AP's Blog

I came across this article by another Business Broker titled "The Case Of The Greedy Business Owner".  Please reserve judgment, read this article, and then see my questions below. 

In my experience, and the experience of pretty much every business broker, 99% of business owners we meet, over-estimate the market price of their business.  As the author above states, convincing a business owner otherwise is often a fool’s errand, resulting in lost business.  Business brokers like everyone else, face stiff competition for new clients.  Like Pavlov’s dogs, brokers learn quickly that it is much easier to list a business at any price, even if it is unrealistic, than it is to convince a business owner to lower his or her expectations. The downside of this approach is usually a much longer selling period, offers that fall apart during due diligence, offers that fall apart when financing, and an overall unsatisfactory experience of all parties involved.

My Questions to you as a Business Owner

1.  If you were in my position, what would you do?   Accepting a listing regardless of the sale price the owner wants, is common practice within the industry.  I have walked away from businesses whose owners stuck to unrealistic expectations, and watched their listings languish with a competitor.  Eventually, they will sell.  Most likely at a reduced price, and earn my competitor a nice fee.  Let me tell you, it is extremely painful to walk away from a potential customer.   What would you do?

2.  As a business owner, which method do you prefer?  Would you rather list at a higher price, and let the market choose a lower price for you, or would you rather list at a price your broker claims is more reasonable for a quick sale?

In a majority of business sales, the seller gets a part of the sale price in forms other than cash.  The times, terms and conditions of these other forms of payment, along with the upfront cash portion, all are part of what is termed the Deal Structure.  Creative deal structuring is what separates novices from the more experienced business brokers.  Most buyer and seller disagreements can be sorted out with the help of an appropriate deal structure that addresses the concerns of all parties involved, i.e. the buyer, the lender, and the seller.  In fact, quite a few commercial lenders prefer seeing some seller skin in the game, usually in the form for delayed payments like notes, or earnouts.  With that in mind, let us look at some common forms of payout and the associated pros and cons. 

Cash

In my experience, most sellers like to sell for an all cash deal.  This is a good structure, when you (the seller) want a clean break, and the buyer is also looking for no seller involvement post-sale.  If the buyer puts down a sufficiently large down payment, most lenders will not have a problem with this. 

Seller Notes

A seller note is when you (the seller) agree to loan the buyer some of the money required to buy the business.  A typical deal may look like this.  The buyer puts down 20%, a commercial lender puts in 70% and you agree to loan the remaining 10%.  So, lets say your business sells for $1M, then in that case, you get paid $900k, and the remaining $100k is paid to you by the buyer over a period of time.  There are many pros to a seller note.  First of all, by reducing the buyer down payment, you are increasing the pool of potential buyers for your business.  Secondly, as mentioned earlier, commercial lenders see a seller note as a vote of confidence by the seller in the business.  Additionally, by spreading the payout over time, you can also spread the tax burden of the sale.  Lastly, there is the interest that you get paid on the loan.  The risk with seller notes is that the buyer may default on them.  While that risk can be mitigated by securing the loan with equipment or assets of the company, remember that the seller note will always be subordinate to the commercial lender’s loan. 

Earn-outs

Earn-outs are usually a part of the deal, when you (the seller) are expected to continue running the company for the new owner.  These earn-outs are tied to revenues, profits, or other metrics like new customers etc.  Buyers pay for a company based on expected future cash flows.  Instead of paying up-front for these cash flows, savvy buyers hedge their bets by making some portion of the sale price contingent upon you meeting these expectations.  Usually in these cases, you and buyer would have hammered out the projections prior to the deal itself, and hence you have some say in targets you are expected to achieve. 

Stock

In small and mid-market sales, you (the seller) usually do not get paid a portion of the buying company’s stock unless you are expected to continue working with the buying entity.  When it does happen, it is important to keep in mind the risks and rewards of getting paid with stock.  Firstly, unless you are getting bought out by a large public company, the liquidity of the stock should be your biggest concern.  The stock of private companies is illiquid and cannot be cashed at will.  There are conditions on when and to whom stock can be sold.  Additionally, valuing this stock is always a problem, since there is no market for the stock.  The company may have to go through a formal valuation at the time you wish to cash this stock.  Because of all these issues, it is rarely a good idea to take your entire payment in stock.  On the plus side, stock gives you the biggest potential upside of all the methods of getting paid.  Structured correctly, the taxes on the sale can also be deferred to the time when you sell your stock. 

One of the most frequent reasons business owners see no value in getting their business valued is because they have heard of industry multiples.  We often hear things like "In our industry, we sell for 24 months of revenues, i.e. 2x annual revenues".  Unfortunately, selling a business on revenue, or net profit, or EBITDA multiples is like selling a Lexus based purely on mileage, with no regard to of hail damage, engine condition, tire quality etc… 

Put yourself in the shoes of a prospective buyer.  Lets say you find a business with $5M in annual revenues, $1M in EBITDA and $500K in Net Income.   Would you pay a 4x EBITDA for it?  You may agree.  Now, what if I told you that sales were declining year over year, the operations were running at full capacity with no room for expansion without massive capital investment, the owner was the only management in place, A/R days were twice industry standards, staff morale was low with high turnover, and 90% of sales came from just 3 customers.  Still feel like paying a 4x EBITDA multiple?  Did I forget to tell you about pending litigation?  My bad…  Unless you are a turnaround specialist, you probably won’t feel like paying even a 1 or 2x EBITDA multiple. 

Lets say, you are now the owner of a business in the same industry with the exact same revenues, EBITDA and Net Income.  Except, you have steadily increasing sales, operations at 40% of capacity with plenty of room for additional product or service delivery capability, a diverse customer base, loyal and energetic staff, and professional management in place.  Would you want to sell for the same multiples as the above business?  If no, then you realize the need to value your specific business.

Most small business owners do not see any value in paying for a formal appraisal of their business.  Business owners have a price in mind when they get ready to sell, & usually this price is not based on a rigorous analysis of the earning power of the business.  In my opinion this is a big mistake.  There are only 3 potential outcomes when you do a valuation… and all of them are positive.

• The price you had in mind is lower than the valuation -

  In this situation, the value is clear.  The valuation prevents you from leaving money on the table.  Lets say you were willing to sell for $2.5M, and the valuation comes in at $3M.  Well, that $5000 valuation you conducted just gave you an extra $500,000.  A 99 times return on your money. 

• The price you had in mind is very close to the valuation -

  In this case the valuation gives you confidence in your selling price.  At first glance this is not a big value, but seller remorse often kicks in after a sale.  I have yet to meet a seller who wonders whether they could have negotiated a better selling price.  Its natural human tendency.  Even if you do a valuation, you will still kick yourself and wonder if you could have gotten another $20,000…   but just not that hard. 

• The price you have in mind is much higher than the valuation -

  Often times sellers do not realize how valuable this outcome is.  First it prevents you from listing your business at an unreasonable price.  You will not attract knowledgeable buyers at this price.  Even if a buyer were to make an offer, s/he could never find financing at this price.  Either outcome (not having buyers, or having buyer after buyer fail to raise financing) is frustrating and painful for the seller.  Knowing beforehand that your expectations are unreasonable gives you the opportunity to change your expectations or to work on your business before you choose to list it. 

Who is a Strategic Buyer?

If you are preparing to sell your business, and have done even a small amount of research, then you no doubt have heard of a mythical creature called the “Strategic Buyer”. This wonderful creature rewards your hard work by buying your business for fantastic multiples of revenues. If you have met a broker, s/he no doubt has mentioned this creature as well. S/he knows where to find this creature, and luckily for you has a list of them in their network. You sign up, and the buyer appears, handing you 8-10x of revenues. You buy a big yacht, and are soon sailing around the Greek isles.

Hmmm… so what’s wrong with this picture. Well, for one thing, if this were true, why would we all not start a small business, reach 300K in revenues, and sell out for a couple of million. Because it doesn’t work that way. “But I keep hearing about all these companies that were sold to strategic buyers” you protest. That’s because most use the term strategic buyer loosely. If you think about it, every purchase is a strategic purchase. Obviously the buyer has some strategy in mind when s/he buys your company, even if it is a purely financial strategy. To get the true idea of strategic purchase, lets delve into an example.

Lets say, you Mr. Seller have been running your firm diligently for the last 25 years. Over these 25 years, you have developed a solid channel of 150 repeat customers, lets say gift shops in Airports and Museums. You have a limited product line of 2-3 products. You are approached by a buyer. This buyer has 30-40 complementary products that could be sold to your customers. However, they have absolutely no presence in your channel. From the buyer’s perspective, it is not unreasonable to assume that they could increase your existing revenues by a factor of 10-15 over the next 2-4 years. Their decision to buy your company is not rooted in your existing revenues or earnings, but in a specific asset you possess that is very valuable to them. This is the key attribute that differentiates a strategic buyer from other types of buyers. They have a clear vision of which assets they will be extracting value from. It could be your channel, it could be your technology, or your patent portfolio.

The point is, no one can have a ready network of strategic buyers. There is no such thing. Every buyer and seller combination may have a unique fit somewhere that could make the sale a strategic acquisition for the buyer. Only with an intimate knowledge of the other party’s business, can a seller identify a strategic buyer, and a buyer identify a strategic acquisition. It is very unlikely for an intermediary like a business broker who knows next to nothing about your business, to have a TRUE strategic buyer for your business waiting in the wings.

Most business owners underestimate the amount of effort and time required to sell a business.  They suffer from what I call the “curse of knowledge”.   They are intimately familiar with their business, its customers, its earning power, and all its warts and beauty spots.  Unfortunately, they assume everyone else is too.  They forget that most buyers will have no clue about the business.  To prepare your business for sale, one of the most effective things a seller can do is to put himself in the buyer’s shoes.

Most likely, this is the first time a buyer will even have heard about your business.   Whether it is a strategic buyer, or a financial buyer or any other type of buyer, she or he will want to learn more about your business.  Here lies the tricky part, you don’t want to reveal too much (especially not your customer lists), but at the same time, you have to reveal enough to give the buyer a sense that yours is a well run, stable, and profitable business.   Most buyers are apprehensive.  This is after all a big purchase, bigger perhaps than his or her last house.

One of the easiest steps you can take to reassure a buyer is to have all your documentation ready to go.  This also helps during the transaction itself.  Here is an example of what you don’t want to happen.  Sam was in the middle of due diligence.  He had found a buyer for his bridal wholesale business.  Linda was eager to conclude the transaction, but requested two additional documents.   It took Sam three weeks to dig them up.  When he sent them over to Linda, she informed him that she had bought another business and was no longer interested.  Far-fetched??  Unfortunately this happens far too often.  The deal loses momentum everytime you stop to search old records.  Never assume that yours is the only business the buyer is looking at.

Here is a summary of documents you should keep ready…

Financial & Legal Documents

1. Financial statements (preferably certified) for the last 3 years
2. YTD (Year to Date) Financial statements
3. Tax Returns for the last 3 years
4. All debts and debt schedules
5. Entity/Corp filings, certificates
6. Profit Sharing plans
7. Copy of franchise agreement (if applicable)
8. Copies of Patents and Trademarks
9. Org Charts

Operational Documents

1. Real estate Leases
2. Vendor & Service contracts
3. Business Insurance documents
4. Employee lists (full-time & part-time), contracts along with benefits information
5. Customer contracts
6. Inventory information
7. Account receivables
8. Sales and Marketing collateral
9. Process manuals

Nice to Haves

1. SWOT Analysis
2. Customer Profiles
3. Business improvement plans for the new owner

Have you had other documents requested by buyers??  Add them in the comments section.