THE ULTIMATE GUIDE

HOW TO VALUE A COMPANY

 

The Ultimate Guide on How to Value a Company

If you had to sell your business today, would you know what your company is worth or how you would value the business? In this guide you will learn how a company is valued, how to determine the amount of money you need to sell your company for in order to maintain your lifestyle and how to calculate your net proceeds if you sold the business (the amount of ACTUAL money you put in the bank).

Whether you want to sell your business today or in 5 years, this guide is for you.

You’ve likely heard it’s a seller’s market. Business valuations are at (or close to) all time highs. No doubt, as an entrepreneur, you feel a tremendous attachment to the company that you’ve nurtured and grown. However, in the current environment, it’s perfectly reasonable to think about what a sale of that business would mean to you and to your lifestyle.

It’s common, and understandable, to be confused on how much your company is worth and what someone would actually pay for the business. You probably hear stories from buddies who have sold, or knew someone that sold, at the golf course, in your local CEO Peer group, or at the bar etc. Usually, it is either someone got a ridiculous price for their business or the exit was a total disaster.

How much is your company worth?

If you went out to the web and did your own research on recent mergers and acquisitions, you’ll likely find similar results; some businesses sell for huge sums of money while others, despite generating more sales or profit, sell for close to nothing.

This guide will provide you with the information and tools to figure out what your business is worth and develop a deep understanding on how to value a company, whether as a multiple of trailing revenue or EBITDA (or a different metric that is more typical for your industry)? More importantly, you’ll learn which numbers matter most in order to stay in maximize your take home dollars at your exit. 

Our goal is simply to make sure you understand the critical metrics and terms related to a sale of your business well before you sell.

The are 5 Chapters to this Guide:

  1. Chapter 1 – Know Your Numbers. Learn all the numbers inside your business that are important to know and measure before you sell the company.
  2. Chapter 2 – How to Value a Business. Learn different methods on how companies are valued.
  3. Chapter 3 – Structuring the Sale of Your Business
  4. Chapter 4Calculating net proceeds on the sale of your business
  5. Chapter 5 – How Much You Should Sell Your Business for. How to determine if your net worth after the sale can support you through the rest of your life.

 

Chapter #1 – Know Your Numbers

Key Takeaways for this Section

  • ✔ Understanding EBITDA
  • ✔ Calculating and normalizing EBITDA
  • ✔ Understanding seller’s discretionary earnings (SDE)
  • ✔ EBITDA, SDE and other important numbers can be negotiated in a sale (if you have solid understanding of, and have trustworthy numbers)

There are plenty of variables that impact and drive a business valuation, however when it comes to the financials, there are a few core figures that need to be readily accessible and VERY accurate when selling a company.

Important Business Numbers to Know

  • Earnings Before Interest Taxes Depreciation & Amortization [EBITDA]
  • “Normalized” or “Adjusted” EBITDA
  • Seller’s Discretionary Earnings [SDE]
  • Goodwill

As business owners, you may already be familiar with some of these terms.

However, even if you are used to finding and reviewing these numbers, when you are selling a business they need to be able to withstand the highest level of scrutiny.

Make sure you fully understand these terms because they are the foundation of what we’ll be using to understand the value of your business.Business valuation multiple of EBITDA, Sellers discretionary earnings, business valuation

 

EBITDA

Most valuation methods start with EBITDA, or “earnings before interest, taxes, depreciation, and amortization”. EBITDA is a non-GAAP metric, but is, nevertheless, commonly used as a measurement of profitability.

Why EBITDA? Why not just look at net income at the bottom of a P&L statement?

Net income is profit earned by your business after all cash and non-cash expenses are paid, including operating costs, taxes, interest, depreciation and amortization. While operating costs are, of course, directly related to your operating performance, taxes and interest fall into the financial realm, and depreciation and amortization are non-cash costs, so don’t impact cashflow. As a result, EBITDA is typically seen as a better measure of your business’s operating performance and cash flow.

Let’s go into a bit more detail to illustrate the point:

  1. You’re growing rapidly, and have tapped into an expensive line of credit to fund growth. You’re paying 7%+ in interest, and that’s reflected in your business’s net profit. A hypothetical alternate owner, however, might have cash or a less expensive source of debt to fund working capital. Netting out interest payments provides a clearer snapshot of your business’s profitability under different ownership.
  2. Taxes also may vary under different ownership. Companies have different marginal tax rates depending on size and other factors. Netting out tax payments from your bottom line helps to reveal the underlying profitability of your business.
  3. Depreciation and amortization are non-cash costs that spread capital expenditures over the useful lifespan of the item acquired. (As a business owner, you’re likely familiar with these non-cash entries.)
    • Depreciation is for tangibles, like vehicles or buildings.
    • Amortization is for intangibles, like patents or trademarks.

Items that are being depreciated or amortized were paid for in the past, and so the subsequent accounting non-cash entries that impact your net income do NOT have any impact on your current cash flow. Netting out depreciation and amortization provides a better snapshot of your business’s cashflow.

In a nutshell, EBITDA excludes non-cash deductions, interest and tax payments, for a better measure of your operating profitability and cashflow.

Recasting Business Financials and ‘Normalizing’ Your EBITDA

When you sell your company, you will likely hear the term normalized EBITDA from the Investment Banker, CPA and potential buyer.

Normalizing” EBITDA is an adjustment to accounting entries that overstate or understate a company’s operating EBITDA (or free cash flow / profits).

Why does this matter to you?

In most business sale transactions, purchase price is driven by a multiple of EBITDA. The higher the number that is used as the multiplier or the higher the EBITDA, the more money the company is worth.

The buyer will want to ensure that EBITDA is not artificially inflated (overstated), and it’s in your interests, as a seller, to ensure that EBITDA is as HIGH as it possibly can be.

The best way to illustrate this is through a few examples.

Inflating and Overstating EBITDA

normalized ebitda, recasting ebitda,

Business owners might have:

  • Paid themselves salaries that are below market levels, thus having a HIGHER EBITDA because they were understating personnel expenses and overstating operating margin.
  • Adjustment: Owner/officers’ salaries are increased to a market rate and therefore resulting in a lower EBITDA.
  • Spinoff a non-core business unit and booked the sale profits as “other operating income” resulting in higher EBITDA because of a one time event.
  • Adjustment: The entry for “other operating income” from the sale of a non-core asset is classified as a 1 time event and removed from the EBITDA into a non-recurring (non-operational) entry, resulting in a lower EBITDA.
  • Removing company events and expenses that ARE necessary to running the business, example: removal of the annual client event that costs $20,000 but IS necessary to keep clients, resulting in a higher EBITDA.
  • Adjustment: The $20,000 would need to be added to the expenses of the business resulting in a lower EBITDA.

IF YOU ARTIFICIALLY INCREASE YOUR EBITDA THERE IS A CHANCE THE BUYER WON’T TRUST YOU AND YOU’LL SACRIFICE THE SALE!

Artificially Reducing or Understating EBITDA

how to increase your EBITDA and increase the value of your business

The owners might have:

  • Included family members on the company payroll who don’t really contribute to the business, resulting in a lower EBITDA.
  • Adjustment: Salaries paid to non-contributing family members are added back into EBITDA resulting in a higher number.
  • Owner paid themselves above-market salaries or bonuses resulting resulting in a lower EBITDA.
  • Adjustment: Owner compensation is reduced to market rates making the EBITD higher than it was before.
  • Expensed car leases, insurance, or other lifestyle related charges that are not essential to the company’s operations and will not be recurring after the business has changed ownership.
  • Adjustment: These expenses are added back into the EBITDA – adjusting the number to reflect what the business actually requires on a recurring basis, resulting in a higher EBITDA.

IF YOU DON’T ADD BACK ITEMS THAT AREN’T NECESSARY OR NONRECURRING YOU’RE LEAVING MONEY ON THE TABLE!

After making these adjustments, a “normalized” EBITDA figure is calculated, which may be more or less than the originally stated EBTIDA.

Once the agreed upon normalized EBITDA is available, the multiple (number of years of income the buyer is willing to pay in advance for your business) is multiplied by the EBITDA, resulting in a business valuation (more to come below).

Smart, sophisticated buyers and sellers use EBITDA to move the company valuation in a direction that best suites them. The more you know and understand how to calculate EBITDA, the better chance you have to guide the negotiation when valuing your business.

Growth & Exit Planning Rules for EBITDA

  • There’s a science, but no right answer to normalized EBITDA … it’s a negotiation.
  • Different buyers and sellers are likely to calculate normalized EBITDA differently, depending on why they are buying the company and what they need going forward.
  • Preparation and organization is key. If you know your numbers you can listen carefully and be ready to negotiate.

 

Seller’s Discretionary Earnings

You may come across the term Seller’s Discretionary Earnings (“SDE”) when talking about buying and selling companies. SDE helps determine how much free cash flow a company has. SDE is commonly used as a valuation metric in the online business space (eCommerce, SaaS and other content sites) however, it is less commonly used in the main street and middle market where EBITDA is predominate as a valuation metric. SDE is very similar to Normalized EBITDA. While your business is much more likely to be valued on EBITDA (or Normalized EBITDA), we wanted to make sure you were aware of the term. For practical purposes, think of SDE as being similar to Normalized EBITDA.

Goodwill

Goodwill is the additional value (or price) applied to the purchase price of a business. It is usually intangible assets that appear on the business buyer’s balance sheet after they purchase a business for a price that exceeds its book value. Goodwill is also sometimes known or referred to as “Blue Sky”.

Goodwill and the value of your brand, goodwill and selling a company

Book value refers to the assets minus the liabilities on the company’s balance sheet. When a buyer pays a price that’s higher than book value, he or she sees additional value beyond that company’s net assets, as reflected on its balance sheet (brand equity, employee relationships, culture, processes, good customer relations, PR, patents, IP, etc.).That additional value is called goodwill.

Here is an example of how Goodwill is used when selling a company:

Susan wants to purchase Jim’s roofing company.

  • The roofing company has $10 million of assets—cash, accounts receivable, vehicles, equipment, buildings, and land;
  • It also has $2 million of liabilities—accounts payable, an operating line, and a term loan;
  • So the book value of the company is $8 million.

But Susan is excited because Jim’s company is quite profitable, and she believes that:

  • She will be able to use her own connections to expedite the growth of the company;
  • The company is already locked in with the best general contractors in the city, and has a stellar reputation; and
  • The propriety technique that Jim’s company has developed to apply sealant to roofing materials is second to none.

Based on the value that she sees in the company, Susan offers Jim a purchase price of $10 million, or $2 million over book value. (We will be covering the valuation process in the next section.)

The $2 million difference between book value and sale price represents the goodwill.

Growth & Exit Planning Rules for Goodwill

  • Goodwill is not a physical asset, but does have value.
  • The value of a company’s brand name or reputation
  • A strong customer base
  • Good customer or employee relationships
  • Patents, proprietary technology or trade secrets

Chapter #2 – How to Value a Business

Key Takeaways for this Section

  • ✔ Your company is worth what a buyer is willing to pay
  • ✔ Formal vs. informal valuations
  • ✔ Market value vs. owner separation value
  • ✔ The impact of a buyer’s perceived risk
  • ✔ Different methods to value a company
  • ✔ Valuation multiples depend on your industry and the type of buyer

There are many different ways to value a business, and different approaches have different outcomes. Why is that the case?

Calculating the value of a business is more or an art than science. It all depends on why the business is getting valued. A business is worth what a buyer is willing to pay, period. However, a business might need to be valued because of a divorce, buy/sell agreement, internal buyout, estate plan and many other reasons where there is no 3rd party buying it as an investment.

Here is an episode of the Life After Business Podcast on business valuations

 

Some key takeaways about business valuations:

  • Some valuations are formal (certified by a licensed business valuator), others are informal (based on pure opinion and experience)
  • There are different reasons for requesting a business valuation other than for a sale of business. Other scenarios requiring a professional valuation might include divorce, estate planning, partnership disputes or some types of loan applications;
  • A valuation of your business will often be driven by the perspective of fair market value (FMV) of potential buyers. Different buyers will have different perspectives.

Certified Business Valuation vs. Informal Business Valuation

fair market value of a business, how to value a busienss

Certified Business Valuation:

  • Conducted by a professional called a Certified Valuation Analyst (CVA) with experience in valuations and has the resources that comes with the designation. This usually includes software that compiles comparable businesses that have had a transaction along with financial models and calculators that are used by the professionals to help get to a “Fair Market Value” price.
  • Legally binding (but can be challenged in court)
  • Necessary for estate planning, the IRS and tax returns;
  • Determines Fair Market Value (FMV) of a business;
  • Expensive and can range from $2,500 – $20,000 depending on who you come across
  • Often required for events like buy/sell agreements, divorce or partnership disputes, or certain types of bank loans like an SBA;
  • Typically NOT indicative of what a buyer will pay for your business in a competitive sale process.

Informal Business Valuation:

  • Less complicated and can usually come from anyone experienced in Mergers and Acquisitions that has exposure to the market and clean financials from the business;
  • Not legally binding and can’t be used for the IRS in an estate plan or for an SBA loan.
  • Provides insight into your business and provides a great benchmark to what it’s fair market value is and what might need to be changed so you can increase the business’s value before you sell.
  • You can ask GEXP Collaborative or access our online business valuation tool HERE.

 

What is the Fair Market Value of a Business?

Fair Market Value (FMV) is the price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arms length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.(International Glossary of Business Valuation Terms)

Fair Market Value is often what you hear when someone is referring to what the market is willing to pay for a business. One factor that goes into FMV is looking at other similarly situated companies in the market (called “comps”), and comparing the acquisition price as a multiple of EBITDA or another metric. This is analogous to your real estate agent making market comparisons to determine the listed price of your house when you sell.

The purpose of a valuation is to realistically predict what you can ultimately expect to receive from a buyer. However, the market will always be the final judge on what your company’s worth.

On the other hand, while someone may be willing to pay FMV for your business, it may not be smart for you to sell for that amount. The FMV might be too low to fit with your post-sale financial goals and objectives. Or perhaps you feel confident that your company is about to embark on a period of rapid growth, which isn’t necessarily reflected in today’s FMV.

In some cases, the sale price may be higher than fair market value. Why would a buyer pay that premium?

A business buyer might pay a premium:

  • To increase speed to market for a product, service or geographical location
  • Opportunities to cross sell
  • To prevent a competitor from buying the company
  • Because they expect to grow the business faster by integrating it with their existing operations;
  • Because they want to roll-up all the participants in the market and then benefit from their new pricing power.

There are a lot of reasons a strategic buyer might pay more than FMV however, it’s difficult to know what your strategic value is until there is a deal done and money transferred. Therefore, you need to have a benchmark on what your company COULD be worth that the best way to do that is through a business valuation.

Listen to this episode of the Life After Business podcast to hear from a Private Equity firm and how they value businesses.

While business owners often do overestimate their business’s fair market value, it’s important to remember that a valuation isn’t set in stone. It’s simply an estimate of what the market is willing to pay you, usually calculated on your financials.

Different buyers will perceive value differently, depending on the benefit that will accrue to them from the acquisition. If you want to dive more into the different types of business buyers check and how they value a company different, check out The Ultimate Guide to Your Internal Exit Options or The Ultimate Guide to Your 3rd Party Exit Options.

In addition, rather than selling at today’s fair market value, taking the time to improve your business’s profitability or implementing an effective growth strategy can yield a significantly higher valuation down the road.

Different Methods to Value a Company

There are several different methods to value a business, depending on the buyer and the industry. Your advisor can run a few different scenarios and see how close or far apart the results of each of these methods are.

How to value a business, different ways to value a business

1.) Equity Valuation

  • Asset-based method. This fair market value conclusion is the value of the company available to its owners or shareholders and incorporates all of the assets included in the “asset value” plus the firmȉs liquid financial assets (cash, A/R, deposits, etc.) and minus its liabilities, (ST and LT). *from BizEquity’s Valuation report – if you want a business valuation get access to the online report HERE
  • This method does not take into account premiums or discounts justifiable for a growing or declining business.
  • Essentially this is a balance sheet valuation. The Goodwill assigned to the valuation is going to be the biggest variable above and beyond the equity in the business.

2.) Discounted Cash Flow (“DCF”)

  • Earnings-based method
  • Projects the target company’s future cash flow, and then discounts it by:
    1. Buyer’s cost of capital (for example, their bank interest if they are borrowing to buy the business); and,
    2. Some level of estimated risk for the company.
  • Discounted future cash flow is the present value of the business.
  • DCF takes into account the time-value of money, for example, $100 today is worth more than $100 three years from now.

3.) Strategic Buyers – Return on Investment (“ROI”)

  • More likely used by strategic buyers, this is an earnings-based method with a twist.
  • Includes an estimate of the incremental value a buyer can generate by combining the company with its own operations, leveraging synergies like:
    1. Cutting headcount and overhead by combining operations.
    2. Selling each company’s products/services to the other’s customers.
  • Being able to more rapidly launch new products/services because of the combination of both company’s capabilities.
  • The ROI method often generates the highest possible valuation, as it reflects an expectation of synergies, which is why strategic buyers are often willing to pay the highest price. (Don’t expect the acquiring company to show its hand, though.)

4.) Multiple of EBITDA

  • In simple terms, this is the number of years of earnings the buyer is willing to pay IN ADVANCE to acquire the company. The higher the multiple, the more years of earnings they are willing to pay upfront, or potentially over time. Higher multiples correlate with higher confidence that the business (and its earnings) will continue and grow over time.
  • This is a market-based method that makes a comparison to the multiple that similar companies in the market were valued at when they were sold.
  • The multiple is simply a number by which the company’s annual earnings are multiplied by to determine the company’s value. Earnings can be EBITDA, normalized EBITDA, or seller’s discretionary earnings.
  • The multiple depends on the industry and size of the business, as discussed below. This is the most common valuation methodology… more detail follows below.

What Impacts the Valuation of a Business

For most businesses, the fair market value will be calculated as a multiple of your EBITDA (or a multiple of your normalized EBTIDA or SDE). “Multiple” refers to the specific number that your EBITDA is multiplied by to reach a valuation. If a buyer is willing to pay a 5x multiple of your annual EBITDA, and your EBITDA is $4,000,000, then the buyer will pay 5 x $4,000,000 = $20,000,000.

Here are a few reason’s businesses can vary in valuations:

  • Industry sector is one of the most significant factor driving the multiple. For example, high-tech companies are much more scalable than factories, and CPA firms are much more difficult to transfer to a new buyer compared to manufacturing business.
  • Within the same sector, larger companies will get higher multiples than smaller ones, as their size is associated with higher confidence that they are more stable, and that their cash flow will continue to grow over time.
  • The economic climate in which the business operates is also a variable. Most companies struggle in a recession (although a few will thrive). In an economic downturn, confidence levels in those future years of profit will drop, and multiples tend to fall as well. For example, after the 2008 housing crisis, home construction industry multiples plummeted.
  • The more asset-heavy a company is – think trucks, planes or plants – the more likely it is to get a lower EBITDA multiple.

If you want understand more about what drives the valuations you can take The Value Builder System™ survey HERE that gives you the results on how where you stand on the 8 key business value drivers.

 

Here are Some Common Valuation Ranges by Industry
(note that these are just historical averages)

Industry Industry Multiple by EBITDA Range
$0M - $1M $2M - $5M $5M - $10M
Manufacturing 4 5 6
Construction & Engineering 3.5 4.5 5.5
Consumer Goods & Services 4 5.5 5.8
Wholesale & Distribution 4.5 6 6
Business Services 4 5.3 7
Basic Materials & Energy 3.3 4 5
Healthcare & Biotech 5.5 6 7
IT 6.5 8 8
Financial Services 5.5 6.5 7
Media & Entertainment n/a 5.0 7
Average 4.5 5.6 6.5
Industry Industry Multiple by EBITDA Range
$0M - $1M
Manufacturing 4
Construction & Engineering 3.5
Consumer Goods & Services 4
Wholesale & Distribution 4.5
Business Services 4
Basic Materials & Energy 3.3
Healthcare & Biotech 5.5
IT 6.5
Financial Services 5.5
Media & Entertainment n/a
Average 4.5
Industry Industry Multiple by EBITDA Range
$2M - $5M
Manufacturing 5
Construction & Engineering 4.5
Consumer Goods & Services 5.5
Wholesale & Distribution 6
Business Services 5.3
Basic Materials & Energy 4
Healthcare & Biotech 6
IT 8
Financial Services 6.5
Media & Entertainment 5.0
Average 5.6
Industry Industry Multiple by EBITDA Range
$5M - $10M
Manufacturing 6
Construction & Engineering 5.5
Consumer Goods & Services 5.8
Wholesale & Distribution 6
Business Services 7
Basic Materials & Energy 5
Healthcare & Biotech 7
IT 8
Financial Services 7
Media & Entertainment 7
Average 6.5

Valuations Also Depend on the Type of Buyer

Digging a bit deeper, valuations will vary with the type of buyer involved, a spin on the old adage “beauty is in the eye of the beholder”. It’s critical to know the type of buyer you’re negotiating with. (For a more complete understanding, please refer to our Ultimate Guide to Knowing All Your Internal Exit Options and Ultimate Guide to Knowing All Your 3rd Party Exit Options.)

Some buyers are willing to pay the highest end of the multiple range, while others simply won’t. A buyer’s willingness to pay a higher or lower multiple depends on the value they see in your business, which is dependent on their perspective. If you get several offers for your company, the offer prices will likely be driven by different multiples.

Different Buyers will Pay Different Prices for the Same Business

  1. Strategic buyers will usually be willing to pay the highest price.
    • May have a specific business reason for wanting to purchase the company. Perhaps they are competitors, or the company presents an opportunity to get into a new line of business.
    • Often expect to realize synergistic cost savings and revenue growth by integrating the company into their existing business.
  2. ESOP (Employee Stock Ownership Plan) will usually be willing to pay the highest price.
    • May have a specific business reason for wanting to purchase the company. Perhaps they are competitors, or the company presents an opportunity to get into a new line of business.
    • Often expect to realize synergistic cost savings and revenue growth by integrating the company into their existing business.
  3. Financial buyers (Family Offices, Private Equity Firms, etc.) rank behind strategics in terms of the multiple they are willing to pay.
    • Primarily interested in how much money the business will return on their investment.
    • Care about your company’s return on equity, cash flow, and potential for leverage.
    • Interested in well-managed businesses.
    • Typically, are medium to long term investors like private equity
  4. Lifestyle buyers
    • Buyers looking for businesses to provide cash flow to fulfill their own cash flow needs and use the cash of the business to grow the value of the business for their personal gain
    • Usually, private individuals who have created sufficient wealth before, maybe with a previous business or a big inheritance.
    • Looking for a new business to diversify and allow enough free time to focus on other life pursuits.
  5. Management buyout occurs when one or more of the company’s current managers buy the business from the owner. Bids will likely be at the low end of the multiple range.
    • Owners may use this as a way to retire and hand the reins to people they trust to capably run the company.
    • Because the buyers are employees, they are usually not in the position to pay a higher multiple, even with the support of bank financing.
    • Often some of the purchase price will be financed by the seller – there is typically a high level of trust after years of working together.
  6. Family buyout / transition occurs when an owner sells to a family member, often a son or daughter.
    • Many times when a family member is the next successor, there are creative ways to reduce the value of the business in order to save significant taxes in the transfer. This will depend on the financial needs of the family member selling the business.
    • Another reason the multiple can be low is if the business is going to be purchased at FMV, the succeeding generation doesn’t have the accumulated wealth and has less borrowing ability from the bank.
    • The biggest two constraints are the small net worth of the second generation and the major reliance of the cash flow of the business to fund the transfer.

As a reminder, for a completely immersive dive into the different exit options and spectrum of potential buyers ,please refer to our Ultimate Guide to Knowing All Your Internal Exit Options and Ultimate Guide to Knowing All Your 3rd Party Exit Options.)

 

Look at Your Business from the Eye’s of a Potential Buyer

Risk ManagementBefore you can look at your business from the eyes of a buyer, you need to understand the relationship you have with your company. If you’re like most entrepreneurs, the parent/child metaphor is a great way to describe your relationship with your businesses.

The metaphor works – as a business owner, you’ve nurtured your company from the start, through good times and bad. You might be proud of working out of the basement for years, the HUGE account you landed that took your business to the next level or that vendor license agreement that was a game changer.

And like a parent, it’s often difficult to take an objective view of the company you’ve built over so many years.

But a prospective buyer will have a different perspective.

When you prepare for a sale of your business, it’s important to consider the buyer’s viewpoint. Potential business buyers care about very specific things: cash flow, future potential, opportunity…and risk.

Before laying out hard-earned (or hard-borrowed) cash to acquire your business, they will assess the magnitude and types of risk exposure inherent in the acquisition. This risk assessment, and the risks that are identified, will impact the price that buyers are willing to pay.

 

Types of risks business buyers look for:

Upfront capital risk.

  • What is the risk that the capital that is paid upfront will be paid back. Substantial money is at risk—usually more than the business makes in a year.
  • Should the business fail for some reason, the buyer—unlike the current owner—loses both the future income generated by the business and the upfront investment made to buy it.

Unknown event risk.

  • Buyers lack the intimate knowledge of the business that the seller has. What skeletons are in the closet? Lawsuits, unknown industry risk, employment issues, vendor issues, etc, etc… What are the risks that these events pop up and shut the business down or significantly lower the profits?
  • They lack the confidence in operations that the seller has after years of running the business.

Transferability risk.

  • Buyers can’t be sure how much of the business’s intangible value will be successfully transferred after the sale.
  • Will customers, suppliers and employees stay with the new owner(s)?
  • Will the company’s goodwill remain intact?
  • Will sales decline because a new owner simply doesn’t have the intimate knowledge of how to run things that the seller does?

Opportunity risk.

  • Buyers will compare the risk and return of buying a business against other uses of the same cash:
  • Investing the amount of the business’s purchase price in the public markets (index funds, etc.). For perspective, in 2017, the return on the NASDAQ composite index was about 28 percent.
  • Purchasing a different business – there are likely other potential acquisitions to consider.
  • Buyers may also evaluate the impact of investing the amount of the purchase price into their own operations to generate organic growth.

Growth & Exit Planning Rules on How to Value a Business

  • Your company will likely be valued based on some multiple of EBITDA (unless it’s a tech company).
  • The industry, size of company, and type of buyer will determine the multiple and the ultimate price you get.
  • There’s no one right answer to the question: “what is your business worth?”. But do your research so that you have a realistic figure in mind.

Chapter #3 – How to Structure the Sale of Your Business

 Key Takeaways for this Section

  • ✔ What’s the difference between a stock and asset sale?
  • ✔ Which structures do buyers and sellers usually prefer?
  • ✔ The Section 338(h)(10) Election

 

The 2 Ways to Structure the Sale of Your Business:

  1. Asset Sale – This is a sale of any of the assets that the buyer wants to purchase, both tangible and intangible (inventory, client lists,  contracts, employees, goodwill, etc.) The Buyer chooses what they want to purchase and leaves everything else they don’t want with the seller. The seller keeps the entity structure and whatever is left of the company and its assets AND LIABILITIES. Because the seller keeps the entity (the EIN number) all the liabilities stay with that entity.
  2. Stock Sale – This is the sale of the entire company, its assets and liabilities (the entity structure, EIN number and everything that comes with it). There is nothing left with the seller other than the payment for the business.

When you sell your business, the buyer will likely push for an asset sale. In fact, close to 95% of all small and mid-size businesses that are acquired are structured as an asset sale…. BUT BEWARE… that could be the worst thing for you the seller.

Why Do Business Buyers Usually Prefer an Asset Sale?

  • The buyer gets some HUGE tax benefits.By structuring the transaction as an asset sale, the buyer will receive an immediate benefit in the form of tax deductions. A stock sale does not provide this. They will be able to depreciate the assets acquired. This means they are able to write off the depreciation of the purchase against their income, overall netting them more money in the long run and increasing their return on investment.
  • All liabilities (including contingent liabilities related, for example, to litigation) do NOT transfer with the assets. They only have to take the assets that they desire.
  • None of the corporate structure comes with. They are able to put all the assets right into their platform and don’t have to deal with your corporate structure, tax landscape or legal issues.

Let’s look at an example. Sam doesn’t get his tax advisor’s input before buying a company. Instead of structuring his acquisition as an asset purchase, Sam acquires all the stock of Pet Food, Inc., for $10 million. On Pet Food’s balance sheet, the tax basis of the company’s assets is recorded as $3 million.

  1. Because Sam agreed to buy the company’s stock, under Section 1012 of the IRS code he will take a $10 million basis in Pet Food’s stock.
    • Stock has an indefinite useful life, so it can’t be depreciated or amortized.
    • Thus, Sam is stuck with the $10 million basis in the stock until he sells the shares, at which point the basis can offset the sale proceeds.
  2. Although Sam has a $10 million basis in Pet Food, the $3 million tax basis of its assets does not change because, on the transfer of shares, nothing changed inside the company.
    • Although Sam paid $10 million, only the remaining $3 million of the company’s tax basis can be depreciated.
    • Therefore, Sam gets no immediate tax benefit from his 10 million-dollar investment.
  3. If Sam had purchased the assets of the company, under Section 1012, a basis of $10 million would have been attributed to the acquired assets.
    • Under Section 1060, the purchase price can be allocated among the acquired hard assets, and any amount paid in excess of the value of hard assets is allocated to intangible assets like goodwill.
    • This is a “stepped-up” tax basis, because the buyer can immediately begin depreciating or amortizing the entire purchase price.

In addition to the tax benefit, acquiring a company’s assets is more favorable than a stock purchase because the buyer can be selective about the liabilities that are transferred. A buyer will have the flexibility to assume all, some or none of the company’s liabilities. In Sam’s case, however, because he now owns all the stock of Pet Food, Inc., any liabilities of the company that are known, unknown, or looming are now his problem. These could include:

  • Tax bills from the IRS, the headquarter’s state or other states.
  • Lawsuits or claims that apply to company activities prior to the sale.
  • Regulatory matters, penalties or fines.

An asset sale addresses this liability issue by allowing the buyer to pick and choose the assets and liabilities (if any) that become part of the deal. Additionally, with an asset sale, the buyer can decide:

  • What accounting measures and structure are used for the assets. With a stock sale, conversely, the company’s existing accounting treatment is typically retained for a certain period of time.
  • Whether to write off goodwill from the assets for tax benefit.

When Would a Seller Prefer an Asset Sale?

In most cases a stock sale—if possible to negotiate – is preferable from the seller’s standpoint. In certain circumstances, however, an asset sale may provide outcomes that are advantageous to the seller. Whether or not the seller perceives these as beneficial will depend on individual circumstances. These include:

  1. Selecting ONLY the assets they want to sell;
  2. Retaining the original corporate structure and stock:
  3. This may, in come cases, be useful from a tax standpoint; or
  4. If the buyer is planning to start a new business, they could do so within the existing corporate structure;
  5. Reducing some or all liabilities in the company;
  6. Allocating the proceeds of the sale to certain assets, which in some cases may help lower their tax burden.
  7. Providing fewer representations and warranties than they would in a stock sale, thus reducing their accountability after the sale is completed.

When Would a Buyer Prefer a Stock Sale?

Sometimes a buyer doesn’t want to buy a company in an asset sale because there are certain contracts that won’t continue afterwards. These could be customer, employee or licensing contracts that, in the event of an asset sale, will need to be re-assigned to the buyer with the consent of the other party to the contract. In a stock sale, the corporate entities transfer, and the buyer can typically obtain the selling company’s contracts without the consent of the other party to the contract. The buyer may not want to risk having to renegotiate or losing these contracts, in which case, a stock sale could be preferable. When this is the case, the buyer must preserve the separate legal existence of the target company so that the target’s key contracts remain intact.

Why Do Sellers Usually Prefer a Stock Sale?

It’s very rare that a stock deal occurs for small and mid-market companies. Close to 95 percent of acquisitions in this size range are asset deals. But if the seller can negotiate a stock sale, that is generally to their benefit:

  • From a tax standpoint, it’s going to offer a more favorable capital gains treatment;
  • From a liabilities standpoint, after a stock sale, the transfer of ownership of the corporate entity includes the transfer of all liabilities, known and contingent.

Growth & Exit Planning Rules on How to Structure the Sale

  • Know whether a stock or asset sale would be better for you.
  • If you’re selling, a stock sale is typically preferable.
  • If you’re buying, an asset sale is typically preferable. But there are exceptions.
  • Talk to your growth and exit planning advisor well before you launch your sales process to avoid making costly mistakes!

 

#4 Calculate Net Proceeds From Your Selling Your Business

Key Takeaways for this Section

  • ✔ Calculating net proceeds can be simple
  • ✔ Good tax planning translates into substantial savings
  • ✔ Consult an experienced advisor at an early stage to most effectively boost your net proceeds

The net cash proceeds from your sale is a critical number. Proceeds may be payable on closing or over time, but whatever the case, the amount you actually receive will have a significant impact on your lifetime cash flow. Expert tax planning is essential to minimize the (potentially large) impact that taxes will have on your proceeds of sale.

Calculating net proceeds:

Gross Proceeds from Sale – Tax – Debt = Net Proceeds

For a deep dive into understanding how much money you put in the bank after selling your business, listen to this podcast episode with an M&A CPA

Tools to Maximize Net Proceeds

A CPA or GEXP Collaborative Advisor with expertise in selling businesses can help you with tax planning. However, as in many cases, all advisors are NOT equal. Many lack expertise in selling companies or structuring a transaction to maximize your proceeds simply because the typical professional may not have clients who frequently buy and sell businesses.

Faced with a complex medical procedure, you’d look to a specialist to perform the operation, rather than your long trusted general practitioner that you see for routine medical advice. Similarly, when the time comes to sell the business that you’ve built, you’ll benefit from the guidance of a specialist – someone with extensive track record and expertise – who can work with you from the exit planning stage to generate and implement tax reduction strategies.

Here are two examples of tools that can cut taxes significantly:

1.) The NING Trust to Eliminate State Tax

One strategy to eliminate your state-level income tax from the sale of your business is to create a NING trust. NING is an acronym for the Nevada Incomplete Gift Non-Grantor Trust. The concept behind this tax vehicle is quite simple:

  1. The business owner sets up a NING trust in the state of Nevada. The business doesn’t have to move, there is simply a trust entity created in that state.
  2. Ownership of the business is transferred to that trust, which the business owner controls. Transfers to the trust are not taxable.
  3. Now the trust is responsible for paying both federal and state income tax on the profits of the business.
  4. When you sell your business, the trust is actually regarded as the seller. Nevada does not have a state-level income tax, which translates into significant tax savings for the seller.
  5. The NING structure must be in place before you identify the buyer or have a Letter of Intent (LOI) or offer letter. This can’t be structured last minute.
  6. While there are states that prohibit the use of NING trust structures, there are other similar structures that may be available to limit or eliminate state-level income taxes.

2.) Section 338(h)(10) Election

There is an exception to the rule that every sale is either an asset sale or a stock sale. Recall that buyers usually want asset sales and sellers usually benefit from stock sales. In some cases, it’s possible to have the best of both worlds. A buyer could acquire a target’s stock for legal purposes—thereby preserving its non-transferable assets—but acquire the company’s assets for tax purposes, giving the buyer the stepped-up basis that allows for better tax treatment.

asset vs stock sale and the use of a 338 h 10 election copy

This “have it both ways” solution is achieved through a Section 338(h)(10) election. It can be made when one corporation purchases the stock of another corporation, but the election must be made jointly by the buyer and the seller. The vast majority of Section 338(h)(10) elections are made in conjunction with seller “S corporations”. Of course, it’s usually better for the seller if the buyer will accept a stock sale, in which case the seller can recognize all the capital gains against their basis in the stock.

But the exception to this rule is when the seller’s basis in the stock of the company is lower than the company’s basis in the assets to be sold. In such a scenario, a Section 338(h)(10) election will result in less tax being due because the gain that’s attributed to the asset sale would be smaller than the gain from the stock sale. Leaving aside the seller’s motivation, most of the time, a buyer of a small- or midsized company will insist on an asset sale.

Given these hard facts, the 338(h)(10) election will likely be more favorable to the seller from a tax standpoint compared to a straight asset sale. And in situations where it is less favorable to the seller from a tax standpoint, that becomes a negotiating point that can be addressed with an increase in the purchase price.

If this section has left you scratching your head about structuring your corporation (and your deal) to optimize tax planning, you are not alone. These are complex issues, best addressed by consulting with a GEXP Collaborative or tax advisor well in advance of a sale transaction. Plan to talk with your tax advisor about whether a Section 338(h)(10) election would make sense for your deal. Failing to have that conversation could result in you paying more taxes on your sale proceeds than you need to.

Growth & Exit Planning Rules

  • Consult a growth and exit planning advisor, tax attorney or CPA who specializes in selling businesses well before launching your sale process.
  • Explore advanced tax planning tactics like a NING structure to eliminate the state tax burden on the sale of your company. Where this structure won’t work, an expert advisor will be able to suggest other effective options for your particular situation.
  • Talk to your tax advisor about special structures like the Section 338(h)(10) Election

 

 

Chapter #5  – How Much Should You Sell Your Business For

Key Takeaways for this Section

  • ✔ Estimate the key metrics before you sell.
  • ✔ Assume that after selling your business, a sustainable lifetime annual income will be equal to 4% of your investable net worth.
  • ✔ Determine whether there is a value gap between the income you want and what your investable net worth will generate (at that 4% rate) over the rest of your life.
  • ✔ An analysis of the value gap will guide you in the timing of your business sale.

Consider this… You’re generating tremendous growth in your company – in fact, business is booming, and you’re taking home plenty of compensation. You’re somewhere in your late 40s or early 50s, working hard but also enjoying the nicer things that a healthy income can provide. For you, maybe that’s a second home on a lake and luxurious travel (when time allows, which isn’t often). Your kids may be in college, or perhaps they’re a bit older, not far off from producing grandchildren for you to spoil. Then, out of the blue, you get an offer to buy your business. What would your first thought be? While you’re likely to have mixed feelings about selling the business you’ve invested decades in, you’re also likely to assume that, from a financial point of view, if you sell, you’ll be set.

But that’s not necessarily the case… There may be a value gap.

If you sold the business today, would you be able to passively make the same amount of money and life the same lifestyle, or would you have to get a job?

What Is A Value Gap?

If you sold your business today and couldn’t maintain the lifestyle you want by passively withdrawing an income from a portfolio of assets at 4%, you have a value gap. After selling your company, you’ll invest the net proceeds with the rest of your personal assets and portfolio. Historical data suggests that a balanced, well-invested portfolio is likely to generate a 7% return and most financial advisors would suggest using a conservative distribution rate of 4%, however, to factor in market fluctuations and other uncertainties.

Listen to this podcast episode if you want to know how much you should sell your business for to be financially independent.

This brings us to a critical question: Would an annual income representing a 4% distribution rate be sufficient to support the lifestyle that you want?

How do you know if you can sell your business and have enough money?
  1. Estimate the amount of annual income you need to live the lifestyle you want: Salary + distributions + business perks, grossed-up.
  2. Divide your required income by 4%. The resulting number is what your investable net worth should be to ensure complete financial freedom.
  3. Create a financial statement that includes all your personal assets.
  4. Obtain a business valuation.
  5. Estimate the net proceeds of your business.
  6. Add your estimated net proceeds to your investable personal assets. The total is your investable net worth.
  7. Compare your required investable net worth to your current actual if you were to sell the business. Is there a value gap?

The result can be unexpected, but with the increase in life expectancy and without careful planning, you could face a financial shortfall in your later years. Let’s walk through the calculation:

Calculate your net worth after a sale:

Total investable personal assets outside the business + Net proceeds from selling your business – Mortgages and other debt (total liabilities)


= Investable Net Worth

You’ve calculated your investable net worth, so let’s move onto the next critical question:

What is the sustainable annual income that my investable net worth will provide, and is that enough to support the lifestyle I want?

To answer this question, you will need to make an assumption about what portion of your asssets you plan to invest after selling your company. Many business owners choose to:

  • Keep an amount in cash in a checking account as a rainy day fund.
  • Make a few big-ticket purchases as a post-sale celebration.

For example, if you direct 10 percent of your post-sale assets to the rainy day fund and big-ticket purchases, you will be left with 90 percent to invest. Assume you earn an average net 4 percent return from interest and dividends on the principal for the next 35 years. As noted, we expect investments to return 7% in the long run, but we use a sustainable 4% distribution rate from the investments due to the reasons referenced above.

What will you need your income to be?

Next, you’ll need to think about your annual income requirements. What are you doing now, and what do you want to be doing? Factor in your lifestyle, your kids (are there college costs to consider?), and possibly grandkids. What do you want to do after you sell? It’ll take some time (and likely some work with an advisor) to put a number on this, but it’s a critical step. If you’re planning to retire after selling, your investable net worth will need to carry you through to the end of your days. You’ll create a high degree of certainty for your financial future by investing in a diversified portfolio of assets that can weather the bad years and consistently allow you to withdraw annual income equal to 4 percent of the principal over the rest of your life. In the above graphic, investable net worth is $5 million, and is net of real estate assets (we’ll assume that’s your home). If the equity in your home is valued at $1 million, with net business proceeds of $4.3 million, $700,000 in other investments, and no other debt, your net worth would be $6 million, and your investable net worth would be $5 million, yielding an annual income of $200,000.

Growth & Exit Planning Rules

  • Estimate the realistic expenses you will incur after you sell the company.
  • Calculate your investable net worth after the sale.
  • Assume you can spend 4% of your investable net worth each year.
  • The difference between the 4% figure and your expenses is your value gap.

Be Realistic About Life Expectancy

While lifestyle and family history are certainly factors, there are also industry values you can use in estimating your life expectancy. Use the same mortality tables that an insurance underwriter would use. According to the Social Security Administration’s tables, for people aged 50 in 2017, the average life expectancy is age 79 for a man and 83 for a woman. However, that’s the average across the entire US population.

You might live longer than average. Plan on it.

Higher income individuals have longer life expectancies for reasons including better access to health care, nutrition and exercise, according to the Brookings Institute. As a prudent financial planner, you should assume a life expectancy that takes you to your 90s. Take a hard look at your annual spending over the past few years. Drawing on that, forecast what your annual spending will be over the next 30-40 years. And remember:

  • Some costs will decrease, for example, your mortgage.
  • Others costs like health care or insurance may increase dramatically as you age.

Growth & Exit Planning Rules

  • Be realistic about your life expectancy.
  • Include lifestyle expenses that your company used to pay for.
  • Get a firm handle on taxes that will reduce your net worth
  • Understand your numbers before you sell, to avoid falling into the value gap.

Brookings analyzed the mortality tables and discerned that there is a “longevity gap”. People with higher incomes live significantly longer than lower income people.

  • For Americans born in 1950, the top 10 % of wage earners lived 13.5 years longer than the bottom 10%.
  • That gap is widening over time.
  • It’s not fair. But it’s real.

Let’s take a look at the hypothetical example of Janet and Keith:

Janet and Keith Sell Out

In 2017, Janet and Keith decide to sell their service business. They’ve built the company to significant size with a staff of 25 employees and healthy cash flow. Prior to selling, they have the following assets:

  • A house and a vacation home, with combined equity of $950,000.
  • $750,000 in IRAs and 401Ks.
  • $50,000 in cash. Rainy day fund.

On the liabilities side, they are also doing pretty well:

  • $750,000 in mortgages on both properties at a low interest rate
  • $50,000 for smaller debts like credit cards and car loans. Car payments come out of the company checking account since the vehicles are for both business and personal use, although they bought them with their personal credit.

Their advisor runs a competitive sale process, generating several offers for the business. After some tough negotiations and small victories, Janet and Keith accept an all-cash offer of $10 million. They’re thrilled with the price and the all cash offer, but then their accountant reminds them of that ugly issue…taxes.

What will their tax bill be?

Between federal capital gains, state and local tax they will have to pay approximately 20% of the sale price in taxes. The result: their net worth after the sale will be:

Keith & Janet’s Net Worth After the Sale

$1,750,000 assets before sale + $10,000,000 sales price – $2,000,000 taxes on the sale – $800,000 liabilities before the sale


$8,950,000 net worth

After the transaction closes, Keith buys himself a ski boat and they both upgrade to nicer cars. They take $150,000 out for these splurges, and leave another $100,000 in a no-interest checking account in case of emergencies, unplanned expenses or unexpected problems. They also decide to help out their daughter with a $200,000 downpayment on a house, and give an equivalent amount to their son to pay down his mortgate. Finally, they use $800,000 of the proceeds to pay off their loans and mortgages so they are now living debt-free. As a result, the amount of money to be invested, including the 401k and the IRAs they had before the transaction, and less the value of their real estate, is now $6,550,000. At a 4 percent withdrawal rate, this amount—the invested principal—should provide them with $262,000 in cash each year. Prior to selling the business Keith and Janet’s expenses were $400,000 annually, and expect to continue incurring this level of expenses after the business sale. While they are now debt free, they are hoping to do more travel, and in addition, expect to incur higher insurance and medical expenses in the coming years. No question, $6,550,000 is a significant investable amount. But will it support the lifestyle that Keith and Janet are hoping for over the next 30-40 years? The short answer is “no”. In order to cover annual expenses of $400,000, Keith and Janet will have to dip into their principal each year. Their principal is substantial, and will last, but after year 28, Keith and Janet will be faced with a negative balance. The story of Janet and Keith highlights the key role of financial planning in (and after) the business sale process. While the couple certainly has the option to cut their expenses to a level that, for many, still represents a comfortable lifestyle, that’s not what they were hoping for. The moral of the story: make sure you know your value gap.

Know your Value Gap

Knowing whether you have a value gap is profoundly important. A reasonable, realistic assessment of your future expenses, and an understanding of what you will require in net proceeds to meet those expenses are critical steps towards ensuring a comfortable post-exit lifestyle. There’s no certainty that a single scenario will be the right one, so it’s wise to test multiple scenarios (with the assistance of your financial planner), varying your projected annual expenses and your estimated net proceeds. We’ve also developed a web application called the Decision Center that makes it simple to run different scenarios yourself. Our demonstration video goes into greater detail, and you can access it on Vimeo by typing in this address:

Once you’ve assessed your value gap, you’ll be better positioned to evaluate your options. Should you sell your company now at its current valuation, or implement strategies that will increase the valuation over the next few years? If you do the latter, you’ll continue to earn a salary from the business, and could increase your post-sale net worth considerably by increasing the company’s valuation.

Run Some ‘What-If’ Scenarios

What if Janet and Keith took steps to increase their company’s valuation, and in three years time, sold for $12 million? What are the implications for the cash flow available to fund their expenses? (Spoiler alert…their principal lasts through their respective lifetimes.) The Decision Center makes it simple to plug in these variables and determine what the implications are. Please use it to test your own set of possible scenarios (using different expense and net proceeds assumptions). Examining your own value gap is the first step towards taking control of your exit. It’s critical to know your numbers.

  • For example, if you’d be fine living on $262,000 annually while debt-free for the rest of your days, and you’re in your 50s, then the $10 million sales price in our hypothetical example would work for you.
  • If you are younger or older, your cashflow requirements may shift considerably.
  • Make sure you are realistic about your projected expenses and post-sale acquisitions. Think carefully about the lifestyle you want to enjoy after you sell, and the cash flow that will be required to sustain it.

Summary

You are an expert at operating your business, but valuing and selling a business falls into a completely different field. The right advisors can help you craft an exit that will maximize your company’s valuation and net proceeds, and minimize the possibility of a value gap. It’s important to remember that your business will be valued differently by different buyers, and running a competitive sale process is most likely to get you the best buyer (and the best value). Keep that in mind. It will help to ensure that you get what you want and what you need out of your business sale. If you want to learn more about building the value in your business as you move towards an exit, watch for additional installments of our “Ultimate Guide” series.