Category: Selling Your Business
How to Value a Small Business Using Earnings Multiples
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 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
- In BizBuySell or Peercomps select the Industry-Business Type (e.g. Distribution, Restaurant, Manufacturing, Construction – note that you can select more specific business types)
- 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.
- 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).
- 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
- 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.
- Peercomps multiples include “normal” inventory and BizBuySell comps may or may not.
- 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
- Quality of Financial Data
- Quality of Product or Service
- Years Established
- Quality & Experience of Staff
- Infrastructure, Systems, Procedures
- 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
Preparing for Due Diligence on the Sale of 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.
- Buyer Due Diligence List: typically 3 to 5 days
- Due Diligence Materials Provided: typically 5 to 7 days
- Review of Due Diligence Materials: typically 10 to 14 days for small to midsize transactions, may be longer for larger or more complex transactions.
- 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.
- Seller Disclosure Statement (part of CABB Purchase Agreement).
- Business Tax Returns, last 3 years.
- Sales Tax Returns (if the Seller has a resale account).
- Bank statements (month by month), last 3 years and year to date.
- Last 3 years P&L statements.
- Balance Sheets for last year end and most recent month end.
- Sales by product or service type/category.
- Customer list (note in some cases this may be redacted for confidentiality).
- A/R and A/R aging report.A/P report.
- Employee list with roles and responsibilities.
- Payroll reports for last 2 or 3 years with W2s.
- Inventory and inventory reports.
- Workman’s Comp policy, mod rate, and claims report.
- General Liability policy.
- Current Lease.
- Equipment list.
- Buyer’s CPA may have additional items requested for review.
- 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.
- CPA or financial advisor representing the buyer if buyer opts to engage one.
- Seller’s CPA, accountant or bookkeeper to answer questions about financial statements.
- 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.
- Seller’s attorney if required such as in a Stock Sale to do the stock certificates and stock transactions.
- 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:
- Buyer Resume.
- Buyer Disclosure Statement (part of CABB Purchase Agreement)
- Buyer Personal Financial Statement (often a copy of their SBA loan application).
- Source of Funds.
- 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
Does a Bear Market Affect Business Values and Sales?
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.
SBA Loans; More Cash at Closing for Sellers, Higher ROI for Buyers
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
- Low Down Payment: SBA loans now offer down payments as low as 10% for qualifying buyers and businesses.
- 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.
- 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.
- 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).
- Enables Buyers to Consider a Wider Range of Businesses.
Advantages of SBA Financing for Sellers
- More Cash at Closing:
- More Buyers Qualify to Buy Your Business:
- SBA Financed Businesses Sell Faster:
- SBA Financed Businesses are More Likely to Sell:
- 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.
How to Minimize Taxes on the Sale of Your Business
As business brokers the first question on every prospective seller’s mind is “how much is my business worth”, immediately following that, the second question is “how can I minimize the taxes on the proceeds?” We are not CPAs, tax or financial advisors, but over the years we have developed relationships with some of the best CPAs and financial advisors in the business and along the way we have found what we consider to be the best tax strategy to minimize taxes on the sale of your business. That tax strategy is the Deferred Sales TrustTM.
First, let’s look at what happens if you do nothing and just sell your business. Depending on the structure of the sale of your business your taxes capital gains tax could be as low as 15% to 20% if the business is sold as a Stock Sale and if the business is sold as an Asset Sale a portion of the proceeds could be taxed as ordinary income (ouch!). Exactly how your proceeds will be taxed unfortunately is not a simple question and you will have to review this with your CPA or tax advisor to determine exactly what your taxes would be. Regardless, when you sell your business, you will be paying significant taxes unless you take action in advance and implement a tax strategy.
Now let’s look at what you can do to minimize the tax liability when you sell your business. Before we dig into what works, a word of caution, there are a number of “tax strategies” that have been created and the IRS has recently ruled that several are not legal or valid. For the sellers that used these now overruled strategies they are facing the full taxes on the sale of the business plus penalties and it is now too late to implement another tax structure. So it is critical that if you chose to use a tax strategy you review with your CPA or tax advisor. There are two tax strategies to minimize taxes on the sale of a business that have survived IRS scrutiny over the years, one is the Charitable Remainder Trust (aka CRT) and the other is the Deferred Sales TrustTM (DST). Our experience with the CRT is that it is complicated as well as expensive to implement and maintain. The DST on the other hand is more straightforward and much less expense to implement and maintain while offering the same tax savings. Here’s how the DST works.
The DST defers the proceeds of the sale of your business by putting the cash into a trust. Thus you do not pay taxes on the full amount of the sale and only pay taxes as the proceeds are taken out of the trust. You can choose how much you take out of the trust each year and the term of the trust to fit your needs. The structure of this is much like a Seller Note or Installment Sale where with the DST the seller transfers the assets of the business to the Trust before the close of escrow and the Trust issues a Note to the Seller for the purchase price of the business. The Buyer then purchases the business from the Trust and the cash is sent to the Trust (no taxable event has occurred for the Seller). The Seller has complete control of the funds in the Trust and can direct the financial advisor to structure the investments as they wish. The Seller can also determine how much cash is taken out of the Trust, the timeline for these payments and can change the payment schedule if they wish. Taxes are paid as the funds are taken out of the Trust.
The diagram below illustrates how the DST works.
We mentioned above that several tax strategies have recently been overruled by the IRS. The DST has been in use for nearly 20 years and in 2009 the IRS issued a Private Letter Ruling on the DST which validates this tax strategy.
For more information on the DST you can use our DST calculator to estimate tax savings on your own and request a complimentary analysis and consultation with the financial advisor we work with, James Peters at Grace Wealth Management.
For Deferred Sales Trust Information Contact us or James Peters
Grace Wealth Management
Pacific Business Sales, it’s Broker and Agents are not financial advisors and are not providing financial or tax advice in this informational blog. Before implementing any tax strategy or tax planning you should obtain the advice of your CPA or tax advisor.
Will Increased Interest Rates Affect Business Values?
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.
In 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 2017||Dec 2017||June 2018||Oct 2018|
|Down Payment $||$100,000||$100,000||$100,000||$100,000|
|Down Payment %||10%||10%||10%||10%|
|Max SBA Rate||7.0%||7.25%||7.75%||8.0|
|Loan Term||10 years||10 years||10 years||10 years|
|Annual Debt Service||$125,397||$126,793||$129,611||$133,034|
|Net After Debt Service||$224,603||$223,207||$220,389||$216,966|
Debt Service Cost
over June 2017
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
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.
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.
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.
- 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.
- Calculate the DE (Discretionary Earnings).
- 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.
- 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.
How Much Money Does a Small Business Make? What are Discretionary Earnings (DE)?
The burning question for buyers looking at prospective small businesses is “how much does this business make?”. This is actually the wrong question. The right question is how much does the owner make? One of the first steps in preparing to sell a business for a professional business broker is determining the Discretionary Earnings of the company.
If you just look at the net profit shown on the business tax returns for most small and midsize businesses it looks like they don’t make much money. What you are missing is the owner’s salary, benefits, and expenses that are run through the business in order to minimize their taxes. These expenses include the owner’s salary, 401K or other type of retirement plan, health and life insurance, auto expenses, travel and entertainment, etc. These expenses can be a significant amount of money, consequently the Discretionary Earnings for a business are always substantially higher than the net profit shown on the business tax returns.
One of the first questions to address is which financial statement to use, the P&L statement or tax returns? The Federal Tax returns are always used for business valuation purposes. The P&Ls are used for expense details and supporting documentation, but the tax returns are treated as the official and final financial statement for the business.
Adding Back Owner Benefits & Expenses (Addbacks)
What is a legitimate owner benefit-expense addback? The simple answer is any expense that is not a necessity for business operations. There is however a caveat to this, in order for an expense to be a legitimate addback it must also be shown on the business tax returns as an expense line item or be part of an expense line item. Expenses not shown on the tax return (e.g. on the P&L or claimed by the owner) would not be added back because these expenses are not being deducted from the business gross margin as an expense. In other words, these expenses didn’t happen from a tax return standpoint.
In addition to owner benefits and expenses there are other addbacks to calculate the DE for a business. These are Depreciation, Amortization, Interest and Taxes. These expense items aren’t “owner benefits” so why would these be added back? While Depreciation and Amortization are not actual owner expenses, they are what is called a “non-cash” expense. There were no checks or actual payments made to Depreciation or Amortization and in fact many small business P&Ls don’t show these expenses. These expenses are added to the tax return by the CPA to write off capital expenses like vehicles, equipment, franchise agreements, and other asset purchases over the life of the asset. For example, a vehicle purchased for $50,000 might be expensed through depreciation over 5 years resulting in a $10,000 per year depreciation expense.
Interest is clearly an actual business expense so why is that added back? While the current owner may have interest expense in the business, it will certainly be very different from the interest expense the buyer will have. So the DE calculation adds back interest to arrive at the business earnings with zero debt and the buyer can subtract their expected debt service (expense) from the DE to arrive at a net after debt service figure for the business.
Banks use this same methodology to calculate the net after debt service earnings of a business for SBA financing.
Common Owner-Seller Addbacks to Calculate DE (Discretionary Earnings)
Below are the common expenses added back to the tax return net profit to arrive at the DE for business.
- Interest Expenses (see explanation above)
- Depreciation (see explanation above)
- Amortization (see explanation above)
- Officer’s Salary (if it is the owner’s salary)
- Family member salary-wages
- Health & Life Insurance (owners)
- Pension & 401K (owners)
- Travel & Entertainment (if not business essential)
- Auto Expenses (owner’s personal vehicles)
- Other Common Expenses where Owners may have Expenses:
- Office Supplies
- COGS (Cost of Goods Sold) – some owners run expenses through this category. While the expenses may be valid, many banks question expenses in this category and you will need receipts that clearly show these are non-business expenses.
- Misccelaneous Expenses
- Legal & Professional
What’s the Difference Between EBITDA and DE?
EBITDA (Earnings Before Interest Taxes Depreciation & Amortization) is a common financial term and more commonly known than DE. EBITDA is most commonly used for businesses with at least $5 million to $10 million in sales and above. While it is a good metric for larger businesses, it does not include add backs for owner’s benefits which can be substantial. Thus, if EBITDA is used for a small business the figure would be significantly understated which is why DE is the preferred earnings figure for small businesses.
EBITDA is used on mid-sized businesses in some cases such as when the business is managed by a full time manager. If you use EBITDA to calculate the value of a small business you add back any owner salaries and benefits. This is referred to as an Adjusted EBITDA by valuation analysts.
Working with a Business Broker
When a buyer is looking at businesses for sale the business broker will have prepared a Confidential Business Review which will include a calculation of the Discretionary Earnings based on the Seller’s tax returns and stated owner’s benefits and expenses. After your offer is accepted you will have the opportunity to verify the DE by reviewing the Seller’s tax returns, expenses, bank statements, invoices, etc during Due Diligence.
Business Buyer & Seller Demographics, Who’s Buying & Selling Businesses
In 2017 the number of businesses being sold increased 27% over 2016 according to Bizbuysell. Who is buying businesses today and what can a seller expect when a buyer is considering making an offer?
The buyers of today are on average younger, ethnically diverse, intellectually savvy and are willing to pay for the value of a business or what the business is worth if they can be shown how the value makes sense. In other words, today’s business buyers are smart and well informed.
Working with a business broker in today’s market places sellers of small business at an advantage. A professional business broker will perform a free business market valuation for your business based on your financial statements combined with comparable sales data (comps) to arrive at a market value that maximizes the sellers proceeds and at the same time demonstrates to a buyer the value of your business.
Being able to navigate today’s buyer pool is important. The buyers are inquisitive, cautious of the value they are receiving for their investment, and asking more questions in regards to the integrity of the finances, operation, customer base, equipment, staffing and market position of the business. A seller can expect to have many questions asked before an offer is made. A good business broker is prepared to answer the questions building a relationship and trust with an interested buyer and at the same time arrive at an optimum offer for both buyers and sellers that will achieve the sellers goals and provide the buyer with a good fit for future success.
The majority of buyers are leveraging the investment they are making, very rarely will a buyer offer all cash. Seller financing is one way to achieve that goal however, SBA financing allows a seller to cash out and offers better terms for the buyer than a seller can provide. Business brokers that have relationships with SBA lenders and are familiar with SBA financing are an advantage to both the buyer and seller. Having the business approved by an SBA lender makes your business more marketable as a result of the low down payment with an SBA loan and 10 year financing.
Today’s buyers are educated and motivated, sellers definitely have a strategic advantage navigating the diverse landscape of today’s market with the knowledge and expertise of a professional business broker.
At Pacific Business Sales we know how to market your business to today’s buyers, contact us for a Free Market Valuation for your business and no obligation meeting to discuss the prospective sale of your business.
Do Yelp and Google Reviews Affect the Value of a Business?
The importance of good Yelp and Google My Business reviews for a business, especially a retail business, is common knowledge; but do reviews affect the value or marketability of a business? Do reviews affect the value and marketability of non-retail businesses such as service businesses, industrial, construction or manufacturing?
As Business Brokers we are very familiar with the value of good reviews on a business and the impact of negative reviews. While Yelp and Google reviews do not directly add value to a business, negative reviews can certainly hurt the marketability of a business and consequently reduce the value. A buyer considering a particular business will almost certainly at some point do a Google search about the business and check the Yelp and Google My Business reviews for that business. Positive reviews are reassuring that the business has a good reputation and is well run. A few negative reviews, especially those detailing a negative experience with the company can be extremely harmful and even cause a prospective buyer to drop that business from consideration.
How to Get Positive Yelp and Google My Business Reviews for Your Business
- Ask customers for a positive review at the conclusion of each sale or project.
- Don’t be shy, ask for a 5 Star review.
- Send them an email with a link directly to your Yelp and Google My Business page. Make it easy for them to give you a review, they won’t search for it on their own.
- Follow up in a few days or a week if they haven’t responded, people are busy and while they may intend to give you a review, your email request may get buried in their inbox and they will forget about it.
- If your customer is a business, give them a positive review first, they are more likely to reciprocate if you do.
How to Get Rid of Negative Reviews or Reduce the Impact of Negative Reviews
- False of fake reviews can be removed, but it is difficult to do. Contact Yelp or Google and let them know why it is a false review, such as wrong business, or not actually a customer. Even in doing this and providing details it is difficult to get reviews removed.
- If the review is untrue you can take them to small claims court or have your attorney send them a letter demanding that the false statement be corrected.
We had one client that was very proactive about this and when a false review was posted he took them to small claims court for defamation with his evidence of the work provided. He had an excellent track record of winning.
- If the negative review is from an actual customer, contact them to see if you can solve the problem and then ask if they will give you a positive review. Some will actually give you a positive review for taking the time to contact them and fix the problem.
Often fixing the problem is sufficient, we had one client that offered a token refund or discount and this often worked. His attitude was that it was worth it to preserve his 5 Star rating.
- There are angry people that just cannot be satisfied. If you are unfortunate enough to have a customer like this leave a negative review, and they will not likely remove or change it,then you are likely stuck with it. The only option in this situation is to flood your page with more positive reviews. See above – How to Get Positive Reviews.
It is difficult to have a perfect 5 star record so the best approach is to be to proactive, always ask good customers for a review, and obtain as many 5 Star reviews as possible.