Some people start a business with the intention of selling out one day – and many people only think about selling well down the road. Either way, it’s our experience that most business owners don’t know much about what selling their business might involve, and many leave it too late to get their businesses ready for sale.
Why Sell Your Business?
Most business owners want to earn a capital return on the hard work they put into building their businesses up, above and beyond what they have taken from the business as salary, interest or distributions. Of course you may choose not to sell – eg if you think the business is not worth anything, or if you wish to pass it on to your family or others after you die – but most business owners will want to sell out at some point, if they can.
But remember that when you sell a business you are losing the rights to those future earnings, as well as any future capital growth opportunities. Its not surprising that many business owners feel conflicted about selling out.
When Should You Sell Your Business?
A lot of business advisers reckon they can tell you how to game the market and “sell high”, but – truth be told – most private businesses are sold for reasons unrelated to broad market conditions.
So our first advice to any business owner is: start readying your business for sale right now, if you haven’t already started, because:
- You may get an unexpected offer, and if your business is not ready for sale you might have to sell at a big discount, or even miss out altogether.
- We’ve learned from COVID that good plans may have to change overnight – for example, illness or a new opportunity may require you to exit your existing business sooner than you intended.
- It often takes a while to maximise the value of your business, e.g. putting in place the sustainable practices that will make it more profitable and less risky in the hands of a new owner.
Of course you should also keep an eye on market conditions, to make sure that your business is not actually losing value because of macroeconomic trends. I’m old enough to remember when the most valuable shops in main streets were often newsagents and hardware stores – before the internet killed printed newspapers and Bunnings went “big box”….
So let’s get started on how to set your business up for sale.
Decide What You Might be Selling
Are you only selling the business’s name, operating know-how, reputation and relationships ? If that is the case your main assets up for sale are “intangibles” – eg business name registrations, trademarks, domain names and that sometimes hazy asset that may be your most valuable asset of all – “goodwill”.
You may also be selling associated “tangible” assets, like a factory, motor vehicles or trading stock. Conversely, you might also transfer liabilities to a new owner, e.g. lease liabilities on assets or employee leave entitlements, if your people will continue working for the new owners.
Of course you can also sell the whole lot, e.g. by selling your shares in an incorporated company.
The choice is yours, but some combinations of assets and liabilities are inherently more valuable and less risky than others to new owners, eg many business buyers won’t buy shares in a privately owned company if they think they may be threatened with litigation down the track based on past problems they may not be aware of, eg product liability claims.
So What is Your Business Really Worth?
Only what someone will pay for it – but many business owners want a formal valuation opinion or informal estimate before they decide to put their business on the market, to give themselves confidence they are making the right decisions based on “facts” – more on that later.
The best way to approach this is to think of each class of assets and liabilities separately:
- Cash is worth just that – dollar for dollar.
- If trade debtors are transferred to a new owner, there is typically a discount applied for potential bad debts that will usually depend on past collection results and whether any debtors have financial difficulties. Many buyers won’t take on previous owners’ debtors for that reason.
- Trade creditors, employee entitlements and lease liabilities are worth the net present value of what has to be paid out to settle those debts.
- Inventories in good condition are usually transferred at the lower of historical or replacement cost. They may need to be discounted if they are deteriorating in quality. Conversely they may occasionally be worth more, if a new buyer can’t find an alternative supplier in time for their own production.
- Plant and equipment (including motor vehicles) are usually sold based on equivalent second hand goods prices, which may be more or less than their depreciated values on your own balance sheet. I worked on a sale project in the 1990s where the main factory assets were worth over twice as much as their depreciated balance sheet values because they had been well maintained, and there was a shortage of new equipment in the market.
- Intangible assets are usually valued by calculating the total value of a business and then deducting the net value of all the tangible assets and liabilities listed above, if they are sold with the business. There are sometimes good reasons (eg based on tax considerations) why it might be a good idea to separately value brands, trademarks or other registered “rights to operate” (such as publishing “mastheads”) vs residual goodwill, but those exercises can be technically tricky.
Usually the total value of an established. profitable privately owned business is determined using an estimate of Future Maintainable Earnings before Interest, Tax, Depreciation and Amortisation (“EBITDA FME”) multiplied by a usually quite subjective number that represents a valuer’s estimate of what the market is prepared to pay to acquire that earnings stream (“the valuation multiple”), adjusted for any “non-core” assets and liabilities included, for example:
- Business A with an EBITDA FME of $1.3m and a valuation multiple of 5.0 has an estimated value of $6.5m, before non-core asset and liability adjustments.
- If Business A is expected to be sold with $200k in collectable Trade Debtors and $300k of Employee Entitlements for transferred employees it is probably only worth $6.4m ($6.5m + $200k – $300k).
- If the estimated value of Business A includes plant and machinery used in the business with a current market value of $1.1m, the total estimated value of the intangible assets will be $5.3m ($6.4m – $1.1m).
- If Business A’s intangible assets includes, say, a franchise agreement that gives it exclusive rights to operate in a territory and that agreement is separately valued by an expert at $1m based on current offering prices, the residual business goodwill will have an estimated value of $4.3m ($5.3m – $1m).
Why EBITDA Matters
Why EBITDA, and not Profit after Tax ? Because EBITDA is the measure of profitability that is most independent of historical, subjective taxation and financing decisions and circumstances that vary between otherwise comparable firms, for example:
- Businesses that lost a lot of money starting out may have tax losses they are still using up.
- Businesses funded with debt rather than equity have lower profits after tax, because interest is usually deductible, even though net returns to investors might be the same as one funded by share equity.
- Depreciation and amortisation charges may be somewhat arbitrary, eg many Australian businesses depreciated asset purchases in full during the COVID19 recession to take advantage of generous tax breaks, thereby depressing profits.
Note that EBITDA FME estimates can sometimes be “gamed” by sellers, eg they may be inflated at first glance by cutting discretionary expenditure excessively in the run up to a business sale. Examples include writing off inventories in one year so that future years’ EBITDA are inflated, slashing preventative maintenance work on machinery, making staff work excess unpaid overtime and leaving obsolete inventories and uncollectible trade debtors on the balance sheet rather than writing them off – all examples of costs and risks that will inevitably hurt future earnings and can even lead to business failure.
Momentum is Everything for FME
Remember, “past performance is no guarantee of future success”. If a business is in decline, eg there are fewer customers, EBITDA FME may be estimated to be lower than recent financial results. On the other hand, valuers may accept higher measures of EBITDA FME based on credible forecasts of future growth, when an industry is trending upwards as a whole.
What if My Business is Unprofitable?
Generally speaking, private businesses that do not have a track record of earning profits are harder to sell, but loss-making businesses with strong prospects can often still be quite valuable in the right circumstances, eg:
- Where they own a unique asset (such as new technology or exclusive operating rights) that will generate strong profits with further investment by a new owner.
- Where that business can be combined with another business to achieve sufficient scale to become highly profitable, eg by reducing competition in a crowded market in a way that doesn’t attract the ACCC’s ire.
However knowledgeable business buyers will use all the tricks they can to reduce what they are prepared to pay for what may still be an inherently risky business, so selling an unprofitable business for a good price usually requires real poker skills.
Valuation Multiples – Art or Science?
Most independent business valuations are done by accountants with access to business sale databases that track recent sales of comparable businesses. Using that data, they divide business sale prices by their estimates of EBITDA FME to determine average valuation multiples. They then track those multiples by industry over time, to get some idea of what the valuation multiple for your business might look like.
If that sounds a bit arbitrary and prone to error to you, you’re right. What if there haven’t been any businesses sold in recent years like yours ? What if the only businesses sold were in worse shape than yours ? What if there were assets and liabilities hidden in the business sale price that distorted the true valuation multiple calculation ? All those risks are higher where privately owned business sales are concerned, because available business data is much scarcer than is the case for listed companies.
So my advice is to treat independent valuations based on apparently scientific valuation multiples with a lot of caution – they may not be worth the fee you have to pay for them, and they may even give you a mistaken impression of what your business is actually worth. Unfortunately it has been my experience that many business valuers try to make their work sound more scientific than it might really be – after all, they often want to charge you big bucks for their impressive-looking report, with the nice logo!
What Maximising the Value of Your Business REALLY Requires
After reading about the risks associated with both EBITDA FME and valuation multiples you might be really concerned about how to proceed, but always remember this: your main business value focus should not be on impressing an accountant who you are paying for a probably materially subjective opinion, it should instead be on:
- Maximising real EBITDA FME, by running a sustainably profitable business with strong future prospects.
- Getting a higher valuation multiple than apparently comparable businesses that are up for sale, by seizing opportunities and managing risks as well as you can.
In other words, if you run your business well as an owner, you are also almost certainly doing the right things to make it more valuable to potential buyers.
So What Should You Do Now?
Before you attempt to sell your business, consciously invest in each of the Six Pillars of business health – here are just three examples that we recommend to our clients, for each Pillar:
- Have a strong sense of business purpose and solid values – because businesses with a clear sense of “why” and the right behaviours stay focused on what will make them successful and valuable.
- Design and execute a great Strategic Plan – because you need to design and prioritise the right strategic actions to achieve your goals.
- Invest in succession planning – because your business is less valuable if it can’t operate with you.
- Make sure you are growing your business with the right brand, marketing and customer acquisition strategy – well branded, growing businesses will have higher EBITDA FME AND valuation multiples.
- Invest in customer retention, eg through long term customer contracts which will give business buyers confidence that the goodwill they are buying will last.
- Invest in product innovation – you need to maintain relevance to both future customers and business buyers.
- Invest in sustainable talent attraction strategies and your employer value proposition, so that your business finds it easier to attract the best talent for the long term.
- Design the most efficient and sustainable structures and roles for your employees, so that your staff efficiencies and good customer service improve EBITDA FME and your employees are likely to stay for the long term, including after the business is sold.
- Invest in career development, so that your staff not only stay longer but become more engaged and productive over time, reducing turnover costs affecting your EBITDA FME and risks affecting your valuation multiple.
- Implement dynamic forecasting practices and tools, to increase EBITDA FME at an acceptable level of risk and also so that any buyer of your business knows how to manage it for continuing growth from day one.
- Always manage working capital wisely, so that no short term liquidity issues kill your business before it becomes valuable and you wish to sell it.
- Find a great accountant – like Jamie Lucas – who can help you manage your taxes and business structures well without complicating a potential business sale – remember, its not all about reducing your income tax assessment.
- Map and monitor your operating capacity and constraints well, so that you can service a growing business and maintain high customer satisfaction at reasonable cost.
- Manage your procurement practices well, so that you have reliable supplies from key goods or service providers on commercially fair terms.
- Ensure your business processes and systems are optimised at regular intervals, to maximise EBITDA FME and also reduce risks for any purchaser of the business.
Structures and Risks
- Structure your business so that it can be easily separated from the rest of your affairs if you choose to sell it, whether you sell the entity as a whole or only certain business assets.
- Monitor and mitigate your business risks at regular intervals, eg using a SOWaT assessment or by completing our free Business Health Check.
- Protect your valuable assets through cost effective insurance policies and by registering Intellectual Property where you can, or at least having sales, staff and supplier contracts in place that preserve those rights.
So You Now Want to Sell Your Business
Once you’ve done the hard work setting your business up for sale you will be ready to find potential buyers on your own terms.
In our next article in this series, I will discuss the typical elements of the private business sale process, and how you can avoid making common mistakes along the way.