Valuations: The Ultimate Question
Wow! Last week’s post got a TON of comments… and TWO tons of questions!
That post, basically for business brokers, was a discussion about defending your numbers. That is, after valuing a business for a potential client, how do you explain that it isn’t you that is deciding on the business’ value, it’s the market?
In the small business segment – those with sales of less than $2 million or thereabouts – there is usually a great deal of discussion between the seller and the broker when the broker presents the valuation – the Most Probable Selling Price (MPSP) – to the seller.
In many cases, this discussion is accompanied by various levels of disappointment on the part of the business owner. We have found that many – perhaps most – owners of small businesses have an exaggerated sense of their business’ value.
This phenomenon occurs across industries, geographic areas and political persuasions. (On the other end of the spectrum, we’ve found that the owners of larger businesses – those with sales of about $5 million and up – are a bit more sophisticated and have a reasonably accurate sense of the range of valuations their business will probably fall in.)
There is, however, one simple question a broker can ask that I’ve found will generally change the tenor of this conversation to one of reflection and ultimately resignation on the part of the seller. Here’s how one of these meetings went recently – and how I was able to get the owners to see why the MPSP was what we said it was.
A Case Study
We were engaged to do a valuation of a small business, one with sales of roughly $650,000. The owners, a husband and wife team, were referred to us by a real estate broker they were friendly with. They were ready to sell.
This was a retail business but one that specialized in serving a specific type of customer. The customer base had few options in the local market and provided a steady revenue stream over the previous three years. Excluding any possible impact of Amazon and its ilk, there was no reason to believe that would change in the near future.
I met with the owners and discussed the aspects of selling; what data would be needed for the valuation, how long the valuation would likely take, the methodology that would be used in the valuation, the level of confidentiality that would be exercised, the probable length of time it would take is to sell the business should they list it with us, etc. Within a week we received most of the data we requested and in another week we received answers to the questions the review of that data raised.
Next, we found a good number of similar businesses in the general geographic area that sold in the previous five years. We were able to determine what the sale prices of those businesses were in relation to both their earnings and their revenue. We did our calculations and came up with a range of probable valuations for the subject business.
What Else do We Ask?
When we do a valuation, we ask a number of questions that, at first blush, might seem to be a bit unrelated to the task at hand. But I’ve been doing this long enough to know that certain extraneous data will be helpful not only for the valuation but also for the valuation discussion that I’ll subsequently have with the business owners. One of those questions relates to the number of employees the business has and what were the hours they worked. Another was asking how much time the owners spend in the business.
This last question is particularly important in cases where the business does not appear to be generating much excess earnings – that is, earnings beyond the basics of the owners’ salaries and modest benefits, a condition that seemed to be the case with the business we were valuing.
What Are The Fundamentals of Value?
As I’ve written previously, a small business must do three things – the Three Essentials – for an owner, a point that I explained in detail in a previous post.
- The business must generate enough profit to pay the buyers (or their hired managers) reasonable salaries 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.
Needless to say, the more free cash that the business generates above the Three Essentials, the more interesting the business is to buyers, the more serious buyers will be attracted to it and the higher its value will be.
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. But if the business is not generating enough cash to cover those items, the proverbial red flag is run up the pole and the broker has to start looking – first, for other measures of value and, second, for ways to logically and coherently explain to the owners why their business may not be worth what they thought it would be.
In the case of the subject business, the Discretionary Earnings were just barely covering the first of the Three Essentials – and even that was debatable because the owners also owned the real estate that the business occupied and wanted to keep that real estate and rent it to whoever bought the business.
See this discussion about how to handle real estate when selling a business.
Such an arrangement required us to determine what a reasonable market rate rent would be, add that number to the future expense projections and adjust the Discretionary Earnings accordingly. Once these calculations were complete, we saw immediately that anyone who would consider buying this business would be doing little more than buying a job. (Buying a job is not unheard of and I’ll do a future post detailing this phenomenon. But from a business valuation standpoint, it is not helpful.)
The (Rest of the) Conversation
Last week, I described the conversation that was likely to ensue and how a broker or advisor might structure it to break the bad news while at the same time not being blamed for that news. It went something like this:
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. 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.”
The Ultimate Valuation Question
But many times those words offer little enlightenment to the owners – and less comfort. But this brings us back to the questions I mentioned above, the ones about how many hours the owners put into the business.
In this instance, the owners were working more than 68 hours per week. After adjusting the Discretionary Earnings to account for the rent that a buyer would be paying, the owners were essentially working for $14.50 per hour. And THIS brings us to the Ultimate Question which always stops the discussion in its tracks.
The Ultimate Question can be phrased in two ways.
1) “Would you buy your business? Specifically, would you buy it for the price you want someone else to pay for it?”
2) “What would you pay for the opportunity to work 68 hours a week for $14.50 an hour?”
When the discussion gets to this point, it can be a bit uncomfortable but in some cases these questions have to be posed. And when they are, as a rule, there is a moment or two of silence as the implications of what was just asked sink in.
The result of this exercise does not lessen the owners’ disappointment but it does illustrate to them – graphically, if not very gently – that the business they’ve worked so hard to grow, while providing them with a living, does not have the horsepower to provide much more than that to a buyer. They begin to see that their business – their “baby” – may not be as desirable as they’d hoped.
As a business broker, you will inevitably find yourself in a situation similar to what I’ve described here. The way you handle it will impact how a lot of people – the business’ owners, the person that referred them to you and everyone they speak with in the near future about the process and the results – talk about you and your business brokers practice. Your objective is to get the owners to see reality without bearing you any ill will.
Granted, this takes a bit of finesse but you want a reputation for honesty, fair dealing and straight shooting. 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 but it will be near impossible for them to argue with your conclusions. But the final card – to be pulled if necessary – is some variation of the Ultimate Question: “Would you buy your business and, if so, what would you pay for it?”
Learn how to broker small businesses…
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!
#business #howto #sellabusiness #becomeabusinessbroker #businessbrokering #businessvaluation