My answer is always the same: If you have a profitable business, an established location (or web store or show circuit) and three to five years of financial statements (income statements, balance sheets and tax returns) then you are probably better off selling your business as a going concern. If not – or if you’re in a hurry to sell – then the better choice is to liquidate your assets and move on. If you’re not in a hurry to sell, then start keeping good financial records, wait three years, and then sell.
Selling a business as a going concern can take a couple of years to accomplish: Potential buyers have to be found, a deal struck, financing arranged,and due diligence performed. Having a store closing sale or an on-site auction of assets can take a few months to get done. Unquestionably, if you can sell your business as a going concern you will get a lot more money than you will just selling off the assets. Sometimes a lot more.
Having decided to sell one’s business as a going concern, the next question is: At what price do I sell? Too many small business owners and non-professional business brokers (read: real estate agents) believe that a simple valuation multiplier will produce a viable selling price. Not so. A valuation multiplier is a “rule of thumb” that gives a “quick and dirty” selling price. For antique stores, the rule of thumb is “20% of annual sales plus inventory”.
There are so many problems with that formula that I don’t even know where to begin. For starters, “sales” does not equal “profits”. If one is losing money on sales of a million dollars a year, how then is an unprofitable business worth $200,000 plus inventory? Also, not all stores with the same sales have the same value. For example, store A, a 20-year-old business with declining sales in a run-down part of town has revenues equal to store B, a five-year-old enterprise with annually increasing sales in an upscale part of town. Which store would you rather own? Store B, of course.
Business buyers will pay extra for good cash flow and profits, provided that you can prove you have them. A selling price above and beyond the value of the assets becomes possible by first “normalizing” your financial statements. Normalizing removes all the non-cash and discretionary expenses from your statements and places those amounts on your bottom line. In business brokerage, I’ve turned $10,000 profits into six-figure profits by normalizing income statements. (No, you won’t owe any more taxes by doing this; it’s simply a paper exercise to arrive at a valid selling price).
You see, for the purposes of selling your business, your financial statements as presented by your accountant are pretty useless. Modern accounting rules are employed to lower your tax liability, which is accomplished by lowering your paper profit. The government has for decades used the tax system to manipulate the economy; rules on depreciation and what constitutes “legitimate” business expenses are forever changing. Normalizing moves many expense items back to the bottom line, thus increasing your profit. When profit increases, your business is worth more.
So, if your company has reimbursed you for a cell phone, vehicle or convention trip, all those expenses are taken out of the expense column and added back in to your profit. Why? Because those are discretionary expenses. Your buyer may not want to take that trip, and may prefer to make other arrangements for a phone or a car. Also, your depreciated fixtures and equipment may have a market value that’s greater than their book value. If you own your real estate, the depreciation on your building can be substantial. In normalizing, all that depreciation money is moved out of expenses and into the profit column.
Once your financial statements have been normalized (your accountant can help you with this), it’s possible to predict (more or less) what the future profits of the company may be. Buyers will pay for these future cash flows as well as for the hard assets of the company. That’s why asset-only sales should be avoided if possible: They leave money on the table. Calculating the value of future earnings is what financial analysts call the “present value of future earnings” or “discount rate”.
Here’s a simplified explanation of how PV (present value) works: Let’s say I promise to pay you one dollar tomorrow for a small loan today. How much would you be willing to loan me today? Depends on how much you trust me, right? In other words, it depends on the amount of risk you are assuming. If you know me to be trustworthy you might just lend me a dollar. If not, maybe only seventy-five cents. Having a dollar tomorrow is only worth seventy-five cents to you today. The entire American financial services industry is run on the basis of PV and discount rates.
If your business produces a modest profit of $10,000/year (allow me to keep the math simple, please) then in 10 years that’s $100,000. If you were buying a business, how much would you be willing to pay today for $100,000 spread out over the next 10 years? $1,000? $2,000? There is no fixed answer to the question; in business brokerage those answers are all negotiable between the buyer and the seller.
The bigger your annual profit, the more the business is worth to a buyer in the long run and the more it’s worth to you right now. That’s why it pays to normalize your financial statements: You can create more profit, and then leverage future profits into a higher selling price today.
One item that buyers won’t pay for is potential. More than once I’ve heard would-be sellers say “but this business has great potential! It could be a million-dollar business!” Maybe. But a buyer isn’t going to pay you a million dollars for potential and then turn around and pay another million dollars to develop that potential.
As a seller, you have to prove what your business is worth today, and negotiate a selling price that is backed by proof, not pipe dreams. Don’t try to sell “blue sky” or “goodwill”. They are both “pie in the sky” and no sensible buyer will pay for them.
Lastly, be aware that any selling price you arrive at is simply a starting point for negotiations. That’s all for now. In my next column, I’ll discuss how to get the deal done.
Originally posted 2014-11-12 15:47:00.