Business Brokers: Defending Your Numbers
We are, in many cases, the bearers of bad news.
This is particularly true in the Main Street market; businesses with transaction values of less than $1 million. That is because many small business owners have worked on their business for many years – sometimes decades – put a couple of kids through university, built a nice home and maybe own a nice vacation spot in the islands, all of which were possible because of the business.
They have invested their blood, sweat and tears in their business and often have an exaggerated sense of their business’ value. It has been, after all, responsible for their enviable lifestyle. However, most businesses, especially small ones, are valued based on how much money they can make for the owner – and buyers will pay for the value of that income stream but seldom more. (I discuss exceptions to that generality at the end of this post.) But as a business broker, if you are engaged to value a small business, you must be capable of defending your numbers.
When brokers present a small business valuation to the business’ owners, those owners may look at the broker in disbelief. They’ll often tick off a list of the material benefits they’ve enjoyed over the years because of the success of their business. They can’t believe it doesn’t have more value. So, what do you, the broker, do? How do you justify and defend your numbers?
A Case Study
One of our brokers found himself in this precise situation recently. He was engaged to value a specialty retail business whose customer range was a small but distinct segment of the population, passionate about what the business sold and the lifestyle and culture the business’ products and services supported.
The subject business was a small business with sales of roughly $1 million. Its location was conducive to its target customers and it carried a deep and diverse inventory all of which was focused on the needs and passion of its customers.
Our broker gathered the necessary information. The books, like those of many small businesses, were a mess but accountant-prepared tax returns were provided lending some level of believe-ability to the numbers.
Our broker found 23 similar businesses that had sold in the previous five years and 10 of these were extremely similar to the subject business giving the broker a respectable data set on which to base his conclusions. His preliminary work suggested that the business would be valued lower than he originally thought and he began to expect that the final numbers would disappoint the sellers. After finishing up his work, he was sure of it.
What Drive a Business’ Value?
A business has to do three things for an owner and buyer, a point that I explained in detail in a previous post. We refer to these as The Three Essentials.
- The business must generate enough profit to pay the buyers (or their hired managers) reasonable salaries – salaries that are competitive with what is paid to the owners of similar businesses – with which they can support their families.
- The business must generate enough profit to pay for itself. Specifically, pay off the note(s) the buyer used for the purchase.
- The business must generate enough profit to provide a return on the buyer’s investment. Specifically, a return must be calculated on the buyer’s cash injection or down payment.
Once a broker or advisor calculates the business’ Discretionary Earnings, it becomes pretty evident whether the business generates enough cash to provide the Three Essentials. And once the financial results illustrated in the data set are applied to the Discretionary Earnings (“DE”) of the subject business, a range of numbers are calculated that form the basis of what we refer to as the Most Probable Selling Price, a number that is based on the transaction data of the previously recorded “sold” businesses and the subject business’ comparative DE. This is how the numbers tell us the “market” – buyers and sellers of similar businesses – is likely to value the subject business.
In many cases, small business owners are disappointed in this number but if the valuation work done by the broker is presented in a professional and comprehensive document, the business’ owners may express their disappointment but they are almost never able to find flaws in the analysis. But reality may take some time to be accepted and the danger at this point is that the relationship between the broker and the owners runs the risk of becoming adversarial, a condition that helps no one. So, how does the broker handle this?
The Importance of Language
Many times the business owner will become defensive at this point. He or she may possibly take offense at what the broker presents. In such cases, it’s important that the broker work to make sure that the owner understands the source numbers (the numbers; not the source OF the numbers) because you want to get any argument about the source numbers and the subsequent calculations off the table. This is math, after all, not philosophy or the righteousness – or lack thereof – of the Spanish Inquisition.
Once the owner grasps the math, profound disappointment may ensue as the owner realizes that the business’ value appears to be lower than he or she had hoped and that their plans for the future – possibly retirement – are no longer possible, at least immediately.
We have seen instances where the owner becomes defensive to the point of irrationally blaming the broker for the low number; essentially blaming the messenger. If you find your self in this situation, language becomes extremely important.You may not be able to salvage a listing (which is why you should charge for your valuation work) but you definitely want to try to salvage the relationship. The owners may not sell at this time but eventually – and hopefully after increasing the value of their business – they will. And you want them to call you.
Language and how you structure your responses will determine how the relationship will evolve. Here’s a little role-playing scenario to illustrate the point.
The owner blames you: “So, you’re saying that my business is worth only X?”
You: “No. I’m saying that this is what similar business in your geographic region have sold for in the past five years. I am not putting a value on your business. I’m reporting what has happened when similar businesses have come up for sale. Essentially, this is what the market suggests your business might be worth. If you intend to bring your business to the market – with or without the involvement of our firm – this is information you need to have.”
Owner: “But what if I want/need more than that?”
You: You can ask any amount you want for your business. The purpose of the valuation is to guide you in determining a reasonable price.” (Our valuations specifically state at the conclusion that “This report offers our opinion of the Most Probable Selling Price which may or may not have any relationship with the asking price of the business or the actual selling price.)
“The numbers in our report illustrate what the market suggests the value may be X. You can certainly put any price on the business that you would like but as you’re considering what number would be appropriate, keep these three things in mind:
a.) A business’ bottom line must provide The Three Essentials.
b.) The time a business stays on the market is directly related to how it is priced relative to its value.
c.) A professional business broker generally will not take a selling assignment for businesses he or she does not believe will sell.”
I have written previously about the P.T. Barnum theory of life and how it obtains in our industry as in any other industry. And I have also written about how businesses losing money may have value and can be sold. But the job of the business broker/advisor is to provide the client with the information pertinent to selling the client’s business. Misleading the client about value does not serve the client well. It also risks wasting a lot of time and money on marketing a business that is over-priced as well as risking damage to the reputation of the broker for not being able to find a buyer.
Knowing how to value a business and defend the results is one of the most important aspects of business brokering. It allows you to discuss the results dispassionately with the business owner, reduce the level of emotion in that discussion and base your position on facts. It may take the owners a while to come to grips with what is in your valuation report – and if it is crafted properly and presented professionally, it will be difficult for most owners to reject it – but it will be hard for them to argue with your conclusions.
Learn the secrets of brokering small businesses…
The Bottom Line
Small businesses are generally bought by buyers that want to be in business for themselves and, as such, may pay a premium to gain that freedom. But the Three Essential do not change. Larger businesses, ones that may be the target of a strategic acquisition, are often bought at a premium because the acquiring company might be looking for something other than the target business’ demonstrated ability to generate X number of dollars in earnings. Access to a customer list, a specific needed technology and a proprietary distribution method are three of the attributes I discuss in this post that have nothing to do with the targeted business’ bottom line. But that is generally not the case with smaller firms.
So, know if you’re valuing a small business, do your research, know your numbers and draft a report that essentially eliminates doubt and argument. (If you’d like some help, let me know in the comments box below.)
If you have any questions, comments or feedback on this topic – or any topic related to business – I want to hear from you. Put them in the Comments box below. Start the conversation and I’ll get back to you with answers or my own comments. If I get enough on one topic, I’ll address them in a future post or podcast.
I’ll be back with you again next Monday. In the meantime, I hope you have a profitable week!
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