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Let's Be Practical - Points to Ponder When Selling Your Business

General Business News

May 2001

Let's Be Practical - Points to Ponder When Selling Your Business

You're sixty-five and you've been ready to retire since you were fifty-five. It's about time you got serious on determining who is going to take over the company you've built over the past thirty years, but you don't have a great many choices.

Your son is a successful attorney and has no desire to run a clothing store. Your daughter is the chief-of-staff at one of the nation's premier transplant hospitals and she sure doesn't want to come home and run the store. So what do you do?

The good news is you have alternatives. Perhaps an employee or group of employees would like to take over. Are you in a town that is attractive to a chain of clothing stores? Perhaps one of them would like to buy you out to gain entry into the market. If you don't have, or feel you have, either of the preceding options, have you thought about a business broker?

In the beginning ...

In everything there is a first step and the first step here, regardless of the potential purchaser, is to determine the value of the business.

Notice we didn't say "figure out what you think your business is worth." We did this for a reason. You, as a business owner, bring certain perceptions of value to the table. Often, the valuation you may choose is colored by your history with the company as well as the current operating results. This can sometimes result in a value that is over inflated in comparison to other, similar, companies. It is also common for business owners to value their businesses too low. Either way you can lose out on significant opportunities.

Consider engaging a CPA, Certified Business Valuation Analyst ("CVA") or someone designated as Accredited in Business Valuations ("ABV"). These are professionals who have a history of dealing with businesses and helping their clients obtain maximum value in business sales and purchases.

These professionals will help you start at the beginning and objectively build a history of the business that will help you arrive at a fair market value for your business. With a professional valuation in hand, you will be much more likely to obtain the proper price for the business, but the valuation will only be as good as the information you supply. This is why it's important to know where you've come from (and all the trials and tribulations along the way) and where you think your business will be going in the future.

How exactly do you value a business?

Generally, the first step in evaluating a business, aside from gaining an understanding of its history, is to get a complete set of financial statements. From here, the business valuation analyst will look over these statements for several key determinations:

Asset mix - Does your business rely heavily on hard assets such as inventory, property and equipment? Is your business mainly a service company like a CPA firm where the real assets are in the customer relationships, not tangible assets? Are both tangible and intangible assets equally important in your business?

Liabilities - What are the liabilities of your business? Do you carry a great deal of debt, including accrued expenses and payables, or did you finance most of the business with your own cash and the company's earnings?

Net assets - We use this term in place of terms such as partners' capital, stockholders' equity and similar terms, but it all comes down to the difference in the historical cost of all assets minus liabilities. In a perfect world, you might say this is the value of the business. But this is not a perfect world and Net Assets do not always equal value.

Revenue and trends - How is the business doing? Are sales increasing or decreasing? Is the mix of sales going from one type of product to another? Are you selling more profitable items and is that trend increasing?

Cost of sales and trends - The trends associated with cost of sales (if present) are tied closely with revenue. While increases in sales are great, it could be that less profitable products are being sold. Hence, it is extremely important to look whether profit margins are being squeezed and to be able to coherently discuss what the future trends will likely be.

Expenses and trends - Finally, the analyst will want to see what past expenses have been, what they are now and where you think they are headed. What are the expenses? Have you had a great deal of past depreciation because of accelerated depreciation, but future earnings will increase because depreciation will be lower? Have the owners been paid salaries much higher than similar companies?

All of the preceding information will be collected by the analyst and used in determining the valuation of the business. Once the analyst has gained an understanding of the business, they will determine the best valuation approach.

Typical Valuation Approaches

The three general methods of valuing companies are 1) the income approach, 2) the net asset value approach and 3) the market approach.

Using the income approach, an analyst will first determine the expected income from a company. This may be based on future cash flow estimates, net income before or after taxes, etc. Based on the income and an assumed rate of return required by a typical investor, the analyst will determine a value to provide the required rate of return. This approach is especially useful when looking at real estate properties.

The net asset value approach is similar to using the net assets of a company, but values those assets at their current values. Does your company have a great number of older assets that have very little value even though their book value is high? Assume your company has been headquartered in California for 50 years and the headquarters building is fully depreciated. Even though your books show low value, it's a fair bet the value of the real estate of the company will be much greater than the recorded cost. This approach can be very useful in those circumstances and similar cases where a company is capital intensive.

Using the market approach, the analyst will obtain information from comparable companies and compare your financial statements to the other companies. This may mean "normalizing" your income for unusual items affecting the income statement and also getting the salaries paid to owners on a basis consistent with the comparable companies. By comparing your company's results with those of similar companies, the analyst can take their selling prices and adjust the value of your company up or down depending on how your company compares.

Now I know how much the company is worth. So what, where's the cash?

Once you have determined your company's value objectively, now you can approach potential buyers. This is where the fun begins, because it isn't always easy to find buyers. Ask any real estate agent how easy buyers are to find.

Only you can ultimately find the buyer. Some potential sources of leads are employees, bankers, attorneys and your friendly neighborhood CPA. You may also wish to investigate business brokers, but beware, they will cost. For that matter, work performed by any professional will cost you, but you will generally get a better deal that way. Depending on the state of competition in your local market, you may even speak to a competitor or two to determine their level of interest.

Whatever route you take, let us emphasize: do not provide any information to anyone until you have a written confidentiality agreement. This agreement typically precludes anyone who looks at your financial and operational information from using that knowledge to your detriment.

Parting thoughts

Buying and selling businesses is complex at best. This is one area where skimping on the use of professionals can be devastating. Next month, we will cover the various tax and business matters to consider when negotiating the final sales deal. Until then, if you have any questions, give us a call. We are always ready to help a friend in need.

Have a great May and Happy Mothers' Day to all you mothers out there.

These articles are intended to provide general resources for the tax and accounting needs of small businesses and individuals. Service2Client LLC is the author, but is not engaged in rendering specific legal, accounting, financial or professional advice. Service2Client LLC makes no representation that the recommendations of Service2Client LLC will achieve any result. The NSAD has not reviewed any of the Service2Client LLC content. Readers are encouraged to contact their CPA regarding the topics in these articles.

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