A Reality Check For Small Business Value

For small business owners contemplating retirement and the sale of their business, determining the value of the business in the market is a starting point.  Employees and government workers can enlist a financial advisor to analyze their pension or 401(k) plan to determine whether they have “enough” to retire.  For the small business owner, though, the financial advisor cannot advise until someone determines how much the business is worth, since it is often the prospective retiring owner’s most substantial “retirement” asset.  After investing much of their time and resources in the business over many years, business owners count on that asset to fund their retirement.

Unfortunately, determining the value of a business is not a simple calculation.  There are many methods and theories to value a business, and the reality is that there are probably too many.  For anyone who is not an accredited business appraiser, it is simply too much information to be useful.  Still, there are some relatively simple approaches that can help the average business owner determine whether they are “in the ballpark” of retirement, or still out in the parking lot.

It is particularly important to perform a reality test if you are a business owner trying to market and sell your business on your own.  It has been estimated that 80% to 90% of businesses listed for sale on business listing websites will not sell.  At Piedmont Business we have experienced the inverse, having been successful in selling nearly 80% of the businesses we have advertised for sale.  However, we are careful to advise business owners to price at a fair value.  The reality is that the majority of businesses listed for sale are overpriced, and that is why the majority do not sell.

A business will often have greater value with a “strategic” investor-buyer, often a competitor or someone in a similar industry.  These buyers can leverage the purchased business, together with their existing business, to increase revenues, improve profit margin, decrease expenses, or in some other manner increase profitability of the combined enterprise.  Aside from strategic buyers, however, the average “financial” buyer is interested in cash flow.  They will use this cash flow to make payments on acquisition and working capital indebtedness, provide a return on their investment, pay themselves or family members a salary and benefits, and fund capital reserves.  If there is not enough cash flow to meet these needs, the prospective buyer who was initially interested in a particular type of business will lose interest quickly.

At a recent online conference, a lead appraiser with a national business appraisal firm presented data suggesting that the vast majority of small businesses will sell at a price multiple of 2.0 to 3.5 times discretionary cash flow, and the average sale price was approximately 2.75 times cash flow, right in the middle of the range.  A simplified definition of discretionary cash flow is the total amount of cash generated by the business on an annual basis, prior to debt service payments, owner salary and benefits, depreciation or amortization, and non-recurring or irregular expenses.  This is the cash flow figure of greatest interest to buyers, since discretionary cash flow is what will allow them to fund the acquisition and meet their personal needs.  This means that a business generating $100,000 of discretionary cash flow will most likely sell for between $200,000 and $350,000, with the average price being $275,000.  This is a vast oversimplification of the market pricing process, but does provide some reliable data for a simple reality check.

Of course, not all cash flow is the same.  So many dollars of cash flow generated by a business with one customer is, all else being equal, worth less than the same amount of cash flow generated from 100 customers, simply because the risk of losing a single customer is far greater in the one-customer business.  A long-established retail customer service business with $100,000 of discretionary cash flow may be worth significantly more than another company dependent upon annual contract renewals or government bids.  Risk must be considered and all businesses are different, but still, the great majority will fall within that 2.0 to 3.5 times discretionary cash flow range.

At Piedmont Business, we always look at the cash flow analysis from a buyer perspective prior to advising an owner of a recommended asking price for a business.  The reason, of course, is that we do not want to overprice a business and waste the seller’s time or prospective buyers’ time, or just as importantly, our time.  Very occasionally buyers will overpay, but most buyers are intelligent and competent and will not overpay for a business, and that is why relatively few of the businesses listed for sale online will actually sell.  As an example, recently I received notice of a new posting for a local business with $700,000 gross income, $75,000 cash flow and an asking price of $610,000.  (The numbers have been changed for anonymity, but the relative values are consistent with those advertised for illustration purposes.)  The business is a retail business in an industry with a downward trend, and the value of its assets (primarily inventory) is only a fraction of the asking price, suggesting a value in the lower side of the typical range.

A cash flow multiple range of 2.0 to 3.5 yields an indicated sale price range of $150,000 to $262,500, with an average of $206,250.  Yet the business recently brought to my attention is priced at nearly three times what the figures would suggest is a reasonable market price.  Businesses often sell at a price below the asking price, but a business that is significantly overpriced will be ignored by prospective buyers.  It does not take much analysis from a buyer perspective to see that the business in this example will be ignored by prospective buyers.  Assuming that the business were sold at a price of $518,500, or 85% of the asking price, with an 85% loan, $25,000 closing costs and estimated working capital need of $50,000, the buyer would have to make a $81,525 down payment.   On a 10-year SBA-guaranteed loan at 6.5% interest, the annual loan payments plus interest on working capital would run about $66,000, leaving just $9,000 for return on the buyer’s down payment (an 11% rate of return, versus typical returns of 25% + on small business investments).  If the seller was working in this business, the buyer will have to replace the seller and work for free, since there is nothing left to provide for a salary or benefits.  It is easy to see that this is not a good deal for the buyer, and most buyers who might otherwise have been interested in the business will move on quickly.

In comparison, let’s take a look at the figures if the business were priced at $206,250.  The principal and interest payments now run about $30,000, leaving $45,000 for return on the owner’s down payment of $34,500 and to compensate for the owner’s time invested in the business.  This may reflect a very high rate of return and justify an increased price, if the owner spends little or no time in the business.  On the other hand, if the owner is working long hours, $45,000 cash flow will not be enough to justify the risk of the investment and effort involved, for many prospective buyers.

It is easy to see that the buyer’s perspective, not the business owner’s retirement needs, will dictate sale prices.  If time allows, there are many things that a business owner can do to improve business value and likelihood of a successful sale.  As with any retirement “plan”, the business owner must seek expert advice on the value of his or her retirement asset in order to understand how well it will support retirement needs.  With a realistic approach to pricing and a well-positioned business, any good business can and will sell at a fair price.

 

Stephen C. Minnich, J.D.

Certified Business Intermediary
Piedmont Business, LLC

(336) 202-7905(336) 202-7905

www.piedmontbusiness.com