Give and Gain Comfort During Negotiations
Tips to Buy or Sell a Business
Readers have told me that this set of tips on how to buy or sell a business is very likely the most important page our web site. It is certainly one of the busiest.
Spend some time on this page to get a feeling for the process for a business transition.
Then keep these tips, pointers, processes or however you want to think of them in the back of your mind. They will do wonders in removing the hassle, smoothing the process and helping us arrive at a successful deal.
The Number One Tip: Moccasins
The Number One Tip to buy or sell a business is to give comfort to the folks on the other side. This is may be good advice for everything in life. But it is of particular benefit in deal-making.
Try to learn, understand and practice all the actions stemming from that old saying to the effect of “walk a mile in his moccasins”.
It is not only very important to discover what the other side needs but to also understand why they need it.
I’ve seen more deals fall apart because the one side doubted or misunderstood the other’s integrity, intentions or abilities.
Mostly this results from the inability to understand why the other side acts in a certain way.
Reflect on this for a bit. Why do you want to own a business? One reason is not so much that you can be boss as the freedom of not having a boss.
You, me and the others who have read and studied this page just don’t like folks telling us what to do.
Look in the mirror and you will likely see the guy sitting across the table.
I’m in the middle. Working with the two of you is like herding cats. You don’t have to quit being a cat. You just have to know you are one and so is the other side.
It is also far better for sellers to show their warts upfront. Their discovery later in the process will immediately raise questions in the buyer’s mind about what else is hiding there. Lose that trust and any subsequent offer will be at lower multiples.
On the other side, to keep the trust of the seller, buyers have to be upfront about how they can afford to pay for the business and why they want to purchase it. Lingering suspicion about ‘tire kicking’ or ‘fishing expeditions’ can ruin a seller’s cooperation with a buyer.
My job is not just to do a deal. It’s to provide ‘comfort’ to both sides.
When I can coach buyers and sellers into following this one tip, the transactions can happen on their own.
So the other tips set out below are just gravy. Become comfortable with these concepts and you’ll find it much easier and quicker to complete your transaction.
What is the value of Goodwill?
I often run into folks who are confused about the term ‘goodwill’. There’s even ‘experts’ who struggle with it.
Think of any business as a collection of people, processes and assets deployed in a way to produce a positive cash flow.
This is where the first confusion sets in. ‘Assets’ here means the ‘operational assets’ such as equipment, plant, customer lists, websites, etc needed to produce the cash flow. It does not mean the ‘current assets’ such as inventory, bank deposits etc which are valued separately and thought of as ‘working capital’.
The continuing cash flow from ongoing business is really all the business seller has to offer potential buyers. It’s a cash-on-cash world first, and only then adjusted for the effects of time and comfort. Don’t ever let anybody tell you different.
The value of the business is worth what somebody will pay for the free cash flowing from the business.
This is the same as saying a buyer is only buying the comfort that the business will produce a certain amount of money for the new owner.
This is a universal idea. A bond issued by Trans-Alta does not have the same comfort as one issued by the federal government (because the Feds own the printing presses at the mint).
Just balance the concept of ‘folks are always going to need electricity’ against having full authority over both the staff of Revenue Canada plus in addition to the guys running the printing presses at the Bank of Canada.
Paper issued by the Fed’s provides much more comfort so is worth more for the same return.
If you don’t think the 4 percent bond issued by the feds should be worth more than the 4 percent bond from the guys owning coal powered electrical plants then you have to re-read your old Economics 100 textbook.
The differences in ‘comfort’ that the cash flow will continue through a change of control explains the price differences between firms flowing the same amount of cash.
And for a business, if this cash flow times the market multiplier (shorthand for the effects of time & comfort) is worth less than the auction value of the all the assets, then the business is worthless and any value is better estimated by what the fixed assets might get at an auction.
This concept can be confusing to the first time business buyer or seller.
This is especially true when comparing firms with a large investment in capital assets against firms flowing the same cash simply by offering services.
There is a great temptation to think comfort from same amount of cash flow from a firm with a yard full of heavy equipment is greater than the comfort from a firm that simply provides a service.
But think of it this way. Say there’s two companies for sale. Both have operating assets worth $100,000.
But one deploys those assets to create a positive cash flow of $100,000 while the other deploys the same value asset base for a positive cash flow of $200,000.
The cash flow in both cases times the market multiplier is worth more than the $100,000 in fixed assets.
Assuming the outlook for each company is the same, which would you rather own? If your answer is not the one producing $200,000 instead of the one flowing $100,000 then you are not cut out for the business world.
But the real question is: What premium would you pay for the larger cash flow than the smaller one?
Remember, they have the same asset value. The answer is that one will sell for about twice as much as the other because it produces twice the rewards of ownership.
The asset base is the same, so what do you call the item that creates the greater value?
Accountants term the amount that a business sells for in excess of its assets to be ‘goodwill’. Only businesses that are not producing cash sell at close to their asset value at receiver’s auctions. More often they can sell for much less than asset value.
Or, think of it this way. If you were to start a business from scratch, you’d put together a collection of assets, produce your goods or service then go out to find customers. As business starts to happen, the assets start to accumulate ‘wear & tear’ so they are not worth as much as they were when you first bought them.
But also note, because business happens, you now have cash flow.
At this moment think of the value of the business.
Your assets are not worth what you paid for them anymore because they are now ‘used’ while the investment you put in the business is starting to pay you a return. The business that was only a dream when the assets were brand new is now real and worth more than when you first started.
As this goes on for a period of time, goodwill, the difference between the depreciating asset value and value of growing cash flow gets wider and wider.
Suddenly, for a successful business, it can seem that all that’s there is goodwill. And yes, a successful business is exactly what you want to buy.
It is very important to understand that if goodwill had no value then there would be no difference in the value of differing companies with the same asset value even though one business was flowing more cash than the others.
It is not unusual to sometimes run across a seller’s intermediary trying to sell a businesses and does not really understand if the business is profitable or not. So here is the way business brokers use the terms.
Sales, Revenues, Gross Income
This is what customers paid the firm for goods and services received. Might also include non-operating receipts such as interest from cash in the bank etc.
Cost of Goods Sold, COG, COGS, or Marginal Costs
This is what the firm paid for the ‘stuff’ it sold to customers. Might also include the transport costs, commissions paid to salesmen or sub-contractors, inventory adjustments, etc. Many service firms do not have COGS unless they have sub-contractors producing their services.
Think of these as expenses that only happen if sales take place as opposed to overhead ‘Expenses’ like rent that have to be paid whether or not sales happened.
Operating Profit, Operating Earnings, Gross Earnings, Gross Margin, or simply Operating
This is what the firm has left to pay rent, wages, profits, etc after paying the cost of goods sold.
Expenses, Operating costs, Overhead
This is what the firm pays to keep the doors open. Rent, wages, utilities, etc plus some bookkeeping items like depreciation, long term interest etc. These all occur regardless of whether there is any revenue.
Positive Cash Flow
Positive cash flow means that over a given period, more money came into a firm than left.
Net Profit, Net earnings, Income
This is what is left after paying the expenses out of the funds from operating profit. This is the number that Revenue Canada cares most about since they get a piece of it.
EBITDA, Earnings before interest, taxes, depreciation and amortization.
Used to create a level playing field to compare the cash on cash return on firms with continuing arms-length management.
Normalized Cash Flow, EBITDA adjusted for owner’s benefits, Free Cash Flow, Owner’s Discretionary Cash Flow
We use this to create a level playing field to compare the cash on cash return of firms run by an owner operator.
Note that this (or EBITDA above depending on the firm’s management structure) is the number the bankers care most about.
Normalized Cash Flow
Normalized Cash Flow is a banker’s term. They use it when they they are assessing the capacity of a firm to service debt.
They have been doing this since the dawn of commercial trading. It is a banker’s measure of comfort.
Business brokers use it as the best way anyone has come up with to compare the cash reward resulting from the ownership of various businesses. For us, it’s only use is to compare different firms. It’s much like a handicap for golfers or total points for a hockey player.
Buyers can use it as the base for a pro-forma to speculate how the numbers would look if they were running the firm
NCF is always based on actual historical numbers. When there is a change ownership, differing circumstances may change the future finances of the firm. But those changes will be reflected before hand in pro-forma numbers, not in the normalized cash flow numbers.
The process to discover normalized cash flow is simple. Start with the earnings statement from the firm’s public tax accountant. The net earnings is the entry showing the dollar amount to be shared between ownership and the tax man.
The banker takes the earning’s number and adds back certain expenses. This means normalized cash flow will always be the same or higher than net earnings.
The expenses that are added back are limited to:
Owner benefits (wages, golf course membership etc). This removes the differences to net earnings caused by one owner taking a salary and benefits while another owner lives off dividends.
Ownership expenses (interest, charitable donations etc). This removes the differences to net earnings caused by the personal circumstances or whims of the current owners rather than the firm’s operations.
Extraordinary expenses (moving to a new location, hiring a lawyer to sue a bad debt). This removes expenses that are not expected to be repeated in the future assuming the normal course of events unfolds.
Non-cash items (amortization or depreciation). This removes expenses charged to net earnings for (mostly capital) items that were paid for in the past and are not real cash disbursements in the period being examined.
Once we have a normalized cash flow number we can use it to compare the values of different firms or to build a Pro Forma.
Build a Pro Forma
Always work with the Seller’s actual historical numbers as the base of your own pro forma. Working with a pro forma built by the seller lets him choose the values for the ‘unknown’ items.
As we get into discussions with a qualified and serious buyer I’ll show the Normalized Cash Flow Statement or EBITDA showing the actual financial results by the current management of the firm.
It is unlikely that the new owner will manage exactly as the seller did and changes should be shown on the pro-forma.
For example, suppose an owner-operated business is going to be purchased by an investor who will hire a manager to run the business.
This will increase the cost of wages and benefits.
Write down and add or subtract this and other expenses by taking the cash flow statement I give you and making the changes to reflect your own management ideas.
The result is a called a pro forma and likely a new bottom line. It may be higher or lower than what the seller managed to eke out.
This is done so the buyer can arrive at a set of financial expectations that more closely reflects their management style and intentions.
This is useful tool to help in the decision to buy or not buy.
But it likely has no more bearing on price than the decision to put a particular stock in either your RRSP or your margin account. The RRSP’s tax free compound growth gives a much better return. But price is driven by the whole market and not any particular buyer or seller’s particular circumstances so a share of Telus is priced the same in a margin account or a RRSP account.
Bankers are in an awful position. A business owner can win, lose, or break even. But a banker can only break even when the borrower lives up to his end of the bargain or lose if the borrower does not.
This comes about because if the borrower parlays the loan into a multi-branch empire, all the banker will get in return for the capital he risked is the same as if the borrower just barely managed to make his payments.
So regardless of your business plan, your brilliant concept and your unbridled enthusiasm, all the banker will lend on is hard assets that he can sell off if you’re wrong.
Since a successful business is worth more than its assets, this often means pledging your house. In fact, the famous Canadian businessman Max Ward is quoted as saying that one can’t call themselves an ‘entrepreneur’ unless they’ve bet their house.
This is a pretty sobering thought that you should dwell on for a moment. In the early 90’s, my new business was growing so fast I had to bring my wife to the bank and get her to pledge the house against an injection of working capital. I didn’t like that.
I lost a million dollar deal back in ’05 when the buyer brought his wife to the bank, the banker explained what could happen, and she said “No”. Mom didn’t want to risk the nest. And that’s okay. Nothing should be more important in your life than Mom and her nest.
There is some hope here. Merchant bankers will loan on character but ask for an arm and a leg instead of your house.
One is the Business Development Bank of Canada for mid-sized loans. I stay in touch with their ownership transition team and can put the two of you together when the time is right.
For larger loans (millions of dollars) we can also put you in touch with the merchant banking arm of the Bank of Nova Scotia.
In Alberta, both Servus and ATB have approached me and let me know they too are looking at this market.
Merchant banks will do management buyouts, buyouts of competitors, and purchases by knowledgeable outsiders.
It’s unlikely that if you have not had a career in torque widgets that they would finance your purchase of a torque widget distributor. But on the other hand, BDC does have an entrepreneur mandate and it’s worth looking over the BDC website.
They are also aware that the first wave of baby-boomers are are getting ready to sell their firms and that there is a need for merchant banking to keep these businesses in Canadian hands.
Generally speaking, BDC wants ‘Notice to Reader’ financials for any loan under $150,000 and ‘Review Engagements’ for loans over that amount. This can be a challenge since few private firms have Review Engagements unless their banks have insisted.
So how much is a business worth? Firstly, what’s being sold? We always figure value assuming plant and equipment being in good working order, that the balance sheet is free of debt and finally, the current position, those rent deposits, prepaid expenses, accounts receivable, payables and inventory, all net out to zero. Any deviation here affects the negotiated (handshake) price dollar for dollar on the close. Folks call this ‘enterprise value’.
A short but correct answer to price is that this value, like those in any other freely traded market, is simply what a buyer will pay. That being the case, why bother with pricing theory?
Well, also like any other freely traded market, there are guides or rules-of-thumb for pricing. What you paid for your home may have been influenced by a Competitive Market Analysis prepared by a Realtor.
When I was a stockbroker we looked at the multiple to GAAP earnings.
The best guide to the pricing of an owner operated business seems to be a multiple of the banker’s Normalized Cash Flow while larger private businesses with continuing arms-length management may trade on a multiple to EBITDA.
Note that the market multiples on GAAP earnings are higher than multiples on EBITDA which in turn is higher than the multiple on Normalized Cash Flow but the resulting values for the businesses are roughly the same since GAAP earnings is a smaller number than EBITDA which again is a smaller number than Normalized Cash Flow. The aim is to use the figure that is the least influenced by the nature of the firm’s ownership.
A big clue that a price may be wrong is if you ever see an owner operated firm advertised at an EBITDA multiple. I’ve seen folks do this to inflate the price of owner operated firms using EBITDA multiples instead of Normalized Cash Flow.
Since the departing owner is leaving with his skill set, the continuing skills implied by EBITDA pricing will not pass on the new owner. When you see owner operated firms priced on EBITDA, expect that you are being kidded about other stuff as well.
A business with a positive free cash flow trend will command a higher price than the average multiple for free cash flow. The trick is to know the average multiple.
This doesn’t vary very much since capital can move from public companies to private companies to commercial real estate or even bonds when the mythical ‘Asian Smart Money’ feels one class of instrument is priced incorrectly relative to the others.
This free movement of capital has the effect of maintaining a fairly stable relationship between the various asset classes.
Public companies may trade at over 20 times GAAP earnings while buyers of owner-operated businesses hesitate to pay more than 3 times Normalized Cash Flow for a successful growing business.
Much of this is a liquidity discount but never for a moment think it doesn’t also reflect the perceived risk of private business ownership.
Once in awhile you may see attempts to value a business based on a discount rate applied to future expectations or internal rates of return.
Few real world transactions take place based on these figures. This methodology is utilized by hedge funds where they straddle the calendar or purchase spreads where their only risk is the methodology and not the underlying instrument. They seldom ever go ‘naked’ and instead almost always do an offsetting transaction to cover themselves so their only risk is the spread.
For private equity, discounting future expectations, using internal rates of return or other financial ratios only serves a purpose when a transaction is not contemplated. This happens fairly often in the course of contested estate settlements, divorces, or partnership break-ups.
Each party will hire an expert witness to convince a judge that one party has to pay the other more or less for the other’s share of the business.
Oddly, each expert will argue that the correct methodology is the one that has the best financial return for his client. I’ve never seen folks rely on this for an arm’s length transaction.
Another common error is using NCF and EBITDA interchangeably when they imply two different concepts.
EBITDA sells at a somewhat higher multiple than Normalized Cash Flow.
And the reason for this is the key difference why the two terms are not exactly interchangeable.
EBITDA implies a firm with continuing management with only the ownership changing. Continuing management means a continuing knowledge base and skill set. That is worth money. This is accounted for with a higher market multiple.
Once in awhile you see a an owner operated business being sold using the term EBITDA and priced at an EBITDA multiple. But the owner is walking away with a lot of that knowledge base.
Maybe the seller’s agent does not know what he’s doing and thinks the terms mean the same.
Or maybe he knows exactly what he’s doing and thinks the buyer doesn’t know that using EBITDA comfort multiples can result in a higher price for his seller. Learn where the lions are hiding.
Should you meet any seller’s advisors unsure of these terms, walk away. Every year, a few folks get really hurt by the nicest people who simply don’t know how to use basics such as shotguns or the vocabulary of simple business accounting.
And also once in awhile, businesses that should be in liquidation are offered at asset value or even a discount to asset value. Unless you think you’re a super manager born under the sign of a horseshoe, avoid these like the plague. Let some other ‘hero’ ride them down. Yes, I speak from personal experience here.
But always, the cardinal rule is that the transaction price is decided by the willing buyer and willing seller coming to their own arrangement. The price is never decided by ‘experts’ or the market alone.
Firms that rely on Relationships
Most businesses deal with a variety of customers or clients. But once in while, you will come across a business where there is no doubt the owner is key to many of the clients doing business with the firm.
The most extreme example is an accounting practice. The operational assets would amount to little more than office furniture, a computer, and a client list. If the practice changes hands there is no way to forecast how many clients will stay with the new owner.
Both the buyer and the seller have to be aware of this and plan for it. Most often the preparations are done as a buyer hold-back (perhaps with the funds in trust) and tied to future revenues. It’s unfair to the seller to tie them to future profits since profits are greatly influenced by the new owner’s management skills while revenues are more influenced by customer loyalty to the old owner.
There’s often other reasons for uncertainty besides relationships. Future oil prices or interest rates come to mind at the present moment.
If the future expectations of the buyer and seller are too far apart to bridge by discounting, then a formula approach may be a good idea.
Other circumstances concerning certain firms or industries will call for different formulas but using this method can result in deals that would die if based on discounting.
Closing Balance Sheet
The current financial situation of an on going business changes daily as business happens.
Current business conditions dictate the levels of sales, inventory, receivables and payables. For share sales, if the balance sheet the buyer viewed is not the balance sheet on closing, there can be, and should be, disputes.
The accepted solution is that all firms are sold without any debt and or current assets. On the close, the lawyers / accountant’s remove all debt from the final handshake price and add all current assets.
It should never be a big surprise since the seller should be able to press a button on his computer at least once a week to get a new value for debt and current assets.
Sometimes, the accountants will propose another solution to minimize taxes with both the buyer and seller splitting the tax savings.
This is a term to describe firms staffed by enthusiasts (or groupies) of the product or service the firm provides. It is likely you know of several of these businesses. Think of your local sporting goods shop or wine making shop.
If they are successful, it’s often because they hire strictly from their customer base. Instead of a bored clerk taking care of customers, there’s an enthusiast who can’t believe he’s getting paid to talk soccer or Chablis all day long. Some of these firms have become giants (think Home Depot or Sport Chek).
This staffing policy has pro’s and con’s. Customer’s get much better service which should trump any other factor. But it means the owner can’t be a ‘foreman’.
Owners of groupie businesses need fine people skills, team building skills and perhaps the insight to ‘clean the washrooms’ themselves just to let the staff know how much they are appreciated. Done right, staff might even pay you to let them work there.
Always take the time to look over any groupie business that you see offered. The staff is loyal, committed and often working for perks like product discounts instead market wages. Properly managed, these businesses can be very profitable.
The name comes from the sax players in the 20’s doing a gig in Memphis then jumping on a train to for another gig in Montreal.
This sector has become big enough to confuse the US Federal Reserve when they do their employment forecasting.
One current example is newly qualified doctors taking on locums instead of building a practice. They cover for different doctors to build up a nest egg that will finance another passion until they need to work again.
The other end of the scale is young millennials financing their foreign travel by taking on jobs in bars or cleaning companies. Word gets out in their circle about who’s good to work for and those firms never have staff trouble. As one staffer saves enough to embark on a new adventure, he’ll have a friend returning broke and looking for job. These too can be great businesses to own.
A business can be priced too high, too low, or just right. Only Goldilocks understands ‘just right’. The rest of us are groping.
The downside of ‘too low’ is easy. The seller leaves cash on the table. Sometimes, for a quick sale, this is not a bad idea.
But ‘too high’ is the real issue. Any potential buyer knows that he must make a time commitment just looking at a business that appears interesting on the surface.
Is it time well spent to investigate the business when the buyer also realizes that if he likes it, he then still has to negotiate the seller down to market values?
And if he and the seller do come to an agreement on price, the buyer still has to worry that the seller may think he was ‘beaten down’ and not co-operate through the transition as well as he would if he thought the price was fair.
I have seen a lot of buyers who have simply refused to look at an otherwise suitable business because the asking price was outside the market and they worried about the human and emotional investment that would be required to negotiate the price down to something more reasonable.
It is my opinion that the best pricing strategy is to set a price that is pretty close to what a buyer will accept. If there is no early interest, that should tell the seller the price is too high and he should either quickly drop the price or plan his affairs so as to keep the business.
Unless there are extenuating circumstances most business brokers will suggest an asking price for an owner-operated business at three times NCF.