Last week I met with a business owner after an introduction by his accountant. He was thinking of selling his profitable waste recycling business, a business he had been running for nearly 30 years. The business had a reliable management team, an enviable customer base and a strong balance sheet. Unfortunately, the owner had a vastly inflated idea of the value of his business.

His thought process went something like this:

“I’ve built this business over 30 years so it must be worth a lot of money. A couple of years ago we built a nice place to retire to and need to clear the mortgage. We also need a couple of million to create a pension pot that will maintain our lifestyle. The business has provided us with a very nice lifestyle and will do the same for the new owners – it has to be worth about $3 million.”

It’s difficult to be objective about something you’ve built from the ground up; a business that has shaped your life and underpins your standing in the community. Coincidentally, $3 million happened to be about the figure he needed to meet his retirement aspirations.

Your Business Value is Directly Affected by Cash Flow

It comes as a shock to a lot of business owners, but the value of their business is fundamentally about the cash flow it generates. In this case, the business generated $250,000 cash flow to the owners, had $500,000 of working capital and freehold real estate worth another $500,000. I valued the business at about $1.5 million. This was a genuine shock for the owner.

Needless to say, I did not get the contract to sell for this owner. The business is now listed with another broker at $3 million. Presumably, this broker believes he can manage the client’s expectations when the business has been on the market a few months. 

Unfortunately, some brokers do overvalue businesses because that’s what the seller wants to hear, and to improve their prospects of securing the sale.

A seller might well think that trying an unrealistic price to start with does no harm – but that is far from the truth. 

We recently took a contract to sell a business that had been on the market for two years with another broker at $1.5 million. On a good day it was really worth about $750,000 and the owner had come to realize that. Unfortunately, he had already turned down two offers at that level. As we began to market the company it became clear that the previous asking price hung around the business like a bad smell. 

It takes a lot of effort and expense to buy a business and credible buyers were reluctant to get involved. They felt the seller still had his heart set on the higher price, and when it came to the crunch might decide not to sell – so why waste their own time and money?

Do You Realistically Value Your Business?

So how as a seller do you make a realistic decision about the value of a business? As a starting point, remember that a broker has nothing to gain by putting forward a low valuation. It’s likely to be an honest appraisal based on information provided and knowledge of the market. My advice is to meet with two or three brokers and listen carefully to what they have to say. They will be far more objective than you could possibly manage. Ask each broker to put his valuation in writing, with an explanation of how he arrived at the suggested figure.

Remember, when it gets down to the nuts and bolts, the value of a business is based on the income it will generate for the new owners and the potential they see for growth. It has nothing to do with the number of years you have spent building the business. Sentiment just doesn’t factor into it.

Overvaluation is only one piece of the puzzle, though. Even when a seller approaches pricing with a level head, the valuation process itself is often more complicated than it appears on the surface. The following section breaks down the specific factors that make valuing a business such a difficult exercise in the first place.

The Difficult Issues Often Attached To Valuing A Business

There is little doubt that valuing a business is often complex. In part, this complexity is due to the fact that business evaluation is subjective. The simple fact is that the value of a business is often left to the mercy of the person conducting the evaluation. Adding yet another level of complexity is the fact that the person conducting the valuation has no choice but to assume that all the information provided is, in fact, correct and accurate.

In this article, we will explore the six key issues that must be considered when determining the value of a business. As you will see, determining the value of a business involves taking in several factors.

Factor #1 – Intangible Assets

Intangible assets can make determining the value of a business quite tricky. Intellectual property ranging from patents to trademarks and copyrights can impact the value of a business. These intangible assets are notoriously difficult to value.

Factor #2 – Product Diversity

One of the truisms of valuing a business is that businesses with only one product or service are at much greater risk than a business that has multiple products or services. Product or service diversity will play a role in most valuations.

Factor #3 – ESOP Ownership

A company that is owned by its employees can present evaluators with a real challenge. Whether partially or completely owned by employees, this situation can restrict marketability and in turn impact value.

Factor #4 – Critical Supply Sources

If a business is particularly vulnerable to supply disruptions, for example, using a single supplier in order to achieve a low-cost competitive advantage, then expect the evaluator to take notice. 

The reason is that a supply disruption could mean that a business’ competitive edge is subject to change and thus vulnerable. When supply is at risk then there could be a disruption of delivery and evaluators will notice this factor.

Factor #5 – Customer Concentration

If a company has just one or two key customers, which is often the situation with many small businesses, this can be seen as a serious problem.

Factor #6 – Company or Industry Life Cycle

A business, who by its very nature, may be reaching the end of an industry life cycle, for example, typewriter repair, will also face challenges during the evaluation process. A business that is facing obsolescence usually has bleak prospects.

Other Issues Affecting Valuation

There are other issues that can also impact the valuation of a company. Some factors can include out-of-date inventory, as well as reliance on short contracts and factors such as third-party or franchise approvals being necessary for selling a company. The list of factors that can negatively impact the value of a company are indeed long. Working with a business broker is one way to address these potential problems before placing a business up for sale.

Once these valuation factors are understood, one theme tends to stand out above the rest: how dependent the business is on its owner. That single issue has such an outsized effect on value that it deserves a closer look on its own.

A Business For Sale is More Valuable When the Owner is Replaceable

Most potential buyers would be averse to purchasing a business if the owner’s shoes are too big to fill or if the owner’s hand would be too difficult to unravel from the operation. When preparing to sell or build value in a business, the owner should not be so involved in the business that it would be difficult for would-be buyers to see the business as being productive under new ownership. Buyers want the owner to be replaceable.

A business is more valuable when perceived risk is low. A business is less risky when it is making money without its owner’s involvement in daily operations. Three things about value:

• Value is dependent on risk
• Value is not about what the business is worth in the current owner’s hands, but in someone else’s.
• The more dependent the business is on its owner, the higher its risk, and the lower its value.

Therefore, to achieve a higher value, it is important to have systems running the business and an experienced staff running those systems. 

An enterprise with infrastructure guiding its revenue-generating capacity is much more appealing than one with a singular person holding the key to the revenue engine. The owner should be free to work “On” the business instead of “In” the business.

Systems and Procedures

Documentation of standard policies, employee records, systems, procedures and controls demonstrate that the business can be maintained profitably after the sale. Business systems include the computerized and manual procedures used in the business to generate its revenue and control expenses. 

It outlines the methods used to track how customers are identified and how products or services are delivered. The following are examples of business systems that enhance business value.

• Personnel recruitment, training and retention
• Human resource management (an employee manual)
• New customer identification, solicitation, and acquisition
• Product or service development and improvement
• Inventory and fixed asset control
• Product or service quality control
• Customer, vendor and employee communication
• Selection and maintenance of vendor relationships
• Business performance reports for management

Staff

Buyers count on taking over a business with an in-place staff that can provide continuity and assist in the growth of the business. If a company’s success is reliant on capable, well-trained employees – not the owner – it means the business will not be negatively impacted under new ownership.

This is an excerpt from one of our business listings currently on the market that is a prime example of the replaceable owner.

“This well-reputed firm has long-term expert personnel, technicians, an office manager, and a bookkeeper that run daily office operations leaving an energetic new owner free to market, network, and build additional recurring revenue streams onto what has already been established in this fine enterprise.”

A business with strong systems and a capable staff reduces one category of risk for a buyer. But even a well-run, owner-independent business can still hide problems that surface only under close inspection. The final section covers the due diligence issues sellers should uncover and address before a buyer finds them first.

Finding The Skeletons in Your Closet to Avoid Problems During the Business Sale

Due diligence is when the buyer reviews all aspects of the company to uncover any warts, wrinkles, and….skeletons in the closet. No bones about it, this step is necessary in evaluating what risk is involved for the buyer in making the acquisition. Skeletons found in due diligence, however, should not normally break a deal but they will be negotiating points on the way to an agreement.

The following are issues that can rear their ugly heads during the due diligence investigation. The issues could be related to:

• Your financial information
• Equipment or real estate
• Inventory
• Accounts receivable
• Intangible assets (patents, etc.)
• Employees, customers or suppliers 

The problems might concern:

• Legal
• Accounting
• Tax
• Regulatory
• Industry
• Technology
• Operational
• Competitive
• Corporate records
• Product
• Product liability
• Contract
• Partnership
• Leases
• Licenses
• Employee benefits
• Insurance
• Debt issues, etc.

This list is a compilation of potential problem areas and may not apply to all types of businesses. It is not meant to be all-inclusive and is in no particular order:

• Accidents
• New competition in the market
• Changes in technology
• Equipment obsolescence
• Liens on the business
• Business licenses are not current
• Facility obsolescence
• Market shifts
• Declining Revenues
• Poor Financial Records is one of the biggest reasons businesses do not sell or sell at a value considerably less than market value
• Low margins
• Capital improvements needed
• Lack of Supplier Diversity
• Lack of Customer Diversity – If too much business is concentrated in too few customers, the risk factor is increased. Should one or more of the customers discontinue patronage of the firm, revenues will be seriously impacted.
• Uncollectible receivables
• Low backlog
• Restricted credit
• Regulatory violations
• Environmental Issues are of concern because it is possible that any and all former owners can be held accountable by the government for very expensive cleanup costs.
• Insurance Cost and Availability
• Slow Moving, Outdated and/or Excessive Inventory – These types of inventory tie up money and make the business difficult to sell. Buyers will refuse to buy or will deeply discount the value associated with these types of inventory.
• Obsolete marketing collateral
• Key Staff Leaving
• Staff that are undocumented or categorized incorrectly (i.e. 1099 vs. W-2)
• Poor Property Lease Terms – Not having a lease or being locked into a lease with onerous terms, such as high escalations, detracts from the value of the business. Not having a lease to assign to a buyer runs the risk that the landlord will increase the rent for the new owner. If the rent goes up, the earnings go down and consequently the value of the business goes down.
• Product liability claims
• Patent expirations
• Sales contract expirations or unassignability
• Cash flow problems

Taken together, these four issues trace the arc of a well-executed sale. Sellers who address all four before going to market are far more likely to attract serious buyers, avoid a stalled listing, and close at a price that reflects the real value of what they’ve built. 

With CBB, You Get a Real-World Valuation, Not a Guess

With over 230 years of combined experience closing more than $1 billion in transactions, CBB’s brokers can tell you what your business is actually worth. Rather than a number built around what you need for retirement, you’ll get an appraisal grounded in cash flow, market comparables, and decades of closed-deal data. 

Discover for yourself how CBB can help you achieve a smooth, successful sale. Contact us today.