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Written by Alexander J. Davie

 

Buying a business is a high stakes matter.  What makes the process even more nerve-wracking is that a business is different from just about any other asset one can buy.  When someone purchases a piece of real estate, a car, or any other tangible product, a buyer usually knows what they are getting and can inspect the goods and has a chance to find hidden problems (or pay a specialist to find them).  A business, on the other hand, is largely intangible.  While some of the aspects of the business may be tangible, many are not.  The business will likely have receivables, inventory (both completed products and parts), intellectual property, and goodwill and reputation. Many of these assets may not have the value that the seller claims they have and may be difficult to value.  The business will also likely have liabilities like hidden debts and potential lawsuits.  Discovering the true extent of these liabilities is crucial in making sure the purchase of the business is worth pursuing.  Finally, there are many intangible considerations that go beyond just the company’s balance sheet.  How does the business operate as a whole?  Is its management team effective and will they stay involved after the change in ownership?  How are the relations between the business and its customers?

Because there are so many hidden traps in buying a business, purchasers will usually engage in due diligence on their target acquisition.  The main purposes behind due diligence are (1) verifying the information provided by the seller and (2) uncovering any material information that the seller hasn’t provided, either intentionally or unintentionally.  Unintentional omissions are actually quite frequent.  Buyers often discover potential legal liabilities of their target or asset impairments due to previous regulatory violations or poor legal work that the seller may not even be aware of.  Not performing proper due diligence can lead to surprises down the road that end up being far more expensive than the cost of doing due diligence upfront.

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Myth I: Valuing a private business should only be done when the business is ready tobe sold or a lender requires a valuation as part of its due diligence process.

Although the business sales and lending processes generally require that valuations be completed, if these events represent the first time an owner has a valuation completed, then you can be sure critical business and estate planning issues have not been addressed. If the business is to have a life beyond that of its current owners, then effective planning for ownership transition requires a regular valuation of the business.

Myth II: Businesses in my industry always sell for two times annual revenue (the revenue multiple). So why should I pay someone to value my business?

The short answer is that data on selling prices indicate that revenue multiples within an industry are generally all over the lot. These rules of thumb used by business brokers, the individuals who often facilitate private business transactions, are median multiple values. The median value indicates that half of the revenue multiples are below the median value and half are above. Thus, the median value is just a convenient midpoint and does not represent the revenue multiple for any actual transaction. Unless the firm that is being valued is truly

Myth III: A local competitor sold his business for three times revenue six months ago. My business is worth at least this much!

Maybe yes and maybe no. What happened six months ago is not really relevant to what something is worth today. What your business is worth today depends on three factors: 1) how much cash it generates today; 2) expected growth in cash in the foreseeable future; and 3) the return buyers require on their investment in your business.

Myth IV: How much a business is worth depends on what the valuation is used for!

The value of a business is its fair market value (FMV). According to the Internal Revenue Service, the FMV is what a willing buyer will pay a willing seller when each is fully informed and under no pressure to act. While there may be a FMV range, the wider the assigned valuation range is, the less reliable is the valuation and the more likely it becomes that the valuation will face greater scrutiny from potential buyers or the IRS.

Myth V: Your business loses money, so it is not worth much.

Most private businesses appear to lose money. Appearances, however, are often misleading. Not long ago, a friend of mine was considering buying an auto parts business inCalifornia. The asking price was approximately $950,000 and, according to the firm’s tax return, it hardly made a profit. Like many businesses of this type, this business was generating a great deal of cash, but this cash was masquerading as legitimate expenses. One expense category really stood out—payments to officers. This payment included the owner’s wage of $80,000 per year and a bonus of $150,000 that the owner paid himself at the end of year. The $80,000 wage is what the business would have to pay a stranger to do the same job as the owner. This was a real expense. The $150,000, on the other hand, represents what finance people call a return to capital. It is the cash the business generated and it is this cash that determines the value of the business.

Excerpts from a SCORE article by Dr. Stanley J. Feldman, Chairman, Axiom Valuation Solutions and Associate Professor of Finance,BentleyCollege.