Putting a Value on Your Business

by Glen Birnbaum
Heinold Banwart, Ltd.

Key questions and takeaways regarding the sale of privately-held businesses…

Market valuations of assets are everywhere—with little to no effort, you can determine the value of your car, your house, your retirement plan, etc. For publicly traded businesses, values are reported on a minute-by-minute basis in a public marketplace where financial and nonfinancial information is readily available.

One sizeable investment of many small business owners is their business itself—an asset that represents many years of blood, sweat and tears. Privately-held businesses are ultimately valued in the private marketplace—a much less transparent and liquid environment. These factors and more can make the inherently complex process of managing a privately-held business even more complicated when the time comes to transition ownership.

Addressed below are key questions and takeaways regarding the sale of a privately held business—and how you can make your business transition as painless as possible.

Are buyer and seller talking about the same assets and liabilities? So, what is the value of my private business? The answer to this question starts with the most basic of questions: What do you mean by "business?" There really is no correct answer to this question! Does it include or exclude these assets?

  • Cash
  • Accounts receivable
  • Real estate Vehicles
  • Life insurance policies.

Does it include or exclude these liabilities?

  • Accounts payable
  • Bank debt.

Example 1: Seller asks for a price of $2 million. Buyer agrees on this price. Deal is done, right? Wrong!

As negotiations continue, it’s revealed that the seller expects to get paid $2 million, plus have the buyer assume $1 million of debt. In reality, the seller’s price is $3 million ($2 million of cash received + $1 million of debt relief = a $3 million sales price). If the buyer accepts the seller’s terms, the purchase price would be 50 percent higher than what was initially offered. The price is not right!

Takeaway: Make it very clear from the outset which assets and liabilities are to be transferred when you begin discussions with a buyer. Involve your accountant and attorney early in the process.

In what two ways are most businesses transferred?
Deals are typically structured as a sale of assets or a sale of stock. Most transactions are asset sales, meaning the buyer acquires certain assets from the seller. What may not be obvious is, often times, the buyer will assume some liabilities of the seller in an asset sale. In general, asset sales are preferred by buyers, while stock sales are preferred by sellers from an income tax perspective. Stock sales are a concern for the buyer because of possible hidden liabilities of the old company that stay with the company.

Takeaway: Consult with both your accountant and attorney regarding deal structure.

What are the typical assets and liabilities transferred in an asset deal?
The value of a business can be broken into six primary categories of assets or liabilities:

  • Cash
  • Current assets (principally, accounts receivable and inventory)
  • Property and equipment (real estate, equipment, etc.)
  • Intangibles (trained and assembled workforce, customer relationships, trade name, goodwill, etc.)
  • Current liabilities (principally, accounts payable and other accruals)
  • Interest-bearing debt.

In a typical private transaction, the first and last categories are the seller’s responsibility. In other words, the seller keeps the cash on hand and is responsible for paying back the debt. A buyer generally has no reason to purchase cash and has arranged for its own financing with different terms and conditions than the seller’s existing debt.

The remaining items (#2-5) are what a buyer looks to acquire. Current assets and current liabilities are typically combined together and called “net working capital.” Therefore, in most deals, the following three items make up the “price”:

  • Net working capital (excluding cash and short-term, interest- bearing debt)
  • Property and equipment
  • Intangibles.

Takeaway: The price noted in the purchase agreement does not necessarily equate to cash proceeds to the seller. Usually, the seller keeps the cash but is responsible to pay back the existing bank debt.

How does the marketplace arrive at a value for my business?
A buyer will typically focus on the future earnings of the business and apply a multiple to that income stream. This is based on its assessment of the risk involved and future growth prospects of the business, among many other items.

Earnings before interest, taxes depreciation and amortization (EBITDA) and earnings before income interest and taxes (EBIT) are two common income measures. Both are used to determine an asset price. Neither measure considers interest expense, consistent with the fact that the buyer uses its own financing assumptions, not those presently employed by the seller. Consequently, the seller is responsible to pay off any debt under this approach.

The following illustrates how a company with an EBIT of $500,000 and a multiple of five might translate to pre-tax proceeds ultimately realized by a seller. In short, $2.5 million initial value could translate to $1.75 million of proceeds.

Takeaway: Make sure you understand the additional adjustments that arise from the application of an EBITDA or EBIT multiple. These can either increase or decrease the price.

What about working capital?
Working capital in the context of a sale usually excludes cash and any interest-bearing debt—this is different from the accounting definition of working capital, in which both cash and short-term debt are included. Remember, usually the seller keeps any cash and is responsible to pay off bank debt. Working capital generally presumes the assumption of some level of trade payables.

A target working capital amount is usually part of the agreement, as it serves to protect both the buyer and the seller. Sellers want to ensure they receive an appropriate share of profits up until the time of sale, even if not realized in cash. Buyers want some level of assurance that a certain level of net working capital is present in the business they are acquiring. Net working capital for a business is like the HVAC system in a home. The seller of a house is not allowed to remove the HVAC system prior to closing.

Determining the appropriate target dollar amount for working capital is beyond the scope of this article, but it is a critical part of the price negotiation. Suffice it to say, the seller wants the target amount to be as low as possible (the HVAC system to be the bare minimum). An illustration of the working capital adjustment follows with two different target amounts.

As this example shows, a lower target working capital amount results in more cash to the seller.

Takeaway: As a seller, you should strive to run your business as efficiently as you can from a working capital perspective. Ultimately, this could result in more cash proceeds for your business.

Conclusion
For a privately-held business owner, getting an accurate valuation of the business can be an important part of understanding how to maximize sales proceeds. Much confusion can arise as to what assets and liabilities are included in the price, including the appropriate target working capital. Be sure to assemble a team that can advise you throughout the process—starting several years prior, if feasible. iBi

Glen Birnbaum, CPA, is head of the valuation department and shareholder in charge of recruiting for Heinold Banwart, Ltd. He can be reached at (309) 694-4251 or gbirnbaum@hbcpas.com.

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