Entrepreneurs want to purchase a business for many reasons: increase revenues, acquire a new product or service line to compliment current operations, enter a new market, acquire intellectual property, acquire talent…the list is endless. One important question to ask is “how much should I pay?”
Businesses are valued in many ways.
Book Value. How much are the assets worth? Assets include machinery, equipment, intellectual property and real estate (either owned or leased). Obtaining an appraisal from a person who is knowledgeable about the industry in which your business competes will provide valuable information. A real estate appraiser will also provide information about the real estate assets. Even if you lease the property, your lease may be valuable depending on location, rent, term and options among other factors.
Multiple of Revenues. Some professionals value businesses based on a multiple of revenues. Factors that are important in determining the multiple include: growth prospects of the industry, growth prospects of the company, quality of customers and the duration of contracts with customers.
Multiple of Earnings. EBITDA is a term that stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. The amount of EBITDA is generally equal to the amount of cash flow that a business generates in a year. The multiple that is used with earnings is typically larger than the multiple that is used for revenues. Again, multiples vary according to industry.
Investment bankers, accountants and financial advisors can provide helpful information about multiples commonly used for various industries.
Many business owners have automobile allowances, travel, entertainment and similar expenses that a purchaser may be able to minimize or eliminate. In addition, an owner may be taking a generous salary and bonus that a new owner could reduce. A portion of these items may be added to the EBITDA in order to generate a higher value of the company.
Earnout. In addition to the business’ purchase price, the seller may request an additional payment for a specified time period following the closing of the sale. A formula to determine the amount of the subsequent payment(s) needs to be negotiated. Elements of the formula could include minimum amount of revenues or earnings necessary to trigger payment of the earnout, treatment of refunds, allowances, and bad debt expense, will certain amounts be expensed or capitalized, and the number and duration of periods (quarterly, semi-annually, annual) for which the earnout will be paid. Will the buyer’s accountant or an independent CPA calculate the earnout? Will generally accepted accounting principles (GAAP) be used? How will long term contracts be treated?
Employment Contract. The purchaser may want the owner to stay on for a period of time after the closing in order to facilitate a smooth transition for the incoming management team. The owner may want to continue with the business for a variety of reasons. Salary, bonus, benefits, and vacation are financial issues that need to be addressed. Title, responsibilities, office location and number of hours to be devoted to the business are key elements that need to be finalized to facilitate a smooth transition.
Due Diligence. The purchaser needs to conduct due diligence on many different aspects of the business, including:
- State and local income taxes, payroll taxes: have all taxes and returns been timely filed?
- Claims and litigation: workers compensation, slip and fall on premises, defective goods, etc.
- Status of customer relations: increasing or decreasing orders from long-time customers
- Intellectual property: status of patents, copyrights
- Loans: can the loan be assumed?
- Leases: can the lease be assigned?
Structure of the Purchase. The purchaser should consult with an attorney to determine whether to purchase the assets of the seller or purchase the shares (corporation) or membership units (LLC) from the owners.
When entering into a contract to sell or purchase a business, the seller and the buyer each need to make certain that financial, tax and legal issues are carefully analyzed and negotiated.