A Business Intermediary s Perspective in Software

Printing Quick Response Code in Software A Business Intermediary s Perspective

11

Retirement, divorce, partnership problems, burnout, illness,

relocation, and company growth beyond the owner s capability or financial resources are typical situations motivating owners to sell their businesses Commonly, businesses are sold to other family members, competitors, suppliers, or customers familiar with the business, as well as proactively marketed to entrepreneurs and corporate acquirers If you have received an offer to sell your business, how do you know what the price should be Are there confidentiality issues that would compromise your business if you disclose proprietary information but do not close on the sale These are some of the issues that should be considered before deciding how to proceed when presented with an offer There is a common misconception among business owners that the possibility of a sale occurs only when a buyer expresses interest in purchasing the business That buyer is often a competitor, and competitors rarely pay premium prices The reason that entrepreneur buyers will usually pay more than industry buyers is because of their need for its operating infrastructure, established accounts, ongoing cash flow, etc On the other hand, competitors already have the infrastructure in place, and many facets of the business are likely to be redundant They often believe they can recreate your business quite easily It becomes

difficult for them to justify even a reasonable purchase price That being said, there are instances where competitors pay premium prices for strategic and/or synergistic opportunities Also, there are certain industries in which industry buyers are almost always the best buyers Do not dismiss the option of proactively marketing your business simply out of fear of the unknown It has been done successfully for decades by large and small businesses, covering virtually every industry Proactively marketing your business is not only a realistic exit strategy, it is a deliberate process designed to find the best buyer and achieve the best price and terms

Just as earnings fuel the value of most public companies, earnings usually determine the valuation of small businesses In concept, most businesses sell in the range of 15 to 35 times earnings, expressed as discretionary earnings, which is defined below In return for paying that sales price, the buyer receives all of the assets of the business, except for cash and accounts receivable The seller keeps accounts payable and other liabilities Inventory is a separate topic that I will discuss later While some types of businesses are valued on revenue, revenue-based rules of thumb are not as common as many sellers and their advisers believe Generally, earnings, or discretionary earnings, is the most reliable method for determining value It is my personal experience that buyers usually expect around a 30 percent return on their investment after subtracting a fair salary and debt service However, that won t apply to smaller businesses in which a reasonable salary represents a big chunk of the earnings This return compensates one for the risk associated with a small business

When discussing Fair Market Value, it is important to understand the definition of earnings For small business sales, discretionary earnings are the relevant measure of earnings Dis-

cretionary earnings are adjusted EBITDA (earnings before interest, taxes, depreciation, and amortization), plus owner s salary and appropriate add-backs Add-backs are those nonessential expenses in the income statement that are credited toward discretionary earnings Common add-backs include charitable contributions and personal expenses charged to the business Investment bankers, who sell larger firms, also use adjusted EBITDA However, their adjusted EBITDA is different than the one described above Theirs would add back only that portion of the owner s salary and related costs that are more than an arm s length salary Thus, if an arm s length owner s salary is $100,000 and the owner actually took $300,000 salary, the add-back to discretionary earnings would be all $300,000, while the investment banker would add back only $200,000 to calculate his or her version of adjusted EBITDA The difference between the two is the owner s arm s length compensation, which can make a significant difference between the two measures In any case, the two terms are not interchangeable for valuation purposes EBITDA is not an acceptable basis for determining value of a small business Methodologies for determining value are discussed at length in other chapters The value basis represents the foundation of the sale, and an experienced Business Intermediary will have a solid understanding of business valuation to effectively communicate with sellers and negotiate with buyers In general, the better the sales, earnings, profit margins, and trend, the higher the valuation multiple tends to be