How to Value a Small Business Using Earnings Multiples

Category: Business Valuation Buying a Business Selling Your Business 

A business owner or prospective seller may want to know the value of their business before deciding to put it on the market.  Buyers may wish to calculate the value or compare the asking price of a business they are interested in. In the case of business owners considering the sale of their business most business brokers offer a free Market Value Analysis and in fact our firm offers a comprehensive Business Market Value Analysis to prospective sellers.  In either case, the simplest method to obtain an approximate business value is to use the Earnings Multiple method (also known as Market Data, Comps, Discretionary Earnings  or DE Multiple).

Most business buyers and sellers/owners are somewhat aware of earnings multiples but few understand how to properly use and apply these multiples to value a business.  There are many myths and opinions about what a business is worth and what “the” earnings multiple is.  In fact earnings multiples vary widely by industry as well as by earnings.  There are different multiples for Discretionary Earnings (DE aka SDE or Seller’s Discretionary Earnings) and EBITDA (Earnings Before Interest Taxes Depreciation & Amortization).  DE multiples are lower than EBITDA multiples because with DE you are multiplying a higher earnings number against a lower multiple and with EBITDA you are multiplying a lower earnings number against a higher multiple.  Ideally you should get roughly the same value for both approaches. There are no valuation multiples for “net profit” for a small-midsize business and simply applying say a DE multiple to Net Profit will result in a dramatically undervalued figure for the business.  As explained below, the Net Profit does not reflect the actual earnings of a small business, thus using it for valuation purposes is meaningless.

While Earning Multiples seem like a simple method to value a business, and they can be, they must be used correctly and on the right earnings value to deliver the correct valuation for a business.  

Discretionary Earnings vs Net Profit vs EBITDA

First you need to understand the difference between each earnings type and how to calculate them, then look at how to apply them.  

 

  • Net Profit:
    This is the starting point for calculating both DE and EBITDA.  When a business broker or valuation analyst refers to Net Profit this is the Net Profit shown on the company tax returns.  The Net Profit on the company P&L is often different from the Tax Return Net Profit as a result of changes made by the accountant or CPA at year end which were not reconciled with the P&L.  The Tax Return Net Profit is the only figure used for valuation purposes (note that SBA lenders and valuation analysts only use the Tax Return Net Profit).
  • EBITDA:
    EBITDA is actually simple to calculate.  Start with the Net Profit from the Tax Return and add the Interest, Taxes, Depreciation, & Amortization.  This is the non-normalized EBITDA and for very large businesses this figure is correct. For small businesses we must subtract a replacement salary for the owner at market rate.  This would be the salary of a manager to run the business in
    place of the seller.  This is called Normalized EBITDA which is used for small businesses.  
  • Discretionary Earnings (DE):
    DE is the most commonly used valuation multiple and it is also the most complicated figure to calculate.  DE basically is EBITDA + owners salary + owner’s benefits & expenses. This sounds simple enough and it would be except that many owners bury these expenses which can make it difficult to verify these figures.  One key rule for owner’s expense add backs is that they MUST be tied to an expense line item on the tax return. If the expense is not shown on the tax return then it cannot be used as an add back for calculating DE as it was not shown as an expense on the tax return, which is what is used to calculate DE.  

 

Finding the Right Earnings Multiple for a Business

You can get Discretionary Earnings multiples and Business Valuation Reports from BizBuySell and Peercomps.  BizBuySell offers valuation reports from $19.95 to $59.95 and Peercomps offers a one time comps search for $49 or a one time business valuation for $99.  

The BizBuySell valuation is the simplest to use and the least expensive.  While it is good for determining a price range, the downside is that it is not an accurate valuation program.  You should only use it for validating a price range and not for determining an exact business value. Note that the comparable sales data in BizBuySell is broker provided, meaning that brokers input this data when a business is sold through BizBuySell.  There are thousands of transactions in the database, the problem is that the way brokers record transactions can vary, making the data less consistent than Peercomps.

The Peercomps valuation is more comprehensive and uses better comparable sales data as their database is from actual closed SBA financed transactions.  All SBA loans require an independent (third party) business valuation (appraisal) by a CVA (Certified Business Valuation Analyst). Thus this comparable sales data is more accurate and more consistent than broker provided comps.  The downside of Peercomps is that it is much more complicated to use and obtain an accurate valuation. The user should be familiar with valuation methods in order to use Peercomps.

Steps to Finding Earnings Multiple Comparable Sales Data

  1. In BizBuySell or Peercomps select the Industry-Business Type (e.g. Distribution, Restaurant, Manufacturing, Construction – note that you can select more specific business types)

  2. Narrow the Gross Sales and Income ranges to values below and above the company’s annual revenue and income.  Set a minimum value to eliminate businesses much smaller than the company you are considering and a maximum to eliminate businesses that are much larger.   

  3. You can change the ranges to narrow or expand your results until you have a suitable number of comps (preferably at least 5 to 10 or more.  In some cases there may be very few if it is a small niche).

  4. Now you should have comparable sales multiples for Discretionary Earnings and if you used Peercomps Normalized EBITDA as well.  The next step is to apply the multiples

Important Notes:

  1. Most DE multiples do not include inventory or A/R (Accounts Receivable) and also assume that all liabilities are paid off by the Seller at closing.  
  2. Peercomps multiples include “normal” inventory and BizBuySell comps may or may not.
  3. Normal inventory is the inventory required to operate the business.  Excess inventory is not included in the earnings multiple.

Applying the Earnings Multiple to Determine Business Value

If you are using the valuation report from BizBuySell or Peercomps you can input the company earnings and revenue to obtain a value based on the Mean or Average Discretionary Earnings multiple.  If you elected to obtain comparable sales data only your next step is to multiply the Mean or Average DE multiple to the DE you calculated. This will give you a value based on the Mean or Average multiple.  

It is important to note and understand that the figure you just calculated is not an exact figure.  The multiple you just used is an average.  Thus, half of the businesses in the comps sold for less than that multiple and conversely half sold for more than that figure.  

If you are considering a business that is exceptional it may be worth a premium and the average multiple may be on the low side.  Likewise, if the business is below average it may be appropriate to apply a discount.

7 Factors that Affect Business Value and Earnings Multiples

  1. Quality of Financial Data
  2. Quality of Product or Service
  3. Competition
  4. Years Established
  5. Quality & Experience of Staff
  6. Infrastructure, Systems, Procedures
  7. Customer Concentration

Earnings Multiples are a convenient and relatively simple way to calculate business values, but as we discussed above, it is not an exact value and more of an average value.  If you are buying a business the Business Broker should have a Recast Financial Statement showing the financials from the Seller’s tax returns and all of the add backs to arrive at the Discretionary Earnings.  The Broker should also be able to provide you with Comps Data and a Market Value Analysis.

If you are Selling your business we recast your financial statements and prepare a comprehensive Market Value Analysis as part of our initial review of the business to determine the asking price.  

INFORMATION ON BUYING-SELLING A BUSINESS

What Questions Should I Ask the Seller About His Business?

Category: Buying a Business 

As a Business Broker one of the most irritating things I see buyers do is spend an hour meeting with a seller and walk away knowing very little about the business.  How does a buyer spend an hour with a business owner and learn almost nothing about the business?

Many buyers focus on the P&L and financial statements almost exclusively, asking questions about specific expenses, depreciation (which most sellers have no idea about since their CPA calculates this), Cost of Goods Sold, etc.  While these questions are appropriate and necessary during Due Diligence, in the early stages of considering a business they provide zero insight into the actual business itself.  Consequently when a buyer spends (wastes) their time focusing exclusively on financial questions they walk away with no understanding of the business.  Who are the customers, what is the owner’s role and daily activities, what do the employees do, what experience do the employees have, what is the competitive edge the company has, what marketing does the company do? These questions give you insight into the business, it’s products/services, infrastructure, and operations.

Ask these 7 Simple Questions to Learn Everything About a Business You are Considering Buying

When you meet with a business owner/seller ask them open ended questions. Business owners are very proud of their business and most love to talk about it. By asking general questions you start a dialogue where you will learn all about the business and the owner.

  1. Tell me about your business…
  2. I’d like to know more about your products/services…
  3. What are your daily activities in the business? What are your primary roles?
  4. What are your employees responsibilities?  Tell me about their experience…
  5. What does your company do for marketing?
  6. Are there any customers that represent over 20% of your annual sales?
  7. I would like to know your ideas and suggestions for what I could do to grow the business…

The goal of your initial meeting with the Seller is to learn as much as possible about the business and the owner.  Is this a business you can see yourself running?  How dependent is it on the owner?  What’s the owner like?  What are the employees like and what is their experience?  By asking open ended questions about the business all of this will come out naturally during the discussion and you will gain much more insight into the business than you do from simply asking questions about the P&L.

INFORMATION ON BUYING-SELLING A BUSINESS

5 Signs a Business Purchase is a Bad Deal and When to Walk Away

Category: Buying a Business 

Finding the right business is a long and challenging process for prospective buyers; when a buyer finds a promising business sometimes it is hard to walk away from the deal.  They’ve likely invested a lot of time into the deal and are emotionally attached to it. At that point buyers will really want to find a way to make the deal work. Often hard work and perseverance pays off and it all works out, but there are times when you should walk away.  

When to Walk Away from a Business Purchase Transaction

  1. Seller is Difficult:
    There are many difficult people in the world.  If the seller you are working with is one of them and you can’t work constructively and productively things will not go well.  You will need this seller to train you and you will be relying on him to be cooperative and committed during the transaction and more importantly during transition and training.  If the seller is difficult to work with it will be nearly impossible to have a smooth transaction and the deal may fall apart later anyway.
  2. The Numbers Don’t Make Sense:
    If the figures on the financial statements don’t make sense and cannot be explained to the satisfaction of you or your CPA it may be time to walk.  While there are many good businesses with imperfect books & records/financial statements, the seller and their CPA should be able to explain them to your satisfaction during your meetings and prove it to your satisfaction during Due Diligence.  The trick here is to determine where that line is and when it’s time to walk away.
  3. Cash Flow Doesn’t Pencil Out:
    If the cash flow after debt service and your required income is not meeting your needs you should seriously consider passing on the business.  While you can grow the business and make improvements, it will take time. If the business will meet your needs in the interim that’s fine, but if it is far short of your income needs you should pass on this one.  
  4. Poor Books & Records:
    If the books & records and financial statements are poor it is nearly impossible to verify the actual earnings of the business.  In situations like this you are flying blind with respect to how the business is performing financially.  Some owners have poor computer records, but good paper records (yes, paper records even today).  In these situations it is possible to verify the revenue and income, it is just a lot of work.  It’s your decision as to if it is worth the work and if you can adequately verify the figures.
  5. The Seller is Evasive or Untruthful:
    If the seller is evasive or untruthful you should walk away, in fact, run away from that deal.  If the seller is not forthcoming and open with information it is very difficult to learn the facts about the business and if they are untruthful then you have no way of knowing what is real and what is fiction.  It’s difficult to conclude a transactions successfully if the Seller is not open and willing to provide detailed information.  

Working with a reputable experienced business broker will definitely be an advantage in finding the right business to buy.  An experienced business broker will be able to facilitate the transaction process and coach a buyer on the above problem areas.  From the initial meeting through closing a business broker should be able to have or get all of your questions answered and let you know where there might be a potential problem.  

Not all problems are deal killers and there are many times when a solution can be reached.  However, there are times to walk away because the risk of buying that particular business can be too high.

INFORMATION ON BUYING-SELLING A BUSINESS

Preparing for Due Diligence on the Sale of Your Business

Category: Buying a Business Selling Your Business 

After an offer for your business has been made and accepted the next step is Due Diligence where the buyer will review the books and records of the business to verify the revenue, earnings and veracity of the business.  Due Diligence is a Contingency for both Buyer and Seller; the buyer’s deposit check is not cashed and Escrow is not opened until after both buyer and seller have removed this contingency. When the Due Diligence Contingency is removed the Business Broker will send the Purchase Agreement documents and buyer’s deposit check to Escrow.  Escrow will deposit the buyer’s earnest money deposit check into their trust account, draft the escrow documents, and once these documents are signed Escrow is opened.

During the Due Diligence process the role of your Business Broker is to organize and facilitate the process and most importantly keep it on track.  The buyer and seller may engage other advisors (see below) to assist and advise them during the Due Diligence process.

Due Diligence Timeline

Due Diligence typically takes 3 weeks for a small to midsize business and can take longer for larger or more complicated businesses; or if the records and business information is not readily available from the seller.  At Pacific Business Sales we use the CABB (California Association of Business Brokers) Purchase Agreements for both business Asset Sale and Stock Sale transactions.  The CABB agreement breaks Due Diligence down into three steps shown below with the number of calendar days specified for each step.  The number of days is specified by the buyer when the offer is prepared with the Business Broker.

  1.       Buyer Due Diligence List: typically 3 to 5 days
  2.       Due Diligence Materials Provided: typically 5 to 7 days
  3.       Review of Due Diligence Materials: typically 10 to 14 days for small to midsize transactions, may be     longer for larger or more complex transactions.
  4.       Total number of days for Due Diligence: typically 20 to 30 days.

At the conclusion of the Due Diligence period each party removes the Due Diligence Contingency and the broker will open escrow.  Should either party decide not to remove the Due Diligence Contingency the transaction is terminated and the buyer’s deposit is returned in full (see Wrapping Up Due Diligence below).

Typical Due Diligence Items

Below is a typical Due Diligence list for a small to midsize business.  Note that different businesses and industries will have additional items specific to that business or industry and the buyer’s CPA or financial advisor may have additional items they wish to review.  If the transaction is a Stock Sale, there will be additional items relating to corporate records that require review.

  1. Seller Disclosure Statement (part of CABB Purchase Agreement).
  2. Business Tax Returns, last 3 years.
  3. Sales Tax Returns (if the Seller has a resale account).
  4. Bank statements (month by month), last 3 years and year to date.
  5. Last 3 years P&L statements.
  6. Balance Sheets for last year end and most recent month end.
  7. Sales by product or service type/category.
  8. Customer list (note in some cases this may be redacted for confidentiality).
  9. A/R and A/R aging report.A/P report.
  10. Employee list with roles and responsibilities.
  11. Payroll reports for last 2 or 3 years with W2s.
  12. Inventory and inventory reports.
  13. Workman’s Comp policy, mod rate, and claims report.
  14. General Liability policy.
  15. Current Lease.
  16. Equipment list.
  17. Buyer’s CPA may have additional items requested for review.
  18. Note that lien searches, releases from state agencies including EDD, Franchise Tax Board, and Dept of Fees (formerly State Board of Equalization), and public notice to creditors are done by escrow once escrow is opened.

Due Diligence Advisors

In many transactions the buyer and seller opt to conduct the Due Diligence review on their own. This is typical for small transactions where the financial statements and other records are straightforward.  Some buyers may engage a CPA to assist them with the financial review and if the transaction is a Stock Sale the buyer may also engage an attorney to review the corporate records. Likewise, some sellers may need to engage their CPA or accountant to provide the requested financial information to the buyer and answer questions about the P&L, Balance Sheet, expenses, tax returns, and owner benefits/expense add backs.

  1.       CPA or financial advisor representing the buyer if buyer opts to engage one.
  2.       Seller’s CPA, accountant or bookkeeper to answer questions about financial statements.
  3.       Buyer’s attorney if buyer opts to engage one (typically for larger transactions and on Stock Sales).  The buyer may also use their attorney to draft a consulting agreement with the seller or other specific agreements if required.
  4.       Seller’s attorney if required such as in a Stock Sale to do the stock certificates and stock transactions.
  5.       Buyer and seller’s insurance brokers.

The Business Broker representing the seller and/or buyer if they are a dual agent cannot act as an advisor to either party with respect to Due Diligence as they are not a CPA or accountant and cannot provide financial or legal advice to either party.  The broker can facilitate the Due Diligence process and assist buyer and seller in organizing the process and answer questions relating to the transaction.

Seller’s Due Diligence

Much of the focus of Due Diligence is on the buyer side, but there is also a seller Due Diligence contingency.  During the Due Diligence period the seller has the opportunity to review the buyer’s qualifications, financial wherewithal to complete the transaction and ability to run the business.  Typical seller Due Diligence items are:

  1.       Buyer Resume.
  2.       Buyer Disclosure Statement (part of CABB Purchase Agreement)
  3.       Buyer Personal Financial Statement (often a copy of their SBA loan application).
  4.       Source of Funds.
  5.       Background Check (this is not always requested but can be).

Wrapping Up Due Diligence

At the end of the Due Diligence period the Business Broker will send buyer and seller a Due Diligence Contingency Removal and Authorization to Open Escrow document for signature.  When the Contingency Removal is signed the broker will send the purchase agreement documents and buyer deposit check to escrow to draft Escrow docs, obtain signatures and open Escrow.

If the parties require more time both can agree, and the broker will write an addendum to the Purchase Agreement extending the Due Diligence period.

If the buyer has found problems during Due Diligence the first step is to review the issues with the seller.  Often the perceived issues are either a misunderstanding of the financial statements, a result of missing information, or a minor issue that is resolved after review with the seller.  

If the issue is significant there are three options 1) negotiate an accommodation with the seller which may involve price or terms, 2) accept the agreement as is if the issue is not significant, 3) terminate the agreement in which case the buyer’s deposit check is returned in full and the transaction is cancelled.

Due Diligence is perhaps one of the most important steps in purchasing a business, second only to the actual purchase agreement and negotiation.  With the help of a professional Business Broker to prepare and negotiate the offer and facilitate the process you can look forward to a timely and successful transaction.

Information on Buying-Selling a Business

Buying a Business is Risky! 7 Reasons to Buy One Anyway!

Category: Buying a Business 

For many people the prospect of giving up their job and steady paycheck to start or buy a business is unthinkable, even terrifying.  In fact, a study sponsored by Weebly and conducted by Wakefield Research found that while most Americans think about quitting their job twice a week, one third of those surveyed fear starting a business more than jumping out of an airplane.  No doubt there is an abundance of fear about starting or buying a business, but is it worth the risk? Are those fears warranted?

7 Reasons to Start or Buy Your Own Business

  1. Control Over Your Life and Destiny plus You’re the Boss
  2. Control Over Your Income and Growth
  3. Pursue Your Passion
  4. Set Your Own Schedule
  5. Wealth creation and tax benefits
  6. Your business is an asset you can sell in the future
  7. Corporate jobs don’t last forever

What are the Risks of Starting or Buying a Business?

Starting a business is risky and  in fact most startups fail within the first few years.  SBA and Census Bureau data show that that 30% of new businesses fail in the first two years, 50% in the first five years and 66% in the first ten years.  So there is justification for the fear of starting a business, but what about buying an existing business?

Buying an existing business is entirely different.  The business has already survived the startup and embryonic phase and is likely a mature business.  The products or services are established and proven. Employees are trained and in place. Customer relationships are established.

Start Up Risks vs Buying an Established Business

Startup AdvantagesEstablished Business Advantages
1. Fulfilling-building your dream.1. Lower risk; established customer base plus products & services.
2. You get to do it your way.2. SBA or seller financing to purchase business
3. You can choose your location.3. Immediate cash flow
4. Possibly less cash upfront (but not in the long term).4. Established Businesses Survive Downturns
(see SBA data below)
5. You can start slow and ease into it.5. No startup phase, it’s up and running.
Startup RisksEstablished Business Risks
1. Unproven product-service.1. Every business, even good ones, have problems which you inherit.
2. Unknown brand, product, service.2. Problems you may miss during Due Diligence.
3. No cash flow initially and slow ramp up.3. Industry or economic downturn.
4. No bank financing available, most startups funded with credit cards and cash (see SBA data below).4. You are not capable of running the business.
5. Industry or economic downturn.
6. Expansion financing will be difficult to obtain for several years other than personal credit.
7. You are not successful in running the business.

There is less risk involved in buying a business and problems within the business can become opportunities for the new buyer.  The majority of sellers want to see a buyer of their business continue to be successful and will oftentimes be willing to stay on after the training period with a consulting fee in order to facilitate a smooth transition with both customers and employees.

How to Buy a Business

For more information about buying a business and how to buy a business see the book written by Bill Grunau, “Own Your Future, Straight Talk About How to Buy a Business and  Build Your Future”.    

In our book you will learn: Own Your Future How to Buy a Business

  • How to Work with Business Brokers
  • How to finance an acquisition with Small Business Administration financing;
  • How to use your 401K or IRA funds to buy a business without penalties or taxes;
  • How to write offers;
  • How to conduct due diligence;
  • How to develop a 100-day and first-year plan;
  • How to develop an exit strategy;
    And much more

More SBA Data and Infographics

  1. Small Business Survival Rates and Firm Age
  2. Do Economic or Industry Factors Affect Business Survival
  3. Small Business Facts – why do businesses close?
  4. Credit Card Financing and Small Business

 

Does a Bear Market Affect Business Values and Sales?

Category: Buying a Business Mergers & Acquisitions Selling Your Business 

A Bear Stock Market causes (or is the result of) the values of publicly traded companies to plummet; but does a Bear Market affect the values of small to midsize (SMBs) privately held businesses?  One may think that in a Bear Market the values of SMBs would be pulled down with those on Wall Street, but this is not necessarily the case. 2018 is a good example of how Wall Street can be on a wild ride while SMB values hold steady, revenues and profits remained solid, and sales of privately held businesses are at record levels.  In fact while the Dow and S&P 500 was down overall in 2018 and nearly lost 20% of the value during December, 2018 was actually a very good year for small and midsize businesses.

A Bear Market can be created on Wall Street by economic forecasts, increasing interest rates, slowing earnings growth, world events, and government economic policies. Small business values are driven by earnings, more specifically the Discretionary Earnings or EBITDA of the business.  That’s it, earnings drive value for SMBs. Because the stocks of publicly traded companies are liquid and easily bought and sold, they are susceptible to speculation and when the economic winds shift, they become volatile. Privately held SMBs are not subject to speculation and are held for long term investment by the owners, thus their values are not driven by speculation.  They do not experience meteoric growth in a Bull Market, nor do they plummet in a Bear Market. In fact, the only time the value of a privately held business is of any real concern is when the owners are contemplating selling the business.

What Does Affect the Value of a Small-Midsize Business?

Earnings are the primary determinant and driver of small business value and the earnings of a business can be affected by internal and external forces.  Internal forces (things within the control of the management) such as management, product life cycles (obsolescence), quality, and pricing can cause the revenue and/or earnings of a business to decline.  External forces (things outside the control of management) such as the economy, competition, and commodity/materials prices, to name a few, can also cause the revenue and earnings of a business to decline.

Thus, if the economy is weak or other external forces affect the sales and earnings of a business the value of that business will be directly affected.  In this sense small business values can follow Wall Street values if the economic factors also affect directly the business and its earnings. While external forces cause the stock market to swing wildly and seemingly instantaneously, changes in the values of privately held businesses are only detectable when an owner is preparing to sell the business or perhaps obtain new bank financing.

Growth in revenue and earnings also affect the value of a business.  Businesses that are growing steadily or rapidly generally get a premium, and businesses with declining sales and earnings are discounted.  The industry type (e.g. distribution, e-commerce, healthcare, manufacturing, construction, B2B or B2C services, retail, etc.) drives the earnings multiple for that business, however, the multiple is a constant and does not generally vary much although it can be discounted due to factors such as lower earnings within each industry, dependence on owner for day-to-day operations (little to no employees) and/or poor books and records.  

How is the Value of a Small Business (SMB) Calculated?

When a small business owner is considering the sale of their business and wants to establish the market value, the first step would be to contact a professional business broker and ask for a Market Value Analysis.  At Pacific Business Sales we offer a free Market Value Analysis for our prospective clients and also offer formal third-party valuations for a fee for clients in need of a full appraisal.

To establish the value of a business, the first step of course is to obtain copies of the last three years tax returns, year to date Profit and Loss Statement and balance sheet.  The next step is to recast the financial statements to calculate the Discretionary Earnings, or DE, of the business. Simply put, DE is the total economic benefit or total income the owner realizes from the business.  Recasting the financial statements involves reviewing the expenses shown on the tax returns and P&Ls and adding back owner’s benefits and non-essential expenses that are discretionary to the owner. The tricky or complicated part of recasting financial statements is that only expenses shown on the tax returns can be added back and any owner’s expense must tie to an expense line item on the tax returns.

When the recasting is complete the business broker or valuation analyst will use a valuation program to calculate the market value of the business based on comparable sales (comps) data and often a valuation method such as the income approach.  At Pacific Business Sales we use the Peercomps valuation program and comps database along with other comps databases to calculate the market value of our client’s business.

Knowing the Market Value of your business is a critical first step in preparing to sell your business.  If you would like to meet with us to discuss the prospective sale of your business and the Market Value of your business please use the button below to contact us.

 

Buying a Business in a Bear Market, Bad Idea or Great Opportunity?

Category: Buying a Business 

Is it a bad idea to buy a small-midsize business (SMB) during or Bear stock market or is it a great opportunity?

When Wall Street turns into a Bear Market, buyers for stocks of publicly traded companies hunker down, hold on to their cash, and wait for the storm to pass.  Some may take extreme steps and sell off stocks they are holding to minimize their losses, create additional liquidity, or to recognize losses for tax benefits at year end and then buy in the new year.  Sellers greatly outnumber buyers in a Bear Market; but there are savvy investors that realize there are still solid companies to invest in that have become great buys and they seize this opportunity to buy at substantial discounts.

Does a Bear Stock Market Affect Small-Midsize Businesses ?

The effect of a Bear Stock Market on small-midsize businesses (SMBs) depends on what is driving or causing the Bear Market.  While 2018 was a wild ride on Wall Street with the Dow and S&P 500 losing nearly 20% of its value from the 2018 peak in December, small business values were not affected and in fact 2018 was a record year for small business sales and values.  Overall, 2018 was a great year for small businesses.  

If the stock market is going through a “correction” after prices have soared and it is simply time for the values to be realigned with their actual economic value, then this generally does not affect small business values.  Likewise, if there is a reaction to global markets, oil price fluctuations, interest rate changes, or government policy changes this generally does not affect small business values. While the Dow and S&P 500 react to economic and world events seemingly instantaneously, privately held business values do not react to these fluctuations which are driven by speculation.  Small business values are driven by earnings (link) and as these companies are privately held, they are not subject to investor speculation since they are held for the long term.

Should I Buy a Business in a Bear Stock Market?

While small business values are not directly affected by a Bear Stock Market, a stock market downturn can cause some prospective buyers to pause and wait to see what happens.  This is an opportunity for serious and savvy buyers as there may be less competition for businesses on the market and you are in a better position to negotiate on price and terms.

But what if the Bear Market is the result of an economic downturn, is it still a good time to buy a business?  During the 2007-2008 recession sales of small businesses dropped dramatically and while some businesses suffered during that recession, the good ones recovered and are having record years now.  The point here is that if one of these 2008 survivors was acquired at that time the company would have been purchased for a fraction of today’s value.

Even during an economic downturn there are quality businesses for sale and during a downturn they will be available for far less than what they would sell for when the economy is doing well.

SBA Loans; More Cash at Closing for Sellers, Higher ROI for Buyers

Category: Buying a Business Selling Your Business 

There is a common belief that SBA loans are difficult if not nearly impossible to obtain when buying a business.  Being difficult and/or impossible to get is a myth and a harmful one that causes many prospective buyers to not even consider SBA financing.  SBA financing is complicated and does require a lot of paperwork, but if you work with an experienced business broker who understands SBA financing and a good bank it goes smoothly.

At Pacific Business Sales we have been doing SBA loans directly with SBA PLP (Preferred Lender Program) banks since 2001 and we have long running relationships with these lenders.  We know what the banks require of the buyer and the business, consequently we close well over 90% of the SBA loans we submit with a purchase offer. As the business broker representing a seller,  we work closely with the banks when we initially bring a business to market and have the bank review the business for a pre-approval and give us the financing estimates for rates, terms and closing costs.

SBA financing in fact is the best financing available for the purchase of a business. While SBA financing does require a buyer to have good credit and a business with earnings, it is well worth the extra effort as it will allow you to buy a bigger business with a much lower down payment which will allow for greater cash flow and result in much higher Discretionary Earnings from your acquisition.

Advantages of SBA Financing for Buyers

  1.       Low Down Payment:  SBA loans now offer down payments as low as 10% for qualifying buyers and businesses.
  2.       10 Year Financing:  Seller notes are typically 5 years and in some cases less than 5 years which results in a short loan amortization and consequently high monthly payments even at a low interest rate.  SBA financing for business acquisitions (SBA 7a loans) are amortized over 10 years which result in lower monthly payments.
  3.       Maximum Leverage on Minimum Equity:  The 10% down payment results in buyers to buy a much larger business than they would with Seller Financing. Normally a 50% or higher down payment is required by sellers and many sellers on small businesses offer no financing.
  4.       Enables Buying a Bigger & More Profitable Business:  By leveraging the available cash a buyer has, a buyer can buy a much larger business with higher revenues (businesses are valued on a multiple of earnings, thus a business with higher earnings will have a higher value).
  5.       Enables Buyers to Consider a Wider Range of Businesses.

Advantages of SBA Financing for Sellers

  1.       More Cash at Closing:
  2.       More Buyers Qualify to Buy Your Business:
  3.       SBA Financed Businesses Sell Faster:
  4.       SBA Financed Businesses are More Likely to Sell:
  5.       Lower Seller Note and Lower Risk:

Comparing SBA Financed, Seller Financed and Non-Financed Business Acquisitions

For sake of a simple comparison and easy math below is an example of a buyer with approximately $150,000 to invest. Considering 3 businesses with different financing terms ranging from an all cash offer to SBA financing, as the buyer has a total of $150,000 to invest we will reserve $25,000 for working capital on the smaller examples and $50,000 for working capital on the larger examples :

 

Example 1:  Cash Offer, No SBA Financing, No Seller Financing

In this example the buyer is making an all cash offer of $125,000 with $25,000 reserved for working capital.

  • Purchase Price: $125,000
  • Down Payment: $125,000
  • Working Capital and other Costs: $25,000
  • Discretionary Earnings:  $62,500 (assuming Purchase Price or Value = 2 X Discretionary Earnings which is typical for a small business)
  • Cash on Cash Return: 50% (seems impressive, but read on…)

Example 2:  50% Down Payment with 50% Seller Note

In this example the buyer is making an offer with a 50% down payment of $125,000 and a Seller Note of $125,000 (50% of transaction value) at 8% over 60 months (typical Seller Note terms).  

  • Purchase Price: $250,000
  • Down Payment: $125,000
  • Working Capital and other Costs: $25,000
  • Seller Note Annual Debt Service:  $30,414 ($125,000 Seller Note, 8%, 60 months)
  • Discretionary Earnings:  $125,000 (assuming Purchase Price or Value = 2 X Discretionary Earnings which is typical for a small business)
  • Net After Debt Service:  $94,585
  • Cash on Cash Return aka ROE:  76%

Example 3:  10% Buyer Down Payment, 90% SBA financing and No Seller Financing

This is where it gets interesting!  By leveraging their down payment the buyer can buy a much larger business with substantially higher earnings.  In this example the buyer has a down payment of $100,000, with $50,000 set aside for working capital (an increase of $25,000), and SBA financing for 90% of the transaction value for a total acquisition value of $1,000,000.

  • Purchase Price: $1,000,000
  • Down Payment: $100,000
  • Working Capital and other Costs: $50,000
  • SBA Loan Annual Debt Service:  $$131,034 ($900,00 SBA loan, 8%, 120 months, current rates as of Nov 2018)
  • Discretionary Earnings:  $400,000 (assuming Purchase Price or Value = 2.5 X Discretionary Earnings which is typical for a  business of this size)
  • Net After Debt Service:  $268,966
  • Cash on Cash Return aka ROE:  269%

Example 4: 10% Buyer Down Payment and a Seller Note of 10% of Transaction Value

In some cases the bank underwriter may require a small seller note with the SBA loan, likewise sometimes the buyer may ask for a seller note as part of their offer.  In this example the buyer has a down payment of $100,000, with a seller note of $100,000, and an SBA loan of $800,000.

  • Purchase Price: $1,000,000
  • Down Payment: $100,000
  • SBA Loan Annual Debt Service:  $116,474 ($800,00 SBA loan, 8%, 120 months, current rates as of Nov 2018)
  • Seller Note Annual Debt Service:  $24,332 ($100,000 Seller Note, 8%, 60 months)
  • Total Annual Debt Service:  $140,806
  • Working Capital and other Costs: $50,000
  • Discretionary Earnings:  $400,000 (assuming Purchase Price or Value = 2.5 X Discretionary Earnings which is typical for a  business of this size)
  • Net After Debt Service:  $259,194
  • Cash on Cash Return aka ROE:  259%

Example 5: 10% Buyer Down Payment with A/R Financed

Financing the A/R with the purchase of the business is a good deal for the buyer and the seller.  The buyer obtains working capital through the purchase and financing of the A/R and the seller increases his cash at closing.  Underestimating the required working capital or not even considering working capital until very late in the transaction is a common mistake by buyers.  By financing the A/R buyers reduce the working capital they need to bring into the business and preserve their cash. For this example we kept the working capital reserve at $50,000 plus the A/R to keep the down payment the same as example 3 and 4.  

  •  Purchase Price: $1,075,000 (includes $75,000 of A/R plus purchase price of $1,000,000)
  • Down Payment: $107,500
  • SBA Loan Annual Debt Service:  $967,500 ($967,500 SBA loan, 8%, 120 months, current rates as of Nov 2018)
  • Total Annual Debt Service:  $140,861
  • Working Capital and other Costs: $50,000 plus A/R purchased of $75,000
  • Discretionary Earnings:  $400,000 (assuming Purchase Price or Value = 2.5 X Discretionary Earnings which is typical for a  business of this size)
  • Net After Debt Service:  $259,138 (note that the Net After Debt Service is almost the same as the previous example and in this example the buyer has an additional $75,000 of working capital)
  • Cash on Cash Return aka ROE:  241%

As you can see, SBA financing really is advantages and a great deal for buyers and sellers.  Sellers get more cash at closing and buyers can leverage their down payment to buy a much larger business increasing their Net After Debt Service Earnings and their Cash on Cash Return (ROE).  

Contact us for information on SBA financing with the sale of your business or purchase of a business.    

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Will Increased Interest Rates Affect Business Values?

Category: Buying a Business Selling Your Business 

With interest rates rising recently business buyers and sellers may wonder, “Will increased interest rates affect the value of a business being sold?” Spoiler… small changes in interest rates do not dramatically affect the value of a business or the net after debt service.  In fact, a 0.25% interest rate increase only increase the annual debt service by roughly $3,000 per year on a $1 million transaction.

While rates have risen from a recent low of 3.25% in 2008 to 5.25% in October 2018, these are far from what would be considered high rates and are actually approaching normal rates in a healthy economy. The all time high Prime Rate was a whopping 21.5% in December 1980 and the all time low rate was 1.75% in 1947, in May of 2000 the rate was 9.5% and it was generally between 4% and 8% throughout the 2000’s, until is was dropped after the recession.

US Historical Prime RateIn theory, as the cost of capital increases the value of a business or income property (such as commercial real estate and investment properties) will decrease. This is because the increased debt service expense reduces the net income and therefore reduces the amount a buyer would pay for the business or property.

The economic theory behind this is sound, and this tends to be the case with investment properties, but it does not always hold absolutely true. In the Orange County and Los Angeles commercial real estate markets prices have continued to increase steadily in spite of recent interest rate hikes. Likewise, business values have not been affected by recent increases in the prime rate and SBA loan rates. So why is this?

Business value multiples have generally stayed the same as interest rates have gone up and down. Business values are driven more by earnings than the cost of capital. In fact, the cost of capital is a minor factor in most business acquisitions as long is interest rates are in the historically normal ranges. The ultra low rates after the recession of 2007/2008 did not increase business values and now that rates are increasing to normal levels they are not decreasing the value of businesses. It is true that business values did drop after the 2007/2008 recession, but this was a result of decreased earnings, the multiples remained largely the same.

For commercial real estate and investment properties in Southern California prices have continued to increase as a result of high demand and a strong economy in Orange County and Los Angeles.

What is the Effect of a 0.25% Interest Rate Increase on Net Income?

Let’s look at some hard numbers as an example to illustrate why small changes in the Prime Rate and subsequently the SBA lending rate have a minor affect on business value.

Let’s say Steve Smith is considering buying a business for $1,000,000. For this example we’ll assume the business has Discretionary Earnings (DE) of $300,000 which would put the multiple at 2.85X DE (note this is a typical multiple for this size business depending on the industry).

The maximum SBA rate is Prime Plus 2.75%, so we will use the max rate for these examples. We’ll use the SBA minimum down payment of 10%, or $100,000 for maximum leverage which will show the maximum effect of interest rates.

If Steve was considering buying this business in June of 2017, the Prime Rate was 4.25% and the max SBA rate was 7%. The annual debt service would be $125,397 and the net after debt service would be $224,603. That’s a nice return on $100,000 down!

Let’s see how that same business acquisition would look in December 2017 with the Prime rate at 4.5% and the max SBA rate at 7.25%. The annual debt service would be $126,793 – an increase of $1,396 per year, and the net after debt service would be $2223,07. Still a very a nice return on $100,000 down!

So how does it look today with a Prime Rate of 5.25% as of October 2018 and a max SBA rate of 8.0%? The annual debt service would be $133,034 – an increase of $7,637 per year from the June 2017 rates, and the net after debt service would be $216,966. Again a very a nice return on just $100,000 down and this deal still makes sense.

June 2017Dec 2017June 2018Oct 2018
Acquisition Price$1,000,000$1,000,000$1,000,000$1,000,000
Discretionary Earnings$350,000$350,000$350,000$350,000
Down Payment $$100,000$100,000$100,000$100,000
Down Payment %10%10%10%10%
$ Financed$900,000$900,000$900,000$900,000
Prime Rate4.25%4.5%5%5.25%
Max SBA Rate7.0%7.25%7.75%8.0
Loan Term10 years10 years10 years10 years
Annual Debt Service$125,397$126,793$129,611$133,034
Net After Debt Service$224,603$223,207$220,389$216,966
Additional Annual
Debt Service Cost 
over June 2017
$0$1,396$4,214$7,637

At Pacific Business Sales we are experts in transactions with SBA financing and most of our transactions use SBA financing. We have excellent relationships with several SBA PLP (Preferred Lender Program) banks and as your Business Broker we will present your business to our preferred SBA lenders to get a preliminary approval (subject to buyer qualifying). If you are a buyer you can be confident that the SBA financing shown in our Confidential Business Review has been reviewed and approved by our SBA lenders.

How to Determine the Value of a Business

Category: Business Valuation Buying a Business Selling Your Business 

What is the value of my business?  This is the first and foremost question on the mind of business buyers and sellers. Business owners that are either considering selling their business or preparing to sell their business need to know what a realistic market value is for their business. Buyers face the same question when they are searching for and considering businesses for sale; what is this business actually worth? Below we explain what a formal Business Valuation is, Market Value Reports, and how to obtain a good estimate of the market value of a business on your own.

Business market values are not as simple as residential real estate where you can go to Zillow or other websites and quickly see what similar homes in the area are selling for. First there are many different types of businesses-industries, and each is valued very differently. Secondly, business values are driven by earnings, so even businesses in the same industry will have very different values depending on their earnings.

Businesses are actually valued by very specific methodologies and there are a number of industry certifications for analysts trained and certified in Business Valuation. The most common professional designations for valuation analysts are CVA (Certified Valuation Analyst), ASA (Accredited Senior Appraiser), CBA (Certified Business Appraiser), and ABV (Accredited in Business Valuation). Many professional Business Brokers have had formal training in business valuation from organizations like CABB (California Association of Business Brokers) or the IBBA (International Business Broker Association) which offer a number of classes in recasting financial statements and business valuation.

A formal third party Business Valuation typically ranges from $2,500 to over $5,000 or even $10,000 depending on the purpose of the valuation. For example valuations for divorces or related to litigation are much more extensive and hence more expensive. Basic third party valuations for smaller businesses can be obtained for around $1,750. Most professional Business Brokers, including our firm, offer free Market Value Reports.

So what’s the difference between a “Market Value Report” and a formal third party  valuation? Many Market Value Reports are very basic and do not include an in depth review of the businesses financial statements. At Pacific Business Sales our Market Value Report is comprehensive. We recast the last 3 years financial statements following CABB and IBBA guidelines, use Peercomps business valuation software to obtain relevant comparable sales data, and use the Peercomps valuation software to calculate an accurate Market Value based the Market Data Approach (comps) and the Income Approach (discounted future cash flow model). This results in an accurate data driven business value.

A Simple Method to Determine the Value of a Business on Your Own

The simplest way to value a business is the Comparable Sales Method, also known as “comps”. Comparable Sales databases provide average sales values based on the industry type with average multiples of Discretionary Earnings,  revenue, and in some databases EBITDA (Earnings Before Interest Depreciation Taxes & Amortization). Chapter 11 of my book, “Own Your Future” explains how to value to a business with examples of using comps to estimate business values.

The concept for using comps is simple, select a similar industry, then select companies with similar revenue and earnings and use the earnings multiples to determine the value of your company. The obvious question is where do I get comps?

Business Brokers and analysts have access to professional databases that are not available to the public.  However, you can access a database of both for sale and sold Comps and run a basic valuation through BizBuySell.com for $19.95 to $59.95. While this is not a formal business valuation, it is a good tool for estimating the market value of a business and it is very simple to use. The BizBuySell.com business valuation tool is easy to use and also easy to obtain erroneous results as the database is not as accurate as others because while the data is from closed transactions it is broker provided figures.

BizBuySell Business Valuation Report
Peercomps offers a more comprehensive valuation tool which is used by business brokers and valuation analysts. The Peercomps database is from actual closed SBA financed transactions and the valuation data is from the actual independent business valuation prepared by a Certified Valuation Analyst. You can obtain a free comps report for your industry and a complete do it yourself valuation report for $99. This is a great deal for a valuation, but it is fairly complicated.

Peercomps Business Valuation - Comps

Steps to Calculate the Market Value of a Business

To get an accurate market value you must use the correct value for the company’s Discretionary Earnings and revenue. While revenue figures are easy to obtain, calculating the correct Discretionary Earnings is more complicated (see What is DE for more information). Simply put, Discretionary Earnings are the total economic benefit of owning the business. This includes the owner’s salary, health and life insurance, and other owner’s benefits such as travel & entertainment, auto expenses, and other personal expenses.

To calculate the DE start with the net profit on the tax returns and then add back the owner’s salary and benefits. It is important to ensure that all expenses are shown on the tax return (some may be shown on expense statements on the tax return or buried in general category). Expenses that are not tied to a line item on the tax return should not be added back.

  1. Tax Returns: You’ll need to have the last 3 years or Federal Tax Returns to calculate the DE for Peercomps. For a rough estimate you can use an estimated DE but remember, a small error on the DE will result in a big error on the estimated market value since this is multiplied by the DE Multiple.
  2. Calculate the DE (Discretionary Earnings).
  3. Comps: look up comparable sales for businesses in the same industry with similar revenue and earnings. It is very important that the industry, revenue and earnings are all similar to get reliable comparable sales figures and multiples. When selecting the comparable sales to use, remove any that have much higher or lower earnings than the company you are considering and use comps from businesses that are as close as possible to the company you are evaluating. Preferably you should have at least 5 or more comps.
  4. Apply DE and EBITDA Multiples: Use the DE and EBITDA multiples from your comps to multiply against the DE and EBITDA for the company you are considering.

For a Free Market Valuation of your business Contact Us.

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