What is Your Business Worth? (Part 2)

It's said that, 'A picture is worth a thousand words.'

So, how much is a business worth?

That's a question that both buyers and sellers need to carefully consider, and it should be addressed through a rational process to determine that value!

Over the years, we've seen a number of methods used to calculate the value for a business:

• Discounted Cash Flow Value
• Going Concern Value
• Net Book Value
• Liquidation Value 

There certainly are a lot of factors that enter into the equation! But having said that, a business that's well structured, properly organized, running efficiently with systems and people in place, will be much more attractive to a purchaser than one suffering from multiple deficiencies. External factors in the market such as demand for the product or service, level of competition, and state of the economy will also come into play. 

Another important consideration that we've seen for those purchasing a business relates to the changes they plan to implement after acquisition. These changes should be reflected in the business plan and financial projections for the business on a go-forward basis.

Once again, we come back to the importance of having a solid business plan. At Pro-Vision Solutions Inc. we work with you and other members of your "team" to help as you build your business. Regardless of where you are in the entrepreneurial process: pre-start, ready to launch, growth phase, mature, reinventing, or exiting ... PLANNING is important, and we'd be pleased to discuss your business planning requirements.

In this post, our friends from Sunbelt Business Brokers provide a follow-up and conclusion to a discussion that was started earlier. We appreciate their expertise and trust that you'll find it helpful as you consider buying or selling a business. And now, please enjoy this guest blog post.

What is Your Business Worth?

Provided by Dale Alton as Part 2 of 2 

Notes: Excepted from “INSIDER TIPS ON SELLING A BUSINESS IN CANADA” by Greg Kells

As you may have read in Part 1, a seller’s price expectation needs to be in line with market reality.

There is a saying that, “a business is worth what a buyer will pay for it”.

For the most part, third party buyers are looking at buying income and a return, based on the owner’s compensation history. The buyer needs to ensure cash flow is sufficient to pay their salary, service the debt incurred to buy the business, build or reinvest in the business, and provide a reasonable return on their invested capital.

Most financial statements of small businesses are prepared to minimize the tax burden for the company and its owners. To reflect the company’s true earnings, we need to “recast”, or “normalize” the balance sheet and income (profit and loss) statement.

The key is to determine a Most Probable Selling Price (MPSP) for your business, and work to improve that number while improving your after tax return.

Recasting income statements 

Owner’s compensation can include pension plans, profit sharing, health and life insurance, auto travel, entertainment, meals, memberships, dues, fees, subscriptions, salary, wages, bonus and payroll taxes, family and relatives on payroll. In a small-to-medium-sized business, owner’s compensation is often based on what the business can afford. It also tends to be the area of biggest adjustment in an income statement, where we "add back" expenses considered discretionary, extraordinary, nonrecurring, or non-cash. We also add back interest as the new owner may have a different capital structure. In recasting, you need to ask: Will the new owner incur this expense to obtain these earnings? This process can take some time and the business broker/appraiser can assist with the right questions.

Let’s look at an example of an auto service centre—Andy’s Auto Service--recast to uncover true earnings (Sellers Discretionary Earnings/SDE*). The company’s income statement shows gross profit is $300,000, based on revenues of $750,000 and cost of sales of $450,000. After subtracting operating expenses of $298,000 the company’s pre-tax profit is $2,000. Would that interest a buyer? Not likely. 

*SDE is net income less: interest; taxes; depreciation and amortization; owner’s compensation (including salary and discretionary expenditures. 

With recasting - operating expenses were normalized to $192,500, leaving an extra $107,500 in the net profit after recasting out discretionary spending, taxes, interest and depreciation. That normalized the net income to $109,500. It’s not that certain expenses aren’t legitimate—it’s whether or not they’re essential for the next owner. Sometimes, we need to add back discretionary expenses that an owner hasn’t included--a family member who works for no pay, an owner who uses his own tools, unrecognized expenses, or where a business is uninsured or under-insured.

In our example, the true earnings were determined to be $109,500, ( 16% of Revenue ) proportionately more in line with the 15 to 25 percent of gross sales that SDE typically represents in a small (four- to six-bay) auto service centre. 

The EBITDA or Earnings Before Interest, Taxes, Depreciation and Amortization in this example is $59,500, as we would have to add back the cost of a replacement for the owner at a fair market wage estimated at $50,000, giving a SDE of $109,500 

Recasting the balance sheet 

We also need to normalize assets and liabilities.

The recast balance sheet should reflect the Fair Market Value (FMV) of the assets and liabilities being transferred. While net book value is used for tax purposes, their value as is, in use, in place, is more relevant here for tangible assets such as furniture, leasehold improvements, vehicles, machinery, and so on. Intangible assets—goodwill, patents, trademarks, database/mailing lists, licenses, permits, franchise agreements—should also be recast to FMV.

Only after recasting can we 1) look at industry benchmarks to analyze performance against similar businesses; 2) identify the value drivers; and 3) begin the process of valuing Andy’s business. For recasting, we need the financial statements as prepared and filed for the past three to five years. We also need the owner’s time and input for our adjustments, which we document with source, rationale and supporting paperwork. All will be required at due diligence.

Back to our Auto Service Centre—after recasting we have a business with SDE of $109,500 and equipment worth $148,000 rather than the book value of $73,000 and inventory worth $43,000. We now have a saleable business operating with the industry norms for its type and size.

Many more factors

There is much more to take into account. Does the year-end represent the normal level of inventory? The value of the inventory is a topic on its own—the method of accounting used and its proper application affects the cost of sales and of course, the earnings.

The operating and accounting systems, employee training and loyalty programs, marketing collateral and programs, customer retention, applicable gross margins and pricing systems, mix of commercial and consumer work, location and factors affecting future market growth, availability of good employees, competition and differentiators, niche focus of the service centre, etc., all affect the value and salability of the business. The structure of the sale and the willingness of the owner to finance some of the purchase price are other major factors.

Discovering a Most Probable Selling Price (MPSP) early in the process will give the owner time to work on tax planning and increasing the value of the business before sale. 

Sunbelt Business Brokers Edmonton

Sunbelt’s team of brokers, operating at local and regional levels, have experience selling small to medium sized businesses. 

Sunbelt is the world’s 

largest business brokerage firm with approximately 300 licensed offices located throughout the world, 

and 33 offices across 

Canada alone.

More than 1,400 Sunbelt brokers annually coordinate an estimated 4,000 Main Street and Middle Market business transactions.

A variety of strategies are required to sell businesses from different industries, of different sizes, and in different economic climates. Many Sunbelt brokers have specific industry experience and cooperate with their counterparts to identify the buyer and create the right framework for the sale.

Your Local Sunbelt Business brokers sell a diverse mix of main street businesses valued under $3 Million. Mergers and Acquisitions of larger and more complex business transactions of up to $30 Million are managed out of the Ottawa Head Office. We would like to help you plan and look forward to retirement, expansion or an exciting new business opportunity. 

Have you ever thought about selling your Business?

Sunbelt represents clients who may be interested in buying a business like yours. If you are thinking of selling a business now or in the next 3 years, discover what your next steps should be. Feel free to contact our Sunbelt Business Brokers Edmonton office if you have any questions or would like a free confidential consultation. Give me a call. Dale Alton – 780-878-8787

Sunbelt - The Place to Buy or Sell a Business.

* Here's a 'Shout Out' to our friends at Sunbelt ... Thank you Michael and Dale for another helpful article!  If you missed the first article in the 2-part series, simply check the index on the right side of this BLOG.

In closing, we invite you to consider Pro-Vision Solutions Inc. as a part of your TEAM of business professionals. We're pleased to assist those who are working on their business plans for start-up, growth and expansion. Let us know if that's something you may require, and let's have a conversation! 

Together, we can help you Build your Business Dream, starting with your Business PLAN.

NOTE: For more information on the services provided by Pro-Vision Solutions Inc. and how we can assist ... please visit our Website: www.pvs4u.ca