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How Much to Pay For a Business

The methodology outlined below is a simplified approach and as purchasing a business is a very significant step and every individual’s circumstances are different, I strongly recommend that you speak with a professional advisor familiar with your personal situation and needs before entering into any binding contract.

VALUING A BUSINESS: CRITICAL POINTS

  1. There is no right or wrong amount – There is only what you are prepared to pay and what the seller is prepared to accept – nothing else is relevant.
  2. How much to pay is based on what CASH you can realistically expect to generate from the business in future years – (There are many valuation methods available from complicated mathematical formulas to a simple percentage of sales. These methods make a good cross-check to the method suggested below).

HOW MUCH TO PAY – THE METHODOLOGY

STEP 1: NORMALISED PROFIT

Calculate a “normalised” annual cash profit (before tax) the business is likely to earn next year based on its past history. This is usually done by beginning with Last Year’s annual profit and making adjustments for items

  • incurred last year but won’t be incurred next year
  • to be incurred next year but weren’t incurred last year
  • Non-cash items

Examples of items you could adjust for

INCREASE PROFIT BY

  • Any wages or benefits paid to the business owner (or people related to the business owner) who will not be continuing when you own the business. This is not just wages but superannuation, medical benefits, motor vehicles, non-business (or slightly business) travel etc.
  • Interest Paid and any Other Finance Costs (that you will not be responsible for)
  • Depreciation and any other Non-Cash Items
  • Any Non-recurring expenses that occurred in the prior year (e.g. legal fees on a case which is now resolved)
  • The expected annual profit of any new (major) customers not included in the past year’s sales

DECREASE PROFIT BY

  • The market wage & benefits payable to you and any partner/relation that will work in the business (the amount is what you would be paid if the business was owned by a 3rd party and not necessarily what you will actually be paid)
  • Any expenses that will be incurred in future years, which are not included in last years’ profit (e.g. the business moved premises 3 months ago into a more expensive site – decrease the profit to reflect the new rental for the next 12 months less what was paid last year)
  • Any revenue earned last year that would be considered abnormal or not likely to occur next year (e.g. a large client was lost to a competitor, a “special” job which won’t occur again)
  • If there is likely to be significant capital expenditure (new equipment) over the next 3 to 4 years then an adjustment should be made (usually the cost of the equipment divided by the estimated years it will be used in the business)

At the completion of this stage we will have a value which represents the NORMALISED CASH PROFIT. This is the amount of profit before income tax that the business is expected to earn next year if it continued to run as it has done in the past.

STEP 2: SELECT AN APPROPRIATE MULTIPLE

There have been books written on what multiple to select and why, but here’s a RULE OF THUMB which has served me well through many purchases. There are 2 ranges

  • Smaller Business (Profit less than $100,000) 2 to 3
  • Medium Business (Profit $100,000 to $500,000) 3 to 4

(This methodology is not suitable for larger businesses)

STEP 3: CALCULATE THE VALUATION RANGE

Multiply the NORMALISED PROFIT calculated in Step 1 with the MULTIPLES in Step 2.

E.g. If you had a normalised profit of $150,000, the valuation range would be $450,000 to $600,000

STEP 4: NARROW THE VALUATION RANGE

To narrow the range further compile a list of factors which either improve or detract from the certainty that you will earn the normalised profit amount calculated in Step 1. Each factor that improves the certainty will support paying a higher amount in the range, each factor that detracts from the certainty supports paying a lower amount in the range. Based upon the number and importance of the factors in each category will allow you to tighten the range to either the lower, middle or upper portion of the range calculated above.

Examples of factors include

1. Age of Business

A business that has existed for 20 years is likely to have more certain earnings and be more established in a market than a business that has existed for 2 years

2. Size of Business

Generally the larger the business the more likely the business would survive any negative events

3. Certainty of Revenue Stream

There are many items that might improve or detract from revenue including

  • Does the revenue naturally occur each year (e.g. an accounting firm which would usually see the same clients to do their tax returns each year) V’s carpentry business which receives most of its clients from internet or yellow pages advertising
  • Is the revenue made up of a lot of smaller clients V’s a few larger clients? Whilst larger clients may be more profitable, they have a higher risk to the business should they take their business elsewhere.

4. Working Capital Required

The larger the working capital required (Debtors + Inventory – Creditors), the less you want to pay. Compare 2 identical businesses, the first requires you hold $200,000 worth of inventory, the second has an arrangement with suppliers to ship directly to customers. At the very least, you save interest on $200,000, plus the extra staff required to receive, pack and ship the stock, do stocktakes etc.

5. Economic Factors

What is the outlook for the next 2-3 years – if the economy or industry is likely to worsen then your valuation should be more conservative.

6. Market Position/Competitors

How secure is the business – are there are a lot of competitors in the industry(many competitors drive down profit margins), are there any new competitors and how difficult is it for a new competitor to enter the market, what impact would a new competitor have on the business.

7. Industry

Is the market growing or declining?

E.g. there are 2 businesses earning identical profit, one sells mobile telephone technology, and one sells facsimile machines. The mobile phone business is likely to have the stronger growth in the future and therefore you’re likely to pay more than you would for facsimile machine business which is old technology and declining sales.

These are only a selection of the factors and there may be others which are very relevant, (perhaps specific to your deal) and these should also be taken into account.

FACTORS THAT YOU SHOULD NOT INCLUDE

There are 2 special factors, which you may be tempted to include but shouldn’t

1. How you will improve the Business

Perhaps you have a special skill, contacts, or insight that will generate more profit than what the business is currently earning. Surely that will allow you to pay more for the business – Yes… and No

Yes, it will increase the profit and add to the value of the business…

No, you should not pay more for the business because of it. This is the extra profit that you are generating for the business, why should you pay the current owner for it? – he hasn’t done anything. The value you add to the business, is what you should receive when you SELL the business, do not pay this to the current owner.

2. Future Opportunities for the Business

The owner has explained to you how the business has many wonderful opportunities for additional sales but he hasn’t had the time or money to pursue.

This will increase future profits so you could pay more – WRONG!

  • it hasn’t happened yet and it might not happen for many reasons, even if it does it’s never as easy as the current owner tells you (if it was, he would have found a way, and he wouldn’t be selling the business)
  • if it does happen – you will be the one who makes it happen – why should he receive anything for this

OTHER TIPS

  • Don’t get into a conversation with the seller about how you arrived at the purchase price. This will spiral into you shouldn’t add back this, did you include that, and the multiple should be higher… this is not helpful. You have calculated a price that you will pay and that’s all the seller needs to know. Of course, there is likely to be a negotiation process so leave yourself some room to go up from your first offer).
  • Get an accountant to assist with the due diligence
  • When apportioning the purchase price amongst the assets, in most countries the best tax outcome will be to put the maximum value to assets in the following order
    • Inventory
    • Equipment and other depreciable items
    • Goodwill (as low as possible)
  • For the seller it is usually best in reverse and I have seen deals where the contract is left blank in this area, and each party fills in their own values later – check with your solicitor
  • Deduct any accrued employee entitlements from the purchase price (e.g. annual leave, long service leave)
  • Whilst it always preferable to have the previous owner to stay in the business for a handover period, if you are taking over their role, in practice it is usually best to let them go as soon as you are comfortable with the business

DISCLAIMER: Many of the comments in this publication are general in nature and anyone intending to apply the information to practical circumstances should seek professional advice to independently verify their interpretation and the information’s applicability to their circumstances. The author expressly disclaims all and any liability and responsibility to any person, whether a purchaser or reader of this publication or not, in respect of anything, and of the consequences of anything done by any such person in reliance, whether wholly or partially upon the whole or any part of the contents of this publication.

The Role of an Attorney in Business Succession Planning

If you’ve spent your life’s work building up a business, it can be hard to think about how the business could ever continue on without you. But the fact is that if you want the business to thrive even after your gone, in the way you think it should, you really need to take some time to for business succession planning.

Since business succession planning can involve both legal issues and emotional issues, an attorney who specializes in business succession planning can really help you make sure that your business is legally sound for the future and can provide third-party counseling about decisions that can be emotionally draining.

There are two important issues that a business attorney can help you with: setting up ownership and managing the impact of estate taxes.

1. Ownership: To determine how your company will be owned, you need to first decide who will manage the company. If you are unattached to the company or want a clean split, you may consider transferring management and selling the company to an outside source. Or, you may want to search for an outside individual who seems to have good managerial and business skills. If you have children who work with you or long-term employees, you may want to leave leadership and ownership to them. If you have multiple children, some of whom work in your business and some who do not, you may want to consider dividing your company into voting and nonvoting stock.

Stock options are also a good way to invest in and retain long-term employees who can assist the transition when your business experiences a change of leadership. Choosing a future management team for your business and trying to divide the worth of your business can feel overwhelming. An attorney can help you weigh your options and devise an ownership transfer to suit your needs and desires.

2. Taxes: If not carefully planned for, taxes that can arise when a business transfers hands can serve a hard and sometimes lethal blow to a business’s finances. Even if you are planning on leaving your business directly to your spouse, you still need to talk to an attorney with business succession planning. Estate taxes can still affect you if your business is worth more than a certain amount and you don’t take additional steps to lessen your tax burden.

If you are leaving your business to a child or long-term employee and you start early enough, you can gradually transfer your assets to them to avoid some of the tax strain. If you are a partner in a business, the partners may want to consider taking out life insurance policies on one another. That way the partners will be able to buy out your investment in the company upon your death and compensate your family. There are so many different taxes that can affect a business transfer and so many different succession scenarios that you really need to seek the advice of a business succession planning attorney for sound advice for your business.

When you spend your life investing in and growing a business, it can be hard to think about having to let go of your life’s work to someone else. But if you want to protect the business as best as you can, you need to plan in advance. A business succession planning attorney can make sure that you plan well.

Selling A Share of Your Business to an Employee

Selling a share of your business (or the entire business) to an employee is often overlooked as a strategy, yet it can be very beneficial for both the owner and employee. There are many different ways this can be achieved and different situations where it might be beneficial. It is also possible that the owner can negotiate a better price as the employee may not have the capacity to purchase the business without the owner’s added assistance.

How does it Work?

One of the reasons why this strategy is attractive is that you can tailor it to meet the requirements of the business, the owner and the employee. There are no fixed rules, work out what both parties need for the deal to be beneficial and it’s a negotiation process from there.

The essential part of the transaction is that the owner will be entitled to receive a payment in return for giving the employee ownership or part ownership of the business.

The following variations can exist

  • If the employee does not have the funds or the capacity to borrow the purchase price, then
  • the purchase price can be paid over a number of instalments
  • the owner can personally guarantee the loan (in the employee’s name) and a separate agreement which entitles the owner to retain ownership of the business sold if the guarantee is activated
  • If the employee does not have the capacity to establish their own business premises then the employee can pay a rent and administration fee to the owner
  • The employee may purchase only one income stream of the business (and the owner continues to operate and own the remainder of the business)
  • The employee may purchase a share of the entire business (which could be Stage one of a number of stages to acquire the whole business)

What situations would it be beneficial?

Some examples which would suit this strategy:

1. The owner requires cash for personal reasons and financing is not an option

Example

Peter owns 3 toy stores which are trading very well. However Peter borrowed heavily to invest in an Aged Care Venture recommended by a friend. The Aged Care Venture has filed for bankruptcy and Peter is struggling to meet his debt obligations personally. The business operated an overdraft and the bank is not willing to lend any additional funds.

Paul has been a store manager for 5 years, and has previously spoken with Peter about purchasing the business or part of the business, but Peter had declined as he felt he would sell the entire business when he plans to retire in 5 years.

Peter and Paul negotiate for Paul to purchase 20% of the business for $50,000.

2. The business is largely dependent on the owner and therefore difficult to sell to an “outside party”. However, through a staged process, the business and its value can be transferred from the owner to the employee

Example

Neville provides engineering consulting services to large mining companies. Almost all of the income is from 4 mining companies that he has consulted to for over 10 years. Daniel is a qualified engineer who has been an employee for 5 years assisting Neville on these contracts (the business also employs 1 engineering undergraduate and 1 administration staff member). Neville wishes to retire.

It is unlikely that this business is saleable to anyone except Daniel. It is also likely that Daniel would not be awarded the contracts himself without Neville’s assistance.

Daniel agrees to purchase the business effective immediately – the deal is

  • 50% of the purchase price is paid now
  • 50% of the purchase price is payable in 12 months if the mining companies agree to maintain the contracts after Neville’s departure
  • Neville agrees to continue in the business for 12 months and is paid a salary

3. The owner wishes to offload part of the business to allow another part of the business to grow OR an excellent employee will leave without being rewarded with ownership.

Example

Annette owns a business that distributes cleaning products. The business has 3 distinct income streams

  • Wholesale of cleaning products to 3 large corporate clients. Annette has known these clients and has been distributing to them for 15 years. Profit on these products is high.
  • Retail of cleaning products to restaurants within a 200km radius. Carol is the manager who looks after this division, and whilst sales growth has been good, profit margins are lower as there are a number of competitors in this market.
  • Annette has developed an innovative cleaning product which is suitable for hospitals. This product has significant potential but Annette will have to invest a lot of time to commercialize, trial and distribute the product.

Carol works long hours and has done a great job with the retail division. Carol is enthusiastic about new products that could be sold through the retail network and has some other ideas to increase profits. Annette however does not have the time, nor the interest to invest money into this division, especially when the same time and money spent on the hospital product could produce much higher profit. Carol is frustrated at this lack of interest and is deciding whether she should approach a competitor to employ her. Carol has been repaying her university debt and does not have much money.

Annette and Carol agree as follows

  • Carol will purchase the retail division for $200,000, payable immediately
  • Carol is unable to obtain finance for $200,000 by herself, so Annette agrees to personally guarantee the loan. They sign an additional agreement which states that if the personal guarantee is called upon then Annette will be entitled to retain the Retail business. The loan term is for 4 years.
  • Carol will pay a Rent and Administration charge to Annette of $2,000 per month for the use of the office, staff and equipment.

DISCLAIMER: Many of the comments in this publication are general in nature and anyone intending to apply the information to practical circumstances should seek professional advice to independently verify their interpretation and the information’s applicability to their circumstances. The author expressly disclaims all and any liability and responsibility to any person, whether a purchaser or reader of this publication or not, in respect of anything, and of the consequences of anything done by any such person in reliance, whether wholly or partially upon the whole or any part of the contents of this publication.