Many of the small and lower-mid-market companies that I interact with (under $25 million in annual revenue) have done little to prepare for a business sale. There seems to be a common belief that preparing for a business sale just means extra work and greater expense, with only an incremental difference in outcome. If done correctly it will actually save most business owners substantial time, result in a far higher purchase price, prevent costly mistakes, and may even make the difference in whether the business will be sellable.
How does being better prepared for a sale save a business owner time?
How does preparing for a business sale increase the probability of a higher price?
The most basic components of the most commonly used valuation approaches are: 1, cash flow; 2, risk factors; and 3, expected growth in cash flow. If through better preparation you can impact these factors, you will increase the probability of achieving a higher price.
To illustrate how this can impact price let's look at a basic capitalized earnings approach to estimating value. This approach involves dividing projected operating free cash flow (OFCF) by a capitalization rate. The capitalization rate is equal to a discount rate minus the expected long-term growth rate of the business. The discount rate is a risk-appropriate expected return on investment. So, let's assume that a business was projected to have $1 million in OFCF in the coming year, and the discount rate was 18% and the expected long-term growth rate was 2.5%, for a capitalization rate of 15.5%. If you divide the $1 million in OFCF by the 15.5% capitalization rate, the estimated value would be $6,451,613.
Now suppose that because of better preparation a buyer perceives less risk and greater growth, and so rather than an 18% discount rate, a 17% rate is used, and instead of a 2.5% long-term growth rate, a 3% rate is used. This would result in a 14% capitalization rate and the value would be $7,142,857. Would being able to achieve a price that's nearly $700,000 more make greater preparation worthwhile?
What type of mistakes can be prevented by preparing for a business sale?
The types of mistakes that a business owner may make are numerous, so I'll provide just a few examples:
"I don't really need a high price for my business. Maybe preparing for a sale doesn't really matter - as long as I get a reasonable price."
Selling a business is far more difficult than many business owners perceive. In fact, many businesses - particularly those that have not adequately prepared for a sale, may not successfully sell at all. Research from various sources show that only 5%-30% (depending on which study you look at) of all small businesses that are marketed actually end with a completed sale. Consequently, it's important for business owners to do all that they can to ensure success which includes not only adequately preparing for a sale, but also using professional representation.
How to prepare for a business sale
In Michael Schwerdtfeger's article "Expect the Unexpected: How to Prepare for a Transaction" he offers three pieces of advice on preparing for a sale:
Out of these, I would suggest that hiring a quality intermediary is probably the most important step. The business broker or investment banker can then help guide you through the steps necessary to best prepare for a business sale. At Codiligent we offer a free Marketability Assessment which provides business owners with feedback on issues that may impact marketability and value based on a focused interview and high level review of recent financial information. For business owners who want to have a deeper level of preparation we offer a program called Always Ready To Sell which involves doing a comprehensive analysis of the company that utilizes multiple years of financial data, a variety of approaches to estimating value, and a deep dive into qualitative and strategic information.
How does being better prepared for a sale save a business owner time?
- It will be easier, more efficient, and more effective to attract the right buyers and get them to move forward.
- It may increase competition for your business, keeping the process moving more quickly and with fewer delays by a buyer.
- It reduces the probability of having a deal terminate with one buyer and having to start over with another.
- The time spent preparing for a sale will reduce the time required during formal due diligence (in essence, you are compiling due diligence information prior to marketing the company - so it's not more time that is required, rather it's a shift in when time is expended).
How does preparing for a business sale increase the probability of a higher price?
The most basic components of the most commonly used valuation approaches are: 1, cash flow; 2, risk factors; and 3, expected growth in cash flow. If through better preparation you can impact these factors, you will increase the probability of achieving a higher price.
To illustrate how this can impact price let's look at a basic capitalized earnings approach to estimating value. This approach involves dividing projected operating free cash flow (OFCF) by a capitalization rate. The capitalization rate is equal to a discount rate minus the expected long-term growth rate of the business. The discount rate is a risk-appropriate expected return on investment. So, let's assume that a business was projected to have $1 million in OFCF in the coming year, and the discount rate was 18% and the expected long-term growth rate was 2.5%, for a capitalization rate of 15.5%. If you divide the $1 million in OFCF by the 15.5% capitalization rate, the estimated value would be $6,451,613.
Now suppose that because of better preparation a buyer perceives less risk and greater growth, and so rather than an 18% discount rate, a 17% rate is used, and instead of a 2.5% long-term growth rate, a 3% rate is used. This would result in a 14% capitalization rate and the value would be $7,142,857. Would being able to achieve a price that's nearly $700,000 more make greater preparation worthwhile?
What type of mistakes can be prevented by preparing for a business sale?
The types of mistakes that a business owner may make are numerous, so I'll provide just a few examples:
- A business owner has a family member on payroll in a marketing position. The person has not been effective and should be terminated, but the business owner doesn't want to rock the boat and figures that paying $60,000 per year to avoid family conflict is worth it and believes that a buyer can terminate that employee if desired. The problem is that it may be difficult to prove that this family member is not adding any value. If the employee is showing up at work, a buyer is going to assume that they must be adding some value. Consequently, many buyers will be reluctant to add back that person's salary (or a portion of it). Yet, if this employee truly isn't adding value, and terminating them would cause their salary to drop straight to the bottom line, it could significantly impact value. If a business sold for 6x Earnings Before Interest Taxes and Depreciation (EBITDA) that could mean a $360,000 lower price. A business owner who understands this would be wise to terminate this employee two years in advance of a sale so that a track record of performance can be demonstrated without that staff member.
- A business owner fails to negotiate client contracts in a way that will increase the marketability and value of the business. For instance, there may be a non-assignability clause that could prove problematic when a business owner is ready to sell and buyers are not confident that clients will enter into new contracts with them post acquisition.
- Financial statements have not reliably been prepared in accordance with GAAP, which will cause buyers to be uncomfortable relying on their accuracy.
- As part of a growth strategy a business owner focuses on growing sales from its largest client which already represents 20% of revenue. A seller may appreciate the ease of dealing with fewer clients, but buyers will perceive greater risk associated with less diversification.
"I don't really need a high price for my business. Maybe preparing for a sale doesn't really matter - as long as I get a reasonable price."
Selling a business is far more difficult than many business owners perceive. In fact, many businesses - particularly those that have not adequately prepared for a sale, may not successfully sell at all. Research from various sources show that only 5%-30% (depending on which study you look at) of all small businesses that are marketed actually end with a completed sale. Consequently, it's important for business owners to do all that they can to ensure success which includes not only adequately preparing for a sale, but also using professional representation.
How to prepare for a business sale
In Michael Schwerdtfeger's article "Expect the Unexpected: How to Prepare for a Transaction" he offers three pieces of advice on preparing for a sale:
- Define your goals
- Address tax and estate issues
- Hire an intermediary
Out of these, I would suggest that hiring a quality intermediary is probably the most important step. The business broker or investment banker can then help guide you through the steps necessary to best prepare for a business sale. At Codiligent we offer a free Marketability Assessment which provides business owners with feedback on issues that may impact marketability and value based on a focused interview and high level review of recent financial information. For business owners who want to have a deeper level of preparation we offer a program called Always Ready To Sell which involves doing a comprehensive analysis of the company that utilizes multiple years of financial data, a variety of approaches to estimating value, and a deep dive into qualitative and strategic information.
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