Do you remember all the excitement and enthusiasm you had when you first started your automotive or heavy truck repair shop? Maybe it was when you got your business cards. Shiny, new, freshly printed with your official company name on them! Or maybe it was when you had your company sign installed on your building? Or perhaps the freshly printed stack of new company checks? All the activity, the work, the unfulfilled dreams – that was then. But this is now! Now, after however many years of running your operation, you’re ready to call it quits. Whether you’ve been wildly successful or have just been able to keep the bills paid and the customers happy, you’re still ready to “call it a day.” If you’re at that point, please pay attention, and you’ll learn some basic strategies to help you navigate the waters ahead. In preparation for writing this article, I interviewed quite a few independent shop owners and was dismayed to hear that not many of them had given any thought as to how they might one day “cash out.”
The first and most important aspect of getting out is to determine what the business is worth, or valuation.
Example #1 You own the property, the real estate, and building.
This example is much more complicated, and most certainly will require the assistance of either a real estate agent, banker, or perhaps a business broker. The options here are almost limitless! You may decide to sell only the “business entity itself”, i.e. the name, equipment, all contents, and most importantly – the customer database. The beauty of this approach may not be self-evident. When a prospective buyer is reviewing his options, he only has a couple. He can do as you did, and start from scratch. He can buy some land which is properly zoned, get the necessary permits, erect a building, buy many tens of thousands of dollars in equipment, hire the staff, and so on. He would then do the necessary advertising to get the first paying customer in the doors. But why would he do that? After all, your cash register is already ringing! Theoretically, you both could close on the sale of your business on a Friday, and he could start earning profits come Monday morning. When negotiating with a serious buyer, it’s crucial you point this out.
You could sell only the actual business, business name, customer database, and equipment. You could then choose to lease the building and property back to the new owner. This is smart for a number of reasons which a prudent real estate agent or broker can help you to realize. Demographic analysis and market studies will tell you if the values of commercial property are trending up or down. If trending up, it might be wiser to maintain control over the property. If analysis indicates otherwise, it might be best to “cut and run.”
Example #2 You do NOT own the dirt or the building.
In many ways, this is a much simpler sale, requiring transfers of tenancy, responsibility of all utilities, etc. Should this be the case, the new owner will most certainly have to qualify and agree to the landlord’s requirements for occupancy. Should the new owner wish to change the name of the business (generally not a good idea unless there is negativity surrounding the existing business name), they’ll have to get concurrence on it, at least from the city or county, as well as the landlord.
So, what is my business worth?
How it works:
- Add up the value of all the assets such as cash, stock, plant and equipment, and receivables.
- Add up liabilities, such as any bank debts and payments due.
- Subtract the liabilities from the assets to get the net asset value.
Similar to bond or real estate valuations, the value of a business can be expressed as the present value of expected future earnings.
There are a lot of ways to value a business. There’s no “right” way, though you could probably come up with several wrong ones. Ultimately, the business is worth whatever you think it’s worth, based on the criteria you set forth. But you can make your estimation by using several different ways to value the business and then choosing the mix that reflects your final value estimate.
You can start by looking at the value of the business’s assets. What does the business own? What equipment? What inventory? After all, a new owner would have to buy all the same stuff if they were starting a teashop from scratch, so the business is worth at least the replacement cost. The balance sheet can give you a good indication of the value of the company’s assets. If the company doesn’t have a good set of books, a prospect might think twice about buying it.
The other valuation approaches all think of a business as a stream of cash. They value a business by trying to come up with a value for that stream of cash.
Revenue is the crudest approximation of a business’s worth. If the business sells $100,000 per year, you can think of it as a $100,000 revenue stream. Often, businesses are valued at a multiple of their revenue. The multiple depends on the industry. For instance, a business might typically sell for “two times sales” or “one times sales.” If you have a good stockbroker, he or she may be able to help you research typical sales multiples for your industry. A good business broker can also help you if he or she has done valuations for your industry.
But alas, revenue doesn’t mean profit. If you’re in doubt, just look at Amazon.com: It had 2002 sales of almost $4 billion, but no profit. In fact, it hasn’t made one cent of profit since the day it was founded. How much would you pay for an ongoing $4 billion per year that you have to pump an additional $380 million per year into just to keep it afloat?
Warren Buffett uses what’s called a discounted cash-flow analysis. He looks at how much cash the business generates each year, projects it into the future and then calculates the worth of that cash flow stream “discounted” using the long-term Treasury bill interest rate. There’s no room to explain the theory or calculation here, but you can do it in Excel using the NPV “net present value” function.
Accurately valuing a small business is often the most challenging part of the process for prospective business buyers. However, it doesn’t have to be an overwhelming or difficult undertaking. Above all, you should realize that valuation is an art, not a science. A buyer should always keep in mind that the “Asking Price” is NOT the purchase price. Quite often it does not even remotely represent what the business is truly worth.
There are several ways to calculate the value of a business:
Asset Valuations: Calculates the value of all the assets of a business and arrives at the appropriate price.
Liquidation Value: Determines the value of the company’s assets if it were forced to sell all of them in a short period of time (usually less than 12 months).
Income Capitalization: Future income is calculated based upon historical data and a variety of assumptions.
Income Multiple: The net income (profit/owner’s benefit/seller’s cash flow) of a business is subject to a certain multiple to arrive at a selling price.
Rules of Thumb: The selling price of other “like” businesses is used as a multiple of cash flow or a percentage of revenue.
Naturally, a buyer’s valuation is usually quite different from what the seller believes their business is worth. Sellers are emotionally attached to their businesses. They usually factor their years of hard work into their calculation. Unfortunately, this has no business whatsoever being in the equation.
These techniques — asset valuation, sales multiple, earnings multiple and cash-flow analysis-value the financial side of the business. Nonfinancial considerations also come into play.
I hope these ideas give you a head start in valuing the business. I’d also recommend you get your banker involved in the valuation. Since your banker may be helping finance the business, he or she will have a good sense of how to do a good valuation for shops in your area.
Let’s look at each to determine what’s best for your purchase:
Asset-based valuations do not work for small business purchases. Assets are used to generate revenue and nothing more. If a business is “asset rich” but doesn’t make much money, how valuable is the business altogether? Conversely, if a business has limited assets, such as computers and office equipment, but makes a ton of money, isn’t it worth more?
Income Capitalization is generally applicable to large businesses and most often uses a factor that is far too arbitrary.
The “Rule of Thumb” method may be too general since it’s hard to find any two businesses that are exactly the same. The Multiple Method is clearly the way to go. You have probably heard of businesses selling at “x times earnings.” However, this can be quite subjective. When selling a small business, every buyer wants to know how much money he or she can expect to make from the business. Therefore, the most effective number to use as the basis of your calculation is what is known as the total “Owner Benefits.”
The Owner Benefits amount is the total dollars that a buyer can expect to extract or have available from the business based upon what the business has generated in the past. The beauty is that unlike other methods (i.e. Income Cap), it does not attempt to predict the future. Nobody can do that. Owner Benefit is not cash flow! It is, however, sometimes referred to as Seller’s Discretionary Cash Flow (SDCF).
The theory behind the Owner Benefit number is to take the business’s profits plus the owner’s salary and benefits and then to add back the non-cash expenses. History has shown that this methodology, while not bulletproof, is the most effective way to establish the valuation basis of a small business. Then, a multiple, based upon a variety of factors, is applied to this number and a valuation is established.
The Owner Benefit formula to use is:
Pre-Tax Profit + Owner’s Salary + Additional Owner Perks + Interest + Depreciation less Allocation for Capital Expenditures
Why Add Back Depreciation?
Depreciation is an expense that allows a business to deduct a certain amount of money each year from an asset so that its purchase value is reduced by its overall useful life. As an example: if the business buys a $25,000 truck and its useful life is estimated at 5 years, then each year the company can deduct $5000 off its income to lessen its tax burden. However, as you can see, it is not an actual cash transaction. No money is physically leaving the business or changing hands. Therefore, this amount is added back.
Why Add Back Interest?
Each business owner will have separate philosophies for borrowing for the business and how to best use borrowed funds, if necessary at all. Furthermore, in nearly all cases, the seller will pay off the business’s loans from their proceeds at closing; therefore, you will have use of these additional funds.
A Note About Add-Backs
After completing any add-backs, it is critical that you take into consideration the future capital requirements of the business as well as debt-service expenses. As such, in capital intensive businesses where equipment needs replacing on a regular basis, you must deduct appropriate amounts from the Owner Benefit number to determine both the true value of the business as well as its ability to fund future expenditures. Under this formula, you will arrive at a “net” Owner Benefit number or true Free Cash Flow figure.
What Multiple?
Typically, small businesses will sell in a one-to three-times multiple of this figure. Now, this is a wide range, so how do you determine what to apply? The best mechanism I have found is that a one-time multiple is for those businesses where the seller is “the business.” In other words: “as out the door goes the seller, so too can go the customers.” Consulting businesses, professional practices, and one-man businesses come to mind.
Businesses that have a strong track record, repeat clients, historical pattern of growth, more than 3 years in business, perhaps some proprietary item, or an exclusive territory, a growing industry, etc., will sell in the 3-times ratio. The others fall somewhere in-between.
So now the big question: what number/multiple do you apply to the Owner’s Benefit number? The answer is simple: nearly all small businesses will sell in the 1-to-3 times Owner Benefit window. Of course, this is a very wide range.
Also, the actual total Owner Benefit figure will impact the multiplier. As the Owner Benefit number increases, so too will the multiple. As an example, a business generating $200,000 in OB, may be worth a 3 times multiple, but one generating $500,000 or $1,000,000 can be worth a four or five times multiple.
Consider applying other valuation formulas simply as a test to your figure.
A wise and successful businessman once told me the following formula:
“A business is worth 2X gross, or 4X net.” Stands to reason. However, does this apply to our type of business – an automotive repair shop? Well, yes…and no. Variables that yield value changes could be:
- Newer equipment, computers, building fixtures, signage, or other, such as parking lot upgrades and so on
- Newer high-tech scan tools and current software, such as Autologic loaded with the most current Asian and European software
- Significant inventory which is still current (not obsolete), especially tires
- A current and accurate customer database
- A super-clean Profit & Loss Statement combined with an accurate Business Summary Report which reflects ALL methods of payments received – especially cash!
- A valuation summary which accurately depicts the shop’s current fiscal condition including such things as Effective Labor Rate, the value of one billable hour, the cost of hourly operations based upon current expenses, and so on. You may need to enlist the help of a professional consultant who understands these things and how to calculate them. This report would be very worthwhile, indeed.
- Whether the geographic radiuses and demographics are on the incline or decline
Who Do I Sell My Business To?
- Family – you could groom a family member to take over the business
- Employee – this is actually pretty common, and has many of the same benefits as selling out to a family member.
- Anyone else – you may need to provide a valuation summary to a potential prospect.
Key Points to Remember
- The time to determine when to “get out” is NOW!
- Clean up your P & L statement and balance sheets
- Determine the true value of your business using some of the methods listed within this article. Hire a professional if needed.
- Last but not least – dream of what you’ll do during your retirement!