Planning the purchase or sale of a closely held business - Wisdom from Wharton

Chief Executive, The, June, 1993 by Robert J. Chalfin

Selling--or buying--a closely held company is a tricky business. Preparation and a fair appraisal can go a long way toward securing an advantageous deal for all parties.

Owners who consider selling closely held businesses face a wide range of alternatives and decisions. Ultimately, the success of the deal for both the buyer and the seller hinges on the establishment of a reasonable price, the acquisition of needed capital along with appropriate repayment terms, and a smooth handoff of the business from seller to buyer.

One of the first questions asked by all potential buyers and potential sellers is, "What is an appropriate price for the business?" A price that is too high will discourage potential buyers from proceeding beyond a preliminary review. In addition, if the seller does not decrease the price in a hurry, the business will, in many cases, decline in value as employees and customers learn of the desired sale and leave or transfer their business to competitors.

On the flip side, if the initial price is too low, the seller will dispose of the business quickly but won't receive full value from the purchaser.

BUSINESS APPRAISAL

To maximize the yield at the time of sale, certain preparations should be made. First, the entity or the portion to be sold should be appraised. Key determinants of a business' value are: expected future cash flow, income, net assets, depth of management, competition, customer base, and employee relations. Ideally, the purchase price should provide the buyer with an appropriate return on investment based on the risk he assumes.

Another smart move would be to study the condition of the economy and of the industry in which the business operates. A business may be more desirable during certain periods or economic cycles. For example, during the real estate boom in the late 1980s, businesses whose revenues were generated from real estate activities--including brokerage agencies, real estate appraisers, and construction companies--were sold for much higher prices than they would have commanded during most other times.

This phenomenon can benefit all parties. For example, a business' major customer may be able to minimize its costs, and offset future expenditures by buying all or part of its supplier. A business may be able to expand its customer base and its revenues by buying a competitor. If the marginal costs of generating these additional revenues are less than the total expenses currently incurred, the buyer will receive more value from the new business than the existing owner. Frequently, a deal can be structured so that the marginal profits obtained from the new acquisition will liquidate debt in a few years.

ESTIMATION PROCEDURES

Although there is no one surefire method that can be used to value all businesses, taking the following steps will ensure a reasonably accurate estimate.

* Calculate the expected or normalized cash flow of the business, excluding salary and remuneration to the owner(s). At this time, you must adjust for any expected increases or decreases in revenues. For example, in one recent acquisition, the buyer utilized its existing sales force and knowledge of the industry to generate additional sales from the target business' customers. This information should be included in the buyer's own calculations of the target business' expected results.

Also, don't forget to add any additional operating expenses the buyer will incur after the sale. These include lease payments where the business' current owner is also the building's landlord, and salaries for employees who will replace a spouse or family who currently is not being paid for working.

Furthermore, any optional or non-business-related expenses or cash expenditures that the buyer will not incur must be deducted. These items include donations, and travel, entertainment, and automobile expenses for the owner(s), family, or friends.

Finally, add the total remuneration the owner(s) received and deduct a reasonable salary for the services they performed, assuming they were non-shareholder employees.

* Determine the loan value the cash flow would support at current available terms and interest rates. For example, if the business generates a cash flow of $50,000 per month, and if money is borrowed on a five-year self-liquidation basis at 9 percent interest, a loan of just over $2.4 million would be amortized.

* Adjust for any assets, net of liabilities, that will be obtained from the purchase of the business. The assets and liabilities should be taken at their fair market or replacement value, not book value. In many cases, the values listed on the business' financial statements do not approximate its fair market value. The fair market value of real estate could be understated on the business' balance sheet, while the value of other items, such as computers, could be overstated. This often happens if the business only receives a compilation or review.

In addition, any asset that can be sold immediately or is not utilized by the business can be used to offset the debt obligation. In a recent transaction, the buyer was able to liquidate large sums of unnecessary or excess inventory and equipment, which significantly reduced the debt obligation needed to acquire the business.