A summary of some of the important considerations in the purchase or sale of a business.
Reasons to Sell or Buy a Business
There are many reasons why people decide to sell a business. Perhaps a sale was one of their exit strategies. Maybe they are retiring and want to realize the value of what they worked so hard to create.
People buy existing businesses because they believe the value is good. There is also a greater chance that the business will be successful if it has been run profitably for a decent number of years. Compared to starting your own business, your odds of success are greater buying an established business. Buying a business can also be a way of expanding your existing business. However, buying an existing business comes at an increased cost.
Considerations in the Purchase or Sale of a Business
There are many variables that go into buying or selling a small business. We cannot cover all of them in this guide but will hit the most important factors to consider. Keep in mind that valuing a business is an art not a science.
The value at which a business is bought or sold is one of the most important factors to consider. There are several methods that can be used to value a business.
• Asset Based Valuation: this method is not appropriate for a small business. Assets are used to generate revenue. However, you can have a business that has a lot of assets but does not produce much revenue. On the other hand, you can have a business that has very little assets but makes a lot of money. Which would you rather buy?
• Liquidation Value: this valuation methodology looks at what the business would sell for if it were forced to sell in a very short time. A sale in connection with a bankruptcy is an example of this. This is not an appropriate valuation to use for a business that is doing well.
• Income Multiple: the net income is subject to a certain multiple to determine the value of the business.
• The Rule of Thumb Method: this method looks at businesses that are like the business being valued. The problem with using this valuation method is the difficulty in finding another business for sale that is very similar to your business.
What Method of Valuation should you Use?
For small businesses, the typical way to value them is using the Income Multiple Method. It is truly the best way to put a price tag on a business. The Multiple Method uses what is referred to as the “Owner’s Benefits,” though other terms, such as “Seller’s Discretionary Earnings” are also used. The Owners’ Benefit is calculated by starting with the net profit of the business. Then you add back into the net profit the Owner’s Salary, depreciation, interest and other expenses that may not be for the sole benefit of the business. The formula for Owner’s Benefit is Profit Before Taxes + Owner’s Salary + Depreciation + “Owner Perks – the items that the business does not really need” and subtract from that number any Capital Expenditures.
Capital expenditures must be figured into the equation, because in capital-intensive businesses, where the need to replace equipment occurs on a regular basis, this number should be deducted to calculate the value and the buyer’s ability to fund capital expenditures going forward. You next need to apply a weighted average to the Owner’s Benefit to arrive at an Owner’s Benefit that you can use to value a business. Using this formula, you have arrived at the Owner’s Benefit number or Seller’s Discretionary Earning.
Computing the multiple is the most important part of the valuation exercise. This multiple will vary according to various factors. The number of years in business, what the competition is, the contracts with customers, the industry, and other factors. The multiple that is appropriate is usually somewhere in a range.
Structure of the Transaction
The way the deal is structured can also have a pretty big impact on valuation. Business sales that require all cash upfront will typically be valued at least 80% less; and sometimes 60% less. If the Seller is willing to finance part of the purchase price, the valuation will be higher. Of course, the Buyer should ensure that it has some protection for repayment of the note. Having a secured note, where it is secured by collateral that can easily be sold to pay off the note, is very important.
Prior to allowing any potential buyer to look at any financial or other business records of the business, the buyer will be expected to sign a confidentiality agreement. Usually these agreements simply provide that the potential buyer will not disclose any information of the business, will only use any information obtained for determining whether, and at what price, it will make an offer to buy the business, and finally the buyer will not disclose the fact that the seller is considering selling the business.
Letter of Intent/Term Sheet
A letter of intent is often signed by the buyer and seller to set forth the more important terms that they intend the acquisition agreement to include. The letter of intent is nonbinding, so no contract to buy or sell the business is created by the letter of intent. The one exception to this is that a letter of intent will often contain a standstill provision. This provision will state that for a certain period, the seller will not entertain any offers for the business from any other party. This standstill provision allows the potential buyer to feel that it has time to complete due diligence, without having the business being sold to another party after having expended a significant amount of time investigating the business.
The form of the acquisition agreement will be dependent on several factors and there are tax implications related to whether an acquisition is done as an asset deal, a stock purchase deal or some type of merger. The form of the acquisition if beyond the scope of this guide.
The acquisition of a business is a complicated process and both buyers and sellers should engage an attorney that practices in this area. There are too many traps for the unwary in such a transaction without the proper guidance on the many aspects involved. This will avoid headaches in the future and ensure you have a properly structured deal.
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