Today’s post comes from my friend and guest blogger Eric Williams, a business broker with Codiligent, LLC. Eric wrote the following:
“I’d like to share a cautionary tale about financial fraud – something that is more prevalent than many people believe. I have a friend who owned a second-generation, multi-state-location manufacturing company and after decades of successful operation he needed to replace the business’ retiring controller. He was very excited about the new controller – someone with impeccable credentials and experience. One of the first things the new controller suggested doing was to replace their old accounting and operations software, with a fully integrated Enterprise Resource Planning software program. The implementation was complicated, took months to get people fully trained, and my friend never became comfortable with the data he was getting from the financial reports.
After about another year, the owner still wasn’t getting information from his controller that he could understand, particularly given that their numbers seemed different than he expected based on his experience with the company’s production level. The owner assumed that he simply was not sophisticated enough to understand the controller’s financial explanations, so he brought in an outside consultant to help him understand things better. To his shock and dismay, the outcome of hiring that consultant was that fraud was discovered. After a lengthy secret review they determined the source of the fraud was the controller, who was promptly fired and prosecuted.
Unfortunately, terminating the controller didn’t immediately solve the problem. Untangling and correcting the problematic financials and operating system required significant time, effort, energy, and focus. When combined with the time necessary to implement new systems, hire a new controller, and prosecute the former controller it required about one-and-a-half years during which time the business would not have been very marketable. After they corrected the problem and had another two years of problem-free operations they sold the business.
The problem with fraud is that victims assume it isn’t happening to them, or that their trustworthy employee would never do such a thing.”
Many small business owners want to know what their business is worth. The answer, as in any transaction, is what a buyer is willing to pay. And what a given buyer will pay may depend on a host of factors regarding the particular industry and the condition of the business. For detailed information, it pays to use a business valuation expert such as Dan Gilbert at Gilbert Valuations, LLC.
Business brokers often use shorthand formulas based on multiples of earnings to project a potential sales price. This makes sense because earnings are more relevant than gross sales. And buyers tend to view the purchase of a business as an investment. Using a multiple of earnings formula allows the buyer to have a sense of how long it will take to recoup that investment and begin making a profit.
Simple enough so far, but how to know what it means for a particular business? For starters, which earnings do we mean? Last year’s? A rolling average of past earnings? Current earnings? Or projected earnings that forecast the future? Assuming we can agree on the right time period to measure, the next question is how do we calculate those earnings? Most accountants commonly use a formula that measures earnings before interest, taxes, depreciation, and amortization (“EBITDA”). It sounds complicated, but the goal is simple – finding out how much cash the business generates from operations.
After deciding which earnings and how to calculate them, the third question is what multiplier to use? For most businesses, it’s somewhere between 3 to 5 times EBITDA. For a buyer, this would mean recouping your investment in 3 to 5 years from profits of the business.
The bottom line is that rules of thumb are simply a shorthand way to “guesstimate” a possible sales price. Many factors come into play, and there’s no substitute for using a qualified professional to evaluate the particulars. As they say, actual mileage may vary.
The most popular exit strategy for small businesses
If family succession planning isn’t viable, and there is no company insider who is willing and able, then an arm’s length sale on the open market may be an option. This is the most popular exit strategy for small businesses. The business owner lists the business for sale and – we hope – ends up with a healthy sales price.
Groom your business for the sale
If you are targeting investors looking for an attractive opportunity, spend some time grooming your business for sale to make it as attractive as possible. A great potential buyer is another business in your industry that is looking for a strategic acquisition to simultaneously expand into a new market while eliminating a competitor.
The key is to target your potential acquirer(s) in advance and position your company accordingly. And of course, convincing your acquirer that your business is worth what you want for it.
Get a professional business valuation before naming your price
There are numerous business valuation formulas ranging from asset-based to future earnings approaches. But no single method can be used in isolation because market trends, economic conditions, and comparable sales also influence what buyers are willing to pay. If you have the resources, hire a professional business appraiser to do a valuation before you set the price. A professional business valuation will increase credibility and may save you legal hassles later on.
Listing your business for sale
After determining the price, an owner can list the business for sale on various business sale websites. Some sites permit sellers to list their businesses directly (think “FSBO” for a house), while others limit access to business brokers. Typically the sites charge a listing fee, but some, such as GlobalBX, are free. Business broker and consultant Eric Williams of Codiligent, LLC recommends that sellers not limit themselves to a single website when listing. Williams notes that many buyers are cognizant of some business sale sites but not others, so to get maximum exposure he recommends that owners list their business on as many as possible.