required (e.g., FHA/ government regulations, state law, etc.) to be a separate transaction.
Fair market value is more hypothetical, whereas, strategic value is typically much higher since it considers value to a specific buyer.
Tina: What methods do you use to appraise a high potential startup with no revenue? For example, an online company with $500,000 invested in web development with positive revenue, no profitability but high growth ahead.
Michael: I currently have a client that is an internet developmental stage company and am well suited to answer this question. There are a number of factors that go into the valuation of a startup: is there anything proprietary about the web or software development? Is there a plan to monetize the site or create a revenue stream? How realistic is the plan? To answer this specific question, the value is going to be centered around (a) what would it cost to build or replicate the site? (b) has any of the web development been capitalized (i.e., shown on the balance sheet as an asset)? And (c) what is the value of the domain name? When is the company projected to become profitable? Has managed explained how those projections can be achieved in the time frame given?
Typically when discussing value, we are referring to fair market value (see definition below). We need to keep in mind the difference between fair market value vs. strategic value. Fair market value is more hypothetical, whereas, strategic value is typically much higher since it considers value to a specific buyer. For example, we may see Google or Facebook, or Apple purchase a technology or company with no revenue for billions because it has that value to them and their strategy.
The International Glossary of Business Valuation Terms, issued by the American Institute of Certified Public Accountants (AICPA), the American Society of Appraisers, the Canadian Institute of Chartered Business Valuators, the National Association of Certified Valuators And Analysts and the Institute of Business Appraisers, defines fair market value as: “The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.”
A minority interest will usually “trade at a discount” compared to a majority interest.
Tina: In many lower middle-market businesses, investment bankers to not recommend an appraisal. Do you feel a business appraisal is necessary for companies looking to sell in the lower middle market ($5-50 Million in Annual Revenue)?
Michael: As a valuation professional (Certified Valuation Analyst via the National Association of Certified valuators And Analysts, NACVA.com), I admit I am biased towards having a valuation. My experience has been that “another set of eyes” usually reveals something (hopefully positive) that may have been missed. The reward of finding “extra value” pays for itself many times over vs. the cost of a professional opinion. A valuation may also lead you to consider other factors that you may not have, for example, the economy (regional or local) or the industry trend, both of which impact value.
A buyer that does not have control or cannot influence operations, usually would not be willing to pay as much as they would for a majority stake.
Tina: Is a business appraisal for a minority interest different than for that of an entire business?
Michael: A minority interest will usually “trade at a discount” compared to a majority interest. The reason is that a minority owner typically has less influence and control over the operations and the ability to influence profits. The same holds true from a buyer’s perspective. A buyer that does not have control or cannot influence operations, usually would not be willing to pay as much as they would for a majority stake. There are exceptions. For example, let’s say there are three equal shareholder’s at 33.3% each. If a 33.3% minority interest were sold to a buyer aligned with one of the other two shareholders, than that 33.3% stake could be viewed as “swing vote or share” and command more value than otherwise expected with a minority stake.
If a death is involved, the surviving spouse will have his/her hands full, and having an updated value for the business will protect all who are involved and make the transition (buyout) much smoother.
Tina: If I am thinking about exiting my business, what are my options and when should I start planning for this?
Michael: Exit planning is very important. To use an illustration, it is like staging a house for sale. You want to give the best appearance and show the value of your asset. A good planning process takes three to five years. This includes maximizing profits, making sure the operation is lean, but has a “platform for growth,” and that all key skill sets are filled in (i.e., depth of management). Other facets of exit planning include tax considerations and communications/public relations. In essence, there should be an exit plan from Day 1, but the tactical and implementation of it normally takes place a few years before the sale.
Tina: What are your comments regarding the language in buy-sell agreements pertaining to the value of the business, or getting the business appraised in the future in the event of a potential issue?
Michael: This is crucial. I recommend that the business value be updated annually. Once the initial valuation is complete, future, successive valuation updates should be less costly and involved. The benefit to annual valuations is that, in the event that there is a death or resignation, or other event in which a shareholder leaves, the business will most likely be interrupted. If a death is involved, the surviving spouse will have his/her hands full, and having an updated value for the business will protect all who are involved and make the transition (buyout) much smoother.
A buy-sell agreement makes sense, not just for the business, but it also will give comfort and assurances to creditors, bankers and even key personnel or employees.
Tina: When does a business need a buy-sell agreement? Is this a common issue that you encounter? If so, what advice do you have for business owners?
Michael: Most businesses with more than one shareholder should have a buy-sell agreement and all businesses should have a continuity plan in the event of the death or incapacitation of the main owner/shareholder. It makes sense, not just for the business, but it also will give comfort and assurances to creditors, bankers and even key personnel or employees. My experience is that most businesses overlook this item. It should be part of every business’s strategic and financial planning. Be sure to consult your attorney.
Tina: Is there a right or wrong time to have my business appraised?
Michael: Business valuations are usually driven by needs: planning purposes, the sale of the business, tax purposes, etc. So there is no “right or wrong time” per se; a business valuation should be done when a need arises. Always seek a qualified, credentialed business valuator.
Audited financial statements are not crucial to the small business owner. Most small businesses are not complex and buyers will rely on federal tax returns
Tina: Should I have my financial statements audited if I am thinking about selling my business?
Michael: Audited financial statements are not crucial to the small business owner. Most small businesses are not complex and buyers will rely on federal tax returns. For a larger or more complex business, a review or audit may be beneficial. Tailor the services to the situation and need by consulting with your CPA and transaction advisor.
Tina: Do you have any other tips or advice for anyone buying, selling or appraising a business?
Michael: Buying and selling a business is a multi-month, and in some cases, a multi-year process. There are a lot of disciplines and skills needed: legal, financial, tax, regulatory, etc. Make sure you have a competent and trusted advisor. If a broker is involved, make sure you understand whether he/she has a contract and or fiduciary responsibility to one of the parties. Typically the business broker represents the seller. If you are a buyer, I highly recommend engaging your own representative. Sometimes the law dictates the parties’ relationship and responsibilities; for example, Florida law requires business brokers to be truly neutral, and the transaction broker is a true “middle man” and does not represent either party. For business valuations, credentials are important, but not the only criterion. Does the valuator have good business acumen? Have they worked in businesses or corporations (i.e., client side)? Is their entire career as a valuation practitioner? Have they owned a business? Do not be afraid to ask questions or ask for references. Don’t miss the obvious such as googling a firm or person.