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While business valuation has its roots in complicated appraisal metrics, the real world of business valuation has roots in practicality. Imagine that you were recently laid off by downsizing corporate America. You have 2 kids in college and a significant mortgage on your home. You were earning $150,000 plus bonus per year but after severance that income stream is going away. Your executive talents are great but the work place does not have a job for you at your salary expectations/needs. Enter the real world of buying a business. The goal is to find a company that suits your vocational talents, is within a suitable geography and will be something you would be proud to own.
While these goals may seem relatively straight forward, the real goal is to replace the income stream to allow you to continue with the life you have become accustomed to. Many business appraisers get caught up with financial analysis, capitalization and discount rates, client concentration, issues of proprietary rights, etc. Yes, these are all important but do these valuation methodologies have anything to do with replacing your income stream? The answer is yes and NO.
Terms of Sale
We often say that it is not the price but the terms of sale that is most important when buying a business. Would you pay a million dollars for a company that a business appraisal expert valued at $700,000? The answer is probably yes if you could pay the deal off at $1 a day for the next million days at 6% interest with no personal guaranty. Your total debt service is less than $400 per annum! Accordingly, that target business may only have a net cash flow (beware of broker terms describing cash flow - SDE, SDC, SDCF, NOI, EBIT, EBITDA - more on this in future blogs) of $200,000 per year but will supply the income stream, after debt service that you require along with adequate working capital. Based on the terms of the sale, the risk is with the seller, not the buyer. Would the seller sell under these terms if they were not comfortable that you would meet the terms of debt year after year? This is an extreme illustration, but very much in the real world of seller financing.
Justification for Purchase
A savvy business appraiser uses a template referred to as a Justification for Purchase (JFP). A JFP looks at the selling price, adds the cost of non-conventional (SBA) lending which is typically 3% and the amount of working capital required to arrive at the total project cost. It then takes net operating income before taxes and subtracts annual debt service and a livable salary for the acquiring party. The remaining number is typically multiplied by a 1.2 to 1.3 coverage ratio. If the resulting number does not meet or exceed the weighted average of earnings over the last 3-5 years, the asking price may be too high.
The SBA (Small Business Administration) has found a way of mitigating this weakness if they feel the business valuation is realistic. To offset the cost of annual debt, they may request that the selling party enter into a stand-by agreement. A Stand-by is where the seller agrees to take a subordinated note behind the lender that is not payable until the lender deems fit. The Stand-by is often 10-20% of the purchase price and can be used as buyer's equity towards the 20-25% down payment required. This results in a win/win with the buyer being satisfied that the seller has a vested interest in his/her success and the seller walking away with 80-90 cash in the sale.
At George & Company, we are always striving to find ways to make win/win deals. If it's not, chances of getting to the closing table are pretty slim.