Impulse purchasing may return the occasional bargain, but when it comes to buying or selling a business - it's simply not worth the risk!
DENNIS MATTISKE reveals the must-know tips to help you buy, or sell, at the right price. Like everything else, the best approach to buying a business is to have a plan. You have to first decide what you want, then find out if the price is right.
Some industries have formulas for valuing their businesses, however care should be exercised if using such a valuation because businesses within any industry do vary. The real key to the value of a business is the profit that it earns, and in particular what it expects to earn in the future, the future maintainable earnings (FM E). This figure must be calculated after deducting a commercial wage for the proprietor(s), interest paid or received and any items of an abnormal or non-recurring nature.
Small businesses advertised often state an amount of return to the owner (usually without deducting any 'wage' for the proprietor), so care must be taken in properly researching what is included or excluded.
Generally, the greater the FME - the greater the value. However, the value of a business is closely linked to the certainty of the suggested FME.
Further, a business with a stable profit history will usually have a higher value than one that has a fluctuating profit. For example, a business with FME of $100,000 and a high degree of certainty of earning that amount year in, year out might be valued at $500,000. But, if there is a low degree of certainty of earnings it might only be worth $200,000. The value of a business is often expressed as a multiple of the FME. In the example just provided, this is either a multiple of five or two. The multiple of five gives a return on the value of the business of 20 per cent and a multiple of two gives a return of 50 per cent.
Therefore, to determine the value of a business you really need to decide what return you want on your money given any perceived risks. For a small business, that would be expected to be a minimum of 15 per cent (multiple of 6.67) up to 30 per cent (multiple of four to 3.3). If the risk of earning the profit was really high, the return required could be 50 to 100 per cent!
If a business has a FME of $100,000 and a purchaser wants a 25 per cent investment return, the value of the business to the purchaser is $400,000 (multiple of four).
It is very important to remember that the return is on the TOTAL investment. Thus the value of $400,000 referred to above must be the total investment, i.e. includes plant and equipment, stock and goodwill. In fact, goodwill is simply what's left from the calculated value (if any) if the value of tangible assets (plant, equipment, stock etc) is subtracted. If the plant and equipment is worth $100,000 and stock is $200,000, the amount of goodwill would be $100,000 (if the calculated value of the business is $400,000). Goodwill can be negative if the plant, equipment and stock total more than the calculated value.
Things to cover when evaluating a business:
1. Review at least the past three years profit and loss accounts and determine any abnormal income or expense items
2. Determine the amount of time spent in the business by the proprietor(s) and estimate an appropriate 'wage'
3. Review staffing levels and remuneration
4. Calculate what you believe is the FME
5. Evaluate the risk in earning the FME, taking account of:
- Potential cost of redundancies/leave
- Age and value of plant, equipment and inventory - the accounting of a business may not reflect the true value, particularly of inventory
- Level of stock and appropriateness for the turnover of the business
- Licences required.
Once a purchaser has established their credentials and signed an appropriate confidentiality agreement, a serious vendor of a business should make all the business records available. This includes sales analysis if available by customer and product, stock and debtors listings, plant register/depreciation and wage records. Weekly and/or monthly figures should be reviewed to determine any unexpected seasonal peaks and troughs.
For a small business, financial statements (profit and loss account and balance sheet) are unlikely to be audited. However, greater reliance can usually be put on accounts prepared by external accountants. It is also important to see copies of tax returns. In some small businesses that operate either as a sole proprietor or a family partnership, a letter from the tax agent certifying an extract of business figures from the tax return may suffice.
The better and more detailed the records the more certainty can be placed on the profit.
The asking price is often not the true value of the business. This may be because the vendor is knowingly attempting to get an inflated price or simply has a misguided idea of the real worth.
Any reputable business broker should have placed a reasonable value on the business, but in the end there are so many areas for judgement that there can be substantial differences in perceived values. In the end, if the vendor is serious, the selling process will ultimately determine the value.
A serious purchaser will substantiate a serious offer.
Most vendors offer to spend time with the purchaser after the sale. Some time is invaluable, especially where there is an element of training. However, there must be a definite cut-off and the vendor should not retain any influence for too long. The fact that there is a change of proprietor, and the degree of influence that this may have on trading, must be factored into the price paid for the business.
If staff retention is important, and it usually is, the staff must be told they are wanted and a specific plan made to keep them.
There needs to be a plan to introduce the new owner to the major customers. In many businesses this should be a joint visit with the vendor. In any event, real effort should be put into managing the handover rather than simply letting it happen.
Again, if it is judged that the business is very vulnerable to loss of customers due to the change in ownership, the price paid needs to reflect this.
Selling a business
In selling a business timing is important, in the same way it is in selling any investments. Often, a small business is sold when the vendor gets too old to run it. In such cases the business is often in the first stage of decline with a corresponding decline in profit and in value. If a vendor wants to maximise the price of the business, it is often necessary to plan for the sale and often for this plan to be over some years. It is what we call 'getting your business investor ready'. As with buying a business, understanding the elements that affect the value is essential.
To reiterate, the two components that affect the value are the FME and the multiplier. A business with FME of $200,000 and a multiplier of four (25 per cent return) is valued at $800,000.
It is in the interests of the vendor to do everything he/she can to convince a purchaser that the stated profits are maintainable in the future and that there is little risk that they will be achieved.
With this in mind the steps involved in selling a business are as follows:
1. Seek professional advice as soon as possible regarding the present value of the business and the reasoning for the value. Most accountants can assist with this or a business broker with whom you may ultimately list the business. Tax considerations, especially when a business is sold on retirement, can significantly affect the net amount a vendor ends up with.
2. Analyse the reasons for the value and determine whether or not the value could be increased or whether or not there are factors that will cause it to decrease. The greater the spread the less the risk of reduced profit from the loss of that customer/competition with that product.
3. Reduce the reliance on the business of the owner. A business that truly runs under management is usually more valuable as it is easy to demonstrate that there should be little affect of a change in owner.
4. Build the operating processes of the business. The less the reliance on people and the stronger the processes themselves, the less the risk from losing people.
5. Invest in people. Good people rewarded with commensurate remuneration will usually stay with a business when sold and provide stability for a new owner.
When the time comes to sell the business, use a business broker or accountant. While it is possible to find brokers that specialise in a particular industry, any good broker should be able to quickly grasp the fundamentals of your business.
A broker should have a website with an up-to-date list of businesses for sale and will help you with the business valuation and help prepare a selling document. The selling document is only given to people who have signed a confidentiality agreement. The document should include a brief history and outline of the business, a summary of operating results, details of equipment, inventory levels and information on any specific aspects of the business that would attract a new owner.
Any person advertising the business for sale and acting as a broker must be licensed. Most accountants don't have the appropriate licence although they can assist with a business valuation and placing an advertisement for you if they simply act as a letter box and pass any replies on to you.
Ensure that information is available that would be requested by a genuine purchaser. This would include:
- financial accounts for the past three to five years
- list of employees showing hours worked, length of service and salary
- copy of leases
- copy of any trademark, certificates, etc
- copy of any business name registrations
While it is possible to find brokers that specialise in a particular industry, any good broker should be able to quickly grasp the fundamentals of your business.
- sales analysis, by product and customer and total sales by month
- inventory listing .
- list of customers .
- list of major suppliers .
- list of equipment - showing age, cost and present value .
- warranty claim history
Be aware of the potential cost of staff leave and redundancies that may come up during purchase price negotiations.
Even if the business is owned by a company it is unusual for a purchaser to buy the company structure as well as the business due to any unforeseen liabilities. However, if the company name is important to the business the company may have to change its name so the name can be used by the purchaser.
Leave time available for assisting the new proprietor with the business including handover of strategic customers.
In some cases, especially for larger businesses, a purchaser may want to negotiate some form of performance linked component of the price. This is a very difficult thing to deal with because the onus of earning the profit is really with the purchaser. It can only work if the vendor still retains some link with the business or an existing manager remains with the business. Above all, give the purchaser an image of a well-run business that is totally under control.
Dennis Mattiske is a partner and business consultant at HLB Mann Judd. www.hlb.com.au
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