Selling Your Business

Copyright © 2002 by Davis Multimedia, Int'l. All Rights Reserved.
As Printed in March 2002, Volume 27, No. 9 of The Engravers Journal.

    Most business owners go through the sale of a business only once in a lifetime. Unfortunately, many are ill equipped for the venture and become overwhelmed by the process, or else they make some very costly mistakes. While it’s somewhat daunting, selling a business can be managed with the right amount of preparation and professional guidance.
    Doug Robbins is the owner of Robbinex Intermediaries. Robbinex is a firm that specializes in business sales and business valuations and is headquartered in Hamilton, Ontario, Canada. According to Robbins, there are over 200 steps involved in selling a business, and the process, which typically takes 1500–2000 hours, can easily be drawn out over a year or longer.
    In my 18 years in commercial lending, I have seen many businesses change hands. My experience has shown me that the business sale process works much better with a financial intermediary involved.
    “You don’t just stick a For Sale sign on the front lawn of your office building or plant,” explains Robbins. “Selling a business is a long and complex proceeding. There are many pitfalls — and that’s why there’s a growing trend toward using business intermediaries to broker the deal.”
    Because financial intermediaries broker businesses for a living, they are much more effective and efficient in completing the 200 steps necessary to sell a business. And while the seller must pay the broker a fee for his or her services (typically 4 to 12 percent, depending on the size of the business), the seller generally comes out much better than if the business had been sold on a direct basis to the buyer due to maximizing the price and minimizing the amount of time required of the seller in the sales process.
Why Sell?
    So, where should you start if you are contemplating the sale of your business? The first step is to ask yourself the question, “Why sell?” Before you get too far into the process, examine your reasons for selling. You don’t want to make a decision that you will later regret. Robbins says there are many reasons to sell a business, including:
        • Retirement — one of the best reasons to sell a business.
        • Lack of capital — usually results in selling the business in a hurry and at a “discount.”
        • Growth requires more capital — can be a good reason if your business is profitable and you can still dictate sales terms.
        • Burnout — might want to consider taking some time away first (even a four- or five-day getaway trip) to think of ways to reduce stress before selling simply because you are “burned out.”
        • Boredom — wait a while . . . if you are still bored, then maybe it is time to sell.
        • Partnership dispute — if you can’t resolve your differences, make sure both parties are committed to selling at a fair price, not a quick price.
        • Divorce — a very difficult situation if the husband and wife have been working together.
        • Failing business — almost impossible to sell for more than liquidation value.
        • All equity tied up in business — you may be ready to diversify your risk.
        • No personal time for family and friends — can be a good reason if you’re working a lot of 16-hour days.
        • Outside economic factors — becoming more common than it was in the 1990s.
        • Illness — usually not a good time to sell, but all too often this is the reason.
    Robbins concurs that you should have a well-thought-out reason to sell your business. This is because your object in selling is normally to realize as much as possible from the sale and then redirect your attention to whatever you want to do in the future. Oftentimes selling for the wrong reason hurts the seller on both counts. For one, you wind up receiving a below-market sale price for your business. Frequently this also means that your future options are limited by your age and financial position. So you might wind up selling without getting enough money to retire on and then need to seek employment where you’d be making a lot less than if you had simply kept the business! In any case, if you become convinced that your reason to sell is viable, the next key step is to allow plenty of time for the sales process.
    “I want to emphasize that the timing of a business sale is critical,” Robbins says. “Consult with your intermediary to determine how you can achieve a smooth transition from owner to owner. And above all, remember that planning ahead is key. I find that too many business owners fail to plan for the day when they will want to sell. Then something happens — most often a health problem — and they are forced to sell quickly.”
Why Buyers Buy
    Once you have decided to sell your business, you need to start thinking like a buyer. In so doing, you will take steps to make your business more attractive to prospective suitors. From a financial perspective, the buyer will be looking for three key results on the other side of the purchase. He or she will want to earn a decent living, repay debt and generate a sufficient return on investment. Of course, all three are subject to interpretation, rendering the process as much art as science. Says Robbins, “The buyer rarely buys what the seller thinks he is selling.”
    According to Robbins, potential buyers can be divided into these seven categories:
        • Competitors/suppliers/customers
        • Individual investors
        • Investment groups
        • Public companies
        • Foreign buyers
        • Next generation (i.e., children)
        • Employees
    All buyer types will focus on one key financial factor — return on investment (ROI). In simple terms, the ROI is calculated by dividing the net annual return by the dollars invested. But this calculation is anything but simple when it comes to the sale of a business. Says Robbins: “The buyer wants the highest ROI (implying a low purchase price), while the seller wants to maximize the sales price. The process is naturally confrontational.”
    Of course, a business broker will provide a buffer to absorb many of the confrontational issues. He/she also will help the seller sort out the key components of ROI: cost of money, degree of risk, greed, liquidity and future expectations of profits.
    Cost of money — The cost of money has an inverse relationship with the denominator in ROI. As the cost of money rises, profits fall and earnings multiples also decline. Lower cost of money leads to higher profits and higher earnings multiples. Interest rates for the cost of money are set by government and market forces. A recent example of these forces at work has been U.S. Federal Reserve Chairman Alan Greenspan’s lowering of short-term interest rates an unprecedented 400 basis points from January to October 2001.
    Degree of risk — The more risk perceived by the buyer, the higher the expected return will be. If your revenue and earnings have been erratic in recent years, the buyer may perceive the purchase of your business to be a higher risk than it would be to buy one with stable sales and profits. If so, he will demand a higher return (which means a lower price).
    Greed — Pure greed may motivate the buyer to try to drive the price down. If you run into a potential buyer with a strong greed factor, it will likely be difficult to consummate a deal.
    Liquidity — Robbins points out that the easier it is to convert an investment into cash, the lower the expected ROI and the higher the earnings multiple. In other words, a potential buyer is going to expect a much higher return buying your business than he could get putting the same amount of money into Treasury Bonds.
    Future expectations of profit — The buyer will be more likely to pay a higher multiple of earnings for a company that has sustained (three years or more), positive sales and net income trends.
Figuring Value
The calculation most often used to compute business valuations is:
Earnings Multiple x Net Profit = Business Value
    However, because the earnings multiple is subjective and net profit fluctuates and is subject to various adjustments, the process of business valuation is quite subjective, particularly for privately held companies. “Rules of thumb are valuation methods that should be used as guidelines only,” advises Robbins. “Valuations vary greatly from business to business. The true value of a business lies in the future as seen by the buyer.”
    It should be noted that the above calculation is not the only way to value a business. The “book value” of a business is computed by adding retained earnings, paid in capital, common stock and shareholder loans. However, book value multiples are rarely used in computing business sale calculations, because the buyer will be dependent on the earnings capacity of the business to earn a living, pay back debt and generate an acceptable return on investment.
    You will not be able to compute the potential sales value of your business just from reading this article. Depending on many factors (business age, location, market potential, financial trends, potential financial adjustments, gross margin level relative to the recognition and identification industry, and condition of business assets, to name a few), the earnings multiple for your business could vary from 1x to 8x or possibly higher.
According to Robbins, there are a number of different financial earnings measurements that can be used to value a business. The five most commonly used are:
        • Shareholder discretionary earnings
        • Earnings before interest and taxes
        • Net profit before tax
        • Net profit after tax
        • Earnings before interest, taxes, depreciation and amortization
    For illustration purposes only, let’s say you and your business broker have determined a ballpark earnings multiple of 5x and your business earns a consistent annual net income of $100,000. The value of your business would be computed at $500,000 (5 x $100,000).
    Robbins reiterates that each transaction is unique. “Earnings multiples are generally established as the result of a transaction,” he says. “They shouldn’t be used to drive a transaction, because there are so many extraneous factors that affect the value.”
    One other point regarding the business valuation process: Robbins strongly advises his clients not to list an asking price when seeking to sell a business. “An asking price puts a ceiling on the value of your business,” explains Robbins, who suggests asking the potential buyer to make the first offer. “Understand how the buyer developed his estimation of the value then be prepared to challenge his or her assumptions.”
Importance Of Recasting
    Robbins says that the historical financial statements alone seldom portray the true financial picture of a business. “It is virtually impossible to value a privately held company without careful analysis and recasting to determine the true level of profits,” says Robbins.
    What is recasting? It is the process of adjusting the out “extra” expenses that are typically run through a closely held business. These expenses are designed to reduce the tax liability of the owner, but they understate the earnings power of the business. It is up to the seller to provide to potential buyers the detail on these expenses.
    Here is an example of some of these expenses. The income statement of an engraving business shows a pre-tax net profit of $100,000 for a given year. However, included in the expenses are the following:
        • A $30,000 salary for a family member who works part time and could be replaced by a part-time employee earning $10,000 per year
        • $7,000 per year for the owner’s leased vehicle
        • $30,000 in overly conservative inventory write-downs
        • $3,000 per year in country club dues
    While this engraving business would appear to have a net income of $100,000 at first glance, the recast net income number would be $160,000. This could have a substantial impact on the potential sales price of the business. For example, using the 5x multiple example mentioned earlier, recasting the business’ financial statements suggests that the value of the business is really $300,000 higher.
    Robbins says there are many expenses that can be adjusted out of the recast income statement to maximize the reported earning power of a business. Some of the most common are:
        • Excessive owner compensation
        • Family compensation to spouse, siblings or children
        • Owner expenses such as vehicles • Owner perks such as club dues and travel
        • Accelerated depreciation or amortization
        • Use of nonconforming accounting principles
        • Conservative inventory write-downs
        • Conservative bad debt write-offs
        • Unusual expenses such as legal expenses associated with a lawsuit
        • Excessive maintenance that appears in one year
        • New product or division start-up costs
        • Capital items expensed (such as a new computer system) that could be depreciated
        • “Toys” such as boats, airplanes and cell phones
        • Charitable contributions
Structuring The Deal
    Oftentimes the structure of the deal is more important than the actual sales price of a business. For instance, if it is important for you to cash all the way out now, you might take $100,000 less for a cash offer rather than take another offer that requires owner financing. In fact, there are numerous ways for you to be paid in the sale of your business:
    1. Cash — The most certain way to collect the entire sales price, but has immediate tax consequences.
    2. Secured notes — Seller is paid over time out of the cash flow of the business and has the right to foreclose as a secondary repayment source if the buyer defaults.
    3. Unsecured notes — Riskier than secured because the claim is unsecured; limited secondary repayment source if the buyer defaults.
    4. Shares in purchasing company — Typically only included as part of the package when selling to a publicly traded company.
    5. Consulting agreement — Seller required to stay involved for a fairly short period of time (usually from six months to two years) in exchange for part of the purchase price.
    6. Employment contract — Seller required to stay involved on a longer-term basis (usually three to five years) to help with transition to new owner.
    7. Lease on assets retained by seller — Most common with real estate or equipment; if you agree to this, you should require the buyer to sign a long-term lease (five years or more).
    8. Non-compete agreement — Seller receives payments over a period of time (usually three to five years) in consideration for agreeing not to open up a competing shop down the street.
    9. Royalty program — Seller receives part of sales price based on future sales generated by the business.
    10. Earnout — Seller receives part of sales price based on future earnings generated by the business; can be problematic if profits decline after the sale.
    11. Selling shares vs. selling
assets — Buyer purchases the shares of the business directly from the owner(s) of the stock.
    While some businesses are sold on an all-cash basis, most sales include seller financing in the form of a secured or unsecured promissory note or some other form of future payout to the seller (such as a consulting agreement and a non-compete agreement). This can prove beneficial to the seller from a tax-planning standpoint. However, the seller becomes a creditor and takes some risk that the business will continue to perform well enough to generate sufficient cash flow to meet future obligations to all creditors.
Example Of A Sale
    No two deals are exactly alike, but what follows is an example of a deal structure for the sale of an engraving business. Assuming that the buyer is obtaining a bank loan to finance the purchase, the buyer will likely be required to put down about 30 percent, with the bank and the seller roughly splitting the remainder of the financing. With a $500,000 purchase price, the financing might look like this:

Buyer’s down payment......$150,000
Seller financing....…....…..$175,000
Bank financing...................$175,000
Total $500,000

    In this scenario, the seller receives $325,000 in cash at closing ($150,000 from the buyer and $175,000 from the bank) with $175,000 payable out of future cash flow from the business. The bank will require a first lien on the assets of the business, leaving you limited collateral for your loan. Still, you can ask for a second lien on the assets, as well as a personal guaranty from the buyer. As for the loan term, you should negotiate for a payback on the note of three to five years, maximum. The interest rate on notes such as these typically is set near the Wall Street Journal prime rate (at press time, 5.5 percent) and can be fixed or variable. Of course, another point of negotiation for you as seller is to ask for a high note rate.
Don’t Fail To Plan
    Robbins reiterates that the process of selling a business should not be rushed. Concludes Robbins, “Business owners never plan to fail, but they do fail to plan, and that gives the buyer an advantage.”
    So, if you are considering the sale of your business, it is advisable that you visit your CPA and involve a business broker in the process as early as possible. If you aren’t sure how to go about engaging a business broker, try contacting the International Business Brokers Association ( for guidance. And above all, be prepared for a process that will require a great deal of time and effort that should pay off in maximizing the sales price of your business in the long run.