Entrepreneur Insight

Buying or Selling a Small Business? How to Get the Best Deal

First: organize financials and figure out an appropriate valuation for a business

You’ve spent the past several years building up your small business and decide that it’s time to exit, for one reason or another. Maybe you’ve reached your business objectives, or perhaps you feel it’s time to move on to a different career path. Or maybe you’re looking to buy an existing business, either to gain a competitive edge in an industry you’re already in, or simply because you want to find a new income path. Regardless of whether you’re trying to buy or sell a company, here is what you need to do to get the most bang for your business.

Plan ahead & organize business financials

For sellers, Jim Chamberlain, a counselor at a small business mentorship organization SCORE, suggests planning an exit strategy at least 36 months in advance. Unless misfortune befalls a business owner, such as an accident or sudden illness, it is imperative to plan ahead in order to get the best possible deal and smoothest transition.

It’s particularly important for small businesses to make sure all their accounting is in order. “Bookkeeping in small businesses is notoriously bad,” says Chamberlain. Sellers need to “straighten out their financial statements” because a prospective buyer often will ask for a company’s past three years’ worth of financials. “And if they’re garbage, a good buyer will walk away,” he adds.

Organizing and compiling your financials could enhance your business’ value and make it more attractive to buyers. For example, make a list of add backs, which are expenses that won’t necessarily be reoccurring under new ownership and are “added back” to a business’ net income. In small private businesses, personal expenses can account as add backs, such as car expenses, family members on payroll, and even excess owner salaries.

Calculating the value of a business

According to Chamberlain, a business’ value is made up of two things: risk and reward. The “reward” (i.e. a business’ cash flow, which indicates to a buyer their prospective return on investment) clearly must outweigh the riskiness of a business, says Chamberlain.

The biggest determiner of a business’ value is its cash flow, believes Chamberlain. However, he admits that most small businesses don’t have a statement of cash flow, so buyers and sellers must first look at an income statement. “With a couple of calculations, you can kind of figure out what their cash flow has been and maybe will be—so you know the rewards side of the company,” he says.

To determine value, a buyer and seller must also combine a business’ cash flow with its riskiness. There are different types of risk, such as competitive (is it easy for competitors to enter the market?), customer (do you only have one major client?), geographic (what are the demographics of your location?) and industry (are there regulations?). The buyer will assign a percentage value to each kind of risk and use that to determine the minimum amount of cash flow necessary for a specific valuation.

Each buyer’s risk appetite will vary, which is both a pro and a con for sellers. “Anticipate the buyer’s needs,” emphasizes Chamberlain. “What drives me crazy may not drive you crazy because your discipline is different.”

Cash flow is an important metric for a business valuation. (Photo credit): Gettyimages.com/simonkr

“If you can make that argument that there’s growth either in your specific company or that industry, the valuation goes up.”

-Jim Chamberlain

For example, Chamberlain says that, as a buyer, he is highly averse to companies that don’t have depth of management, or only have one major client. So, he will add that to his minimum return. “So, 5 percent of single owner, another 3 percent for single customer. I keep going down the list as I talk with the owner, and I’ll come up with a number,” he explains. “In a small business, usually the number is between 20-40 percent. I come up [and] in order for me to buy this business, I need a 30 percent return—are they generating 30 percent cash flow?”

There are six main valuation methods a buyer or seller can use:

1. Book value: the net asset value of a company calculated as total assets, minus intangible assets (i.e. patents) and liabilities (i.e. loans). Chamberlain says that book value is not necessarily an accurate representation of a company’s value, but is a good starting point in the valuation process, since the book value figure is available to almost all businesses.
2. Liquidation value: the total worth of a company’s physical assets, such as real estate and equipment, if it were to go out of business.
3. Capitalized excess earnings: a summation of the net tangible value of business assets with the capitalized value of excess earnings.
4. Multiples models: valuing a business by saying it is worth “x” times its earnings. The multiples model is mainly used by public markets and larger companies. There tend to be industry averages, which are based off of the financial information on large, publicly traded companies in those industries. Chamberlain adds that those numbers might not be applicable to small businesses, since small businesses have many more variants.
5. Comparative value: seeing how much a similar business sold for and applying that price to your own business.
6. Discounted cash flow: best for valuing businesses where the “future performance is projected to be materially different from its past or current performance.” Chamberlain says that a discounted cash flow analysis should be used for companies showing growth.

Showing growth means higher valuation

In order to get the maximum value out of your business, a seller should always mention growth, says Chamberlain. It can be industry growth rates, or it can be growth within your own business. “If you can make that argument that there’s growth either in your specific company or that industry, the valuation goes up,” says Chamberlain.

It boils down to being able to show those growth numbers, which is why having clear and organized financials is so important. “If you’ve got a $10 million valuation and you can back it up with logic, then chances are you’re going to be ahead of the game,” Chamberlain states.

There are also other tactics that a seller can utilize to try and convince a buyer of their ideal valuation. A business can talk about new product lines, or that with some more advertising their business could continue growing. “Talk about how with just a little bit of marketing, this company can grow 25 percent a year, but I’ve held back because I don’t have the capital,” he suggests. “It really comes down to how good you are at persuading someone.”

Seeking out the right buyer

Deciding who to sell to is a bigger decision than most owners realize. Although there are other options such as selling your whole business or a portion of your business to your employees, Chamberlain says that most people sell their company to another person. When searching for a buyer, there are two main types to consider: financial and strategic. Financial buyers are people who are primarily interested in the return on investment from buying a business, who may be looking at businesses in a variety of industries. Strategic buyers are interested in how that business fits into their own overall strategy, are usually in the same industry, and are often willing to pay more for an acquisition.

Because they are willing to pay more, Chamberlain advises that “owners should always seek out a strategic buyer first” and should keep tabs on other companies in their industry. “I tell people that they should get to know their competition, go have breakfast with them—they don’t have to be enemies,” he adds. Then, once you are ready to sell, you know exactly which businesses would make great strategic buyers and can actively seek them out.

Go for broker?

For some businesses, hiring a business broker to handle the sale could be a good bet. A broker will recast business financials, calculate the valuation and find potential buyers. However, Chamberlain says 80 percent of small business deals are done without a broker and with just the assistance of an attorney.

Brokers usually charge a fee between 8-12 percent, with minimums. But Chamberlain adds that sometimes brokers won’t get involved if the deal is too small (i.e. a business is worth less than $500,000). “They tend to have to do all the same work for a very small deal as they would for a larger deal, so they’re going to allocate their time to the larger ones,” he explains.

If you are looking for a business broker, Chamberlain advises you to make sure they are qualified and that they have all the necessary professional designations. He lists Certified Business Intermediary as an important qualification to have, along with designations from organizations like the American Society of Appraisers and National Association of Certified Valuation Analysts. Chamberlain adds that brokers must also have a real estate license, since frequently business deals involve real estate.

“Brokers have to have continuing education,” he says. “They don’t really need a degree, but they need to take an exam given by organizations to prove that they know what they’re talking about.”

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