The first step in placing a value on your business is identifying the "right buyer." The range of values that different buyers may be willing to pay is staggering. Buyers pay for opportunity. The buyer who perceives the greatest opportunity is the buyer willing to pay the most for your business.
Identifying the "right buyer" requires understanding the four main classifications of buyers:
Strategic Acquirer: These are the very best buyers. They almost always pay cash and buy at a premium. Typically public or very large private companies base their decision to buy usually around considerations of economies of scale, new channels of distribution, new technologies or other integration considerations. To be attractive to a strategic acquirer, your company should fit most, if not all, of the following criteria:
- Sales in excess of $10 million.
- Proprietary product or process.
- Unique market presence or share.
- Synergistic fit with the acquirer.
- Suitable management willing to stay.
Sometimes a business that does not meet these criteria can be the target of a "strategic acquirer." A good example might be a small business that an acquirer believes could be franchised or expanded into a chain of similar locations. At VR, we look for every reason that may make your business attractive to a strategic buyer.
Sophisticated Buyer: This group of buyers emerged as a force when the "merger mania" of the late '80s ended and buyers began to recognize the opportunities in the private sector. Lower interest rates have also spurred the growth of these buyers by encouraging the formation of investment groups whose purchases are made using a "schooled" approach. There are two distinct types of sophisticated acquirers and the acquisition criteria they use are as follows:
Private Equity Group
- Revenues from $10 million upwards to $100 million.
- Earnings of $1 million for platform acquisitions.
- Earnings of $250k minimum for add-on acquisitions.
- Investment of considerable cash or equity.
- Pay 3 to 6 times earnings.
High Net Worth Individuals
- Revenues from $2 million upwards to $20 million.
- Looking for a business that can be expanded exponentially.
- Expect 6-figure future earnings.
- Expect to leverage a part of the purchase.
- Expect the Seller to finance part of the buy.
- Pay 3 to 5 times earnings.
Sophisticated buyers sometimes buy companies smaller than the outlined criteria. A good example of a business attractive to the sophisticated buyer is a light manufacturing business expandable into multiple markets through expanded marketing and solid management.
Main Street Buyer: By far the largest group of buyers, main street buyers are the most common buyer for main street and upper main street businesses. These buyers (also called financial buyers) tend to focus solely on present and past earnings and will not typically pay a price based on future earnings. The financial buyer is buying a job and will consider a price fair if the transaction meets the following criteria:
- A living wage typically commensurate with the initial investment.
- A modest return on the cash investment, willing to pay 1.5 to 3 times earnings.
- SBA or Seller financing.
- A good fit with their skills and the opportunity to make the business better.
Many small businesses are purchased by financial buyers. VR maximizes the amount the financial (main street) buyer is willing to pay by finding the right financial buyer for your business.
Industry Buyer: Unless they are doing a consolidation or roll up in their industry, these buyers are almost always the buyers of last resort. If you have to sell, an industry buyer is usually the only buyer you will attract. The difference between industry buyers and all others buyers is the value of goodwill. Most of the time industry buyers won't pay for it. Industry buyers typically will pay:
- Liquidation value.
- Book value.
- Adjusted book value.
All too often, business owners who are attempting to sell their business on their own say, "Why not? I know everybody in the industry." Unfortunately, many times, a sale to the industry buyer means a deeply discounted sale. The first step in selling your business is understanding what it is worth. VR Mergers & Aquisitions can assist you with a professional business valuation. There are three different approaches to valuing your business and they are as follows:
- Asset Approach: Simply stated, the asset approach values the assets of the business. The value of the assets of a business are, however, not always easy to ascertain. For example, the value of the assets as stated on the balance sheet, "book value" is almost always not the true value of the assets in the marketplace. If a business is being liquidated and the assets must be sold by next Friday, then book value is not of importance. However, if the assets can be sold over a course of several months, then the value of these assets is closer to their fair market value (FMV). Most of the time, assets are valued at FMV, defined as the price that a reasonable buyer would pay a reasonable seller when neither were under pressure to buy or sell. Unless you are buying a business that is very asset intensive, marginally profitable, or losing money, the asset approach usually is not the best indicator of the true value of the business.
- Income Approach: The income approach uses one or more methods to determine the value based upon the anticipated benefits of business ownership. Simply stated, the income approach determines the value of the anticipated stream of business income. Although entire books have been written on this subject, the most relevant discussion revolves around what are the earnings and what is the discount rate or capitalization rate applied to the earnings. Earnings, as discussed elsewhere, are the adjusted profits of the business. Most professional valuations use one of two types of earnings:
1) SDE, or seller's discretionary earnings, is a direct measurement of the true bottom-line benefit of owning a small business. SDE includes the owner's salary or take-home compensation.
2) EBITDA, or earnings before interest, taxes, depreciation and amortization, differs from SDE in one key area: it includes compensation for management. Discount or capitalization rate can vary greatly by the type of prospective purchaser and the overall risk of the continuity of the income stream. Depending on the buyer and the business, some potential areas of risk can be the size of the company, competitive forces, barriers to entry, growth rates, lack of management, etc. As a broad-brush example of risk, an investor investing in a portfolio of stocks representing the entire stock market may believe that an 8% rate of return is adequate given the enormous diversification in industry and given that these publicly held companies have top quality management. On the other hand, a potential buyer of a beauty salon may seek a 50% rate of return given the large number of competitors, high employee turnover, low barrier to entry, and the necessity of constant supervision.
- Market Approach: The market approach determines the value of a business by comparing it to similar businesses that have been sold. Although not as complete or comprehensive as residential comparable sales, there are several very good databases of sold businesses. Businesses are seldom exactly the same, but grouping like businesses by type and or region makes comparisons relevant. VR subscribes to these databases and often checks numerous sources to find like businesses. Ratios considered when using the market approach are the price to earnings and price to revenue.