ASSISTING A BUYER IN DETERMINING THE VALUE OF A BUSINESS
Advice from a SCORE volunteer on information that should be obtained from a business seller prior to finalizing an agreement to buy a business.
REQUEST FOR INFORMATION
In assisting potential business buyers, the first consideration is information – the more information the better.
When listing a business, business brokers put together an information package. If this isn’t available and the potential buyer is dealing directly with the seller, the same types of information should be requested. These include:
Profit and Loss Statement for the past three to five years and year-to-date
Tax Returns for the past three to five years
Accounts Receivable and Average Date of
Copy of Personal Property Tax Statement for the most current year
Most recent Depreciation Schedule
List of Equipment
Current and average levels
Copy of most current appraisal
If appraisal isn’t available, general information including size, age, layout, site plan, type of heating/cooling systems, etc.
Copy of Real Estate tax bill for most current year
Property Condition Report
Workman’s comp claims
Copies of licenses
Copy of franchise circular (if applicable)
Copy of lease(s) (for equipment or real estate)
Copies of any vendor agreements
Assisting a Buyer
QUESTIONS, QUESTIONS, QUESTIONS
Along with obtaining information, it is important that the buyer spend time with the seller reviewing it and gaining additional details about the business.
After qualifying a buyer and meeting with him or her, commercial brokers typically have the client sign a Confidentiality Agreement. This is important because it protects both parties from disclosure that might be detrimental. Once the broker lists a business that might be a match, the information packet is provided. This includes some, but not all, of the information listed above. Once the potential buyer receives the general information and is interested in learning more, a meeting is set up between the buyer and seller.
If not represented by a broker, clients should be instructed to sit down with the buyer and learn more about the business. Some questions to ask:
Who is your competition?
Are there any areas where the business could be expanded?
What are your hours? Are they adequate or excessive?
How many employees do you have?
What is the average rate of pay and benefit package?
How has employee turnover been?
What is your most successful product?
How long have you owned the business and why are you selling?
Have you had an accountant do a business appraisal?
How did you set your price?
Do you have any special promotions, coupons or advertising that I would
have to assume?
Would you consider seller financing?
Will you sign a Non-Compete agreement?
How much training are you willing to provide?
Do you have any prepaid expenses that I would have to assume?
What are the trends in your industry?
The first meeting between the buyer and seller should last between one and two hours. If the potential buyer has not yet received the information noted above, this is a good time to request it.
So, how much is the business worth? Business brokers usually determine the value by looking at the assets of the business and value of the cash flow. The value of the cash flow will determine ho much the seller can ask for goodwill. The value of the hard assets takes into account the market value of the real estate, liquidation value of the equipment, and the wholesale cost of inventory (less any dead inventory).
Assisting a Buyer
It is best to recommend that prospective buyers take the financial information to a business accountant. Like a business broker, the accountants will analyze the statements and pick a multiplier x discretionary income. The multiplier for small businesses is usually in the 1.5 to 2.5 percent range. There are sources such as BizComps that provide averages from actual business sales. Another excellent resource is the Business Reference Guide.
If a buyer has been provided with a financial statement that includes add-backs, it is important that extra attention be paid to each of these items. Some business brokers attempt to make the cash flow of the business appear stronger by adding back items that should remain as expenses. Some examples might include:
Advertising – the broker may claim that the business spent an unnecessary amount for advertising and some of the expense should be added back.
Professional Fees – they may add back amounts that they consider to be above average under the assumption that there is additional cash flow to be had.
Business Travel – it could be a legitimate and necessary expense to travel to conventions or trade shows.
Insurance and Employee Benefits – they may claim that you can eliminate bonuses or other employee benefits, but it is unlikely that this could be accomplished without losing employees.
Other – carefully review every add-back for legitimacy.
Once there is a reliable cash flow number, this should be compared to the past three to five years and year-to-date for trends. An accountant will give a weighted average for a three to five year period. The resulting figure is then applied to the multiplier for a fair value of the goodwill.
Suppose the business is a printing company with a discretionary cash flow of $100,000 and there is a multiplier of 2.5 % for this type of business. The goodwill of the business would be worth about $250,000. However, the buyer needs to take this information a step further. If the hard assets of the business are $320,000 and there is an inventory cost of $50,000, the buyer would need to come up with $620,000 cash at closing (plus a credit line for operating expenses). That would require an average of 20 to 25% down ($124,000 to $155,000) and financing of $465,000 to $496,000. To finance $465,000 at 7% with an amortization of 10 years, debt service would be $64,788 per year. This wouldn’t include the interest on the line of credit and return on the investment of the 20 to 25% down. All of a sudden, the $100,000 cash flow that had looked so promising has shrunk to less than $36,000 per year. At this point, the potential buyer has seriously questioned the purchase.
Assisting a Buyer
However, if the buyer has found that the numbers make sense, and the accountant agrees, it is probably time to make an offer and start the due diligence process. This is the point where the buyer can request more detailed information including:
Customer records (look for diversity of accounts rather than a few accounts that accounts that account for most of the sales)
Collection of accounts receivable
Work in process and how it will be valued
Prepaid expenses and what buyer will assume
Computer system and software
Accounts receivable/payable – assume?
Sellers tend to be overly optimistic about the value of their business, and buyers need to watch for the following:
A failure to provide information
Lots of excuses
Trying to sell on the upside of the business (the business is worth what it is currently producing)
New and undisclosed competition
Negative trends in the industry
Lack of disclosing regarding adverse conditions (regarding the real estate, equipment, inventory, or business)
INFORMATION AND QUESTIONS
In summary, the astute buyer needs to obtain a great deal of information and ask detailed questions about the business. If a seller seems hesitant to cooperate during any part of the process, this is a red light that should alert the buyer.