When a buyer looks at acquiring a business, they will calculate an anticipated rate of return on their investment. When calculating their return, they will look beyond the purchase price of the business and will also take into consideration additional money they will need to invest in working capital, improvements, and capital expenditures. If the anticipated capital expenditures are significant, it may result in a lower value and less marketable company simply because of the impact capital expenditures will have on a buyer’s return on investment.
If your business is in need of significant capital expenditures, should you go ahead and make them before selling? There isn’t an easy answer to this question, and you should always consult your business sale advisors to discuss the specifics of your company’s situation, the type of asset(s) in question, the level of investment, whether financial performance can be maintained without the investment, and the short-term impact on cash flow. If such decisions are made without consulting advisors, a seller may be shocked by the impact on their ability to sell.
While having aging payables may seem like somewhat of a positive as it indicates the ability to conserve cash, payables that are aged beyond 30 days can cause concern for a business buyer. The reasons for this concern include:
Do you prefer securing fewer clients who each generate more revenue, or working with more clients but who in aggregate produce a similar level of revenue? If you are like many small business owners you may perceive this to be a no-brainer, understanding that the fewer clients you work with the less sales, general, and administrative expense you'll likely have - not to mention the hassle and headache of dealing with a broader number of clients.
However, when it comes to selling a business, having higher percentages of revenue coming from fewer clients may negatively impact marketability and value. Business buyers are interested in acquiring companies that have low risk to future cash flow. Generally when a business has more than 7% of its revenue coming from any single client, buyers will begin to be concerned about the financial risk of losing larger clients and this will start to impact price and deal structure.
Following are a few suggestions on ways to prevent this from becoming a marketability issue:
Following are two videos that provide more information about earn-outs.
Seasonality is the fluctuation in business from one part of the year to another. Generally speaking, businesses with less seasonality will be more marketable and valuable than businesses that don’t have seasonality. However, for many businesses seasonality is simply a given due to the nature of the customers they serve. For example, a tutoring company serving school-aged children will have more business during the school year from September through May than during the summer break from June through August.
While many businesses have natural seasonality, it’s important to keep in mind that buyers are likely comparing your business to other types of businesses that may not have seasonality (unless the buyer is a strategic industry buyer only looking at businesses exactly like yours). To the extent a business can pursue initiatives to level-out revenue and reduce seasonality, it will reduce the business’ perceived seasonality risk and therefore add to value and marketability. For example, the tutoring business noted above could consider adding summer day camps that focus on different academic subjects to boost off-season revenue, reducing seasonality.
One of the most critical mistakes I've seen business sellers make is selecting the wrong attorney to handle their business sale transaction. Sometimes a business seller will insist on using a friend who is a business litigator or an attorney who helped them with other business or real estate issues but who has limited experience with business sale transactions.
Here are a few things to consider when selecting an attorney for a business sale transaction:
For Sale: Medical Billing Software Company with Recurring Revenue, Low Client Churn, and High Margins
Codiligent is marketing a developer of a SaaS business model medical billing software used by the behavioral health industry.
Listing Number: 1000010614
Price: $17.3 million
EBITDA: $1,554,322 (12 months ending 8/31/15)
Link to more information: intro package for 1000010614
The following video from the Kauffman Foundation exposes some myths about entrepreneurship but they excluded one of the most significant myths: 7 out of 10 businesses fail in the first five years. This tired old misperception stems from confusion about the difference in the definitions of "non-survival" and "failure". Non-survival isn't the same as failure. Many businesses that don't survive are far from being failures. Contact Codiligent business brokers if you'd like to learn the truth about business failure rates (which are significantly lower than commonly perceived).
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.
Do you have the knowledge and skills needed to fully realize the benefits from owning your business?
Beginning October 6, a new season of SPBO (Strategic Planning for Business Owners) Workshops will commence, offering business owners knowledge and tools to optimize the performance of their businesses, achieve more work-life balance, and prepare for retirement. These low-cost interactive 2-hour workshops, led by experienced professionals, are designed to efficiently provide education on critical business management elements often misunderstood or ignored by business owners.
Register here for the first workshop in Portland, Oregon: "Creating a Strategic Plan", scheduled for Tuesday October 6 from 7:30 AM - 9:30 AM and emerge from the session with an outline of a realizable strategic plan for your business and the tools to actually make it happen.
BENEFITS OF ATTENDING
You will leave this workshop equipped with the knowledge and tools to help you:
Subsequent workshops will include topics such as cash flow management, determining and optimizing the value of your business, marketing consistent with your strategic plan, how to recruit and retain the right employees, mitigating risk, and more.
Seats are limited for this unique opportunity for business owners. Check out the SPBO website for detailed information.
Buy and Sell Well
Codiligent Business Brokers' blog on entrepreneurship, capitalism, and successfully buying and selling businesses.
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