If you’re seriously thinking about selling your business, there are three steps you’ll need to take to prepare your business for sale.
A business appraiser will be almost a must when you’re serious about selling your business. The appraiser will utilize the different valuation methods to arrive at a value for your business and also provide an arm’s-length valuation that the two parties may be able to agree upon.
There are several associations in the business appraisal industry providing training, testing and accreditation for licensed business appraisers. You’ll want to make sure the appraiser you choose has credentials issued from an organization such as the National Association of Certified Valuators and Analysts or International Society of Business Appraisers, just to name a couple. I suggest you interview several appraisers in the process of selecting the right professional for you.
In the end, a business appraiser will use a combination of several valuation methods to arrive at a “fair market value” for the asking price. It’s important that you understand the basics of these methods because it will help you learn how to increase the value of your business now and give you a range of what your business may be worth before you officially engage a broker or appraiser.
When the appraisal begins, it’s based on the financial disclosures of the seller. To protect you in this process, all the parties involved (especially any potential buyers) will be obligated to sign a nondisclosure agreement (NDA).
Just as the seller is nervous to disclose information, the buyer is generally also concerned about signing an NDA. The buyer doesn’t want to be held back from moving into the industry (even if they don’t buy the seller’s business). For example, a buyer could learn something insightful in the process (even unintentionally), and they won’t want the seller to later claim that they, the buyer, “stole” a secret that threatens the seller’s business if the buyer doesn’t follow through with the sale. As such, the NDA is carefully drafted to protect both parties, and it’s highly recommended for both buyer and seller to sign and abide by its terms.
It’s also typical that a new term will start to get thrown around during the discussions and valuation: the concept of the “normalized” financials. These are financial statements that are adjusted from a business owner’s tax returns or financials he or she may give to a bank. Essentially, the owner needs to create a normal set of financials or books for a buyer to review and get a sense for the value and health of the business. Why do the financials need to be adjusted? Well, a good business owner should be writing off a variety of expenses particular to their family needs or tax strategies.
For example, the seller may have justified four-wheelers in the warehouse for moving supplies around or travel expenses to attend a semi-annual convention. These may be costs a buyer wants to cut out. The seller wants to show “normalized financials” with these types of costs removed so it drives up the profit and thereby a potential valuation and asking price.
Finally, the financials disclosure will need to indicate the owner’s compensation in the form of a salary, a draw, or a combination of the two. A buyer wants to know how turnkey this operation will be. In other words, they want to know if they’ll need to hire anyone to replace the seller’s personal service in running the business. This is a scenario buyers need to be prepared for at this point.
The goal in the disclosure process is for the buyer to get as clear a picture as possible of the profitability of the business. Then the buyer and seller can engage the business appraiser to tear apart the financials and list of assets and liabilities to come up with a valuation. This is where EBITDA comes into play.
EBITDA is an equation and stands for:
Earnings Before Interest, Taxes, Depreciation and Amortization
The equation itself is really quite simple: subtract expenses from revenue (excluding interests and taxes) without depreciation and amortization. The remaining number gets to the heart of the cash flow the business might produce and provides clarity for the valuation.
As I stated earlier, one of the first priorities in the appraisal process is to get to a set of agreed-upon normalized financials or normalized EBITDA. As such, there are positive and negative “add backs” you can make to EBITDA depending on the party’s perspective, goals and needs. The term of procedure of add-backs means you’ll add back to income or expenses certain dollar amounts that are personal or particular to the current business owner that won’t apply to a buyer if they were to take over the business. Let’s look at some examples.
To determine sustainable cash flow, some positive add-backs that increase EBITDA may include:
- Owner’s excess compensation
- Rental expense above market rates
- Owner’s benefits that aren’t required to run the business, such as automobiles, vacations, etc.
- Tax strategies particular to the owner’s family or personal/business lifestyle
- Unnecessary employees that are part of the owner’s family or friends
Add-backs that may decrease EBITDA may include:
- Rental expense below market value
- Increased expenses due to special rates or deals exclusive to the owner’s contacts
- Recent or significant annual capital expenditures
- Additional salaries required when the owner departs
Once “normalized EBITDA” is determined, the owner, buyer and appraiser can start to implement various valuation methods more clearly and start to arrive at a fair asking price for the business.
Starting to fine-tune your financials and engaging an appraiser early on can help you understand what your true income is. Remember, a buyer may not value the same benefits or strategies you do. Get your financials dialed in and start to look at valuation methods and you’ve taken the first steps to selling your business.