3 More Rules of Engagement When Buying or Selling a Small Business
Navigating the nuances of buying or selling a business, part 2 three more rules of engagement
Whether buying or selling a small business it’s important to follow guidelines to foster understanding and value.
Recapping part 1 So You Want to Buy (or Sell) the Business? Rules of Engagement were rules one though three rules were addressed:
- Rule 1: Take Emotion Out of the Equation
- Rule 2: Be Honest With All Rule 3: Due Diligence Is Required for All Deals, Big and Small
- Rule 3 is simply recognizing that no deal is simple. Do your homework and don’t ignore that inner voice that tells you something does not make sense.
Completing the six rules of engagement when buying or selling a small business are rules four through six.
Rule 4: Strategic Buy versus Buying A Job
When a buyer is looking for a business deal, sometimes it is a buyer who is looking to add compatible industries or product lines to an already existing business. This type of buyer is a strategic buyer, who will eliminate common costs of his existing company and the new SBE acquisition, and possibly use opportunities to have his sales people cross-sell products or services. For instance, imagine a person who owns an insurance business, and he realizes that the same customers would also come to him to do their tax returns.
He might choose to purchase a small tax preparer business, operating from the same office, and then cross-sell insurance policies to the tax preparer’s customers.
This type of strategic buyer is often a better candidate to buy your business, because of the economies of scale, and because the buyer is already likely to be experienced in business. The buyer may also have a profitable company, which may allow him easier access to credit lines to fund the deal. A strategic buyer will often pay a premium for an SBE if it is the right fit.
Conversely, some buyers may simply want to leave a job and enter into the world of self-employment. In effect, the buyer would replace the outgoing owner. Sometimes, the buyer already works in the business. In either case, the buyer will need income to pay his own salary, plus the deal will need to be self-sustaining. Ironically, the best talent to buy a company out is often from within the company’s current group of employees.
Unfortunately, such buyers ,may have gotten comfortable with a “paycheck” mentality, or may have needs which require a weekly paycheck. Therefore, the buyer is inheriting what the company is today, and may not be able to grow the company immediately.
Rule 4 requires both sides to see the buyer for what he or she is, and to understand that each type has different limits and compatibilities with the SBE being purchased.
Rule 5: Beauty is Not in the Eye of the Beholder
Owners of SBE’s love to talk in platitudes and rules of thumb that every person has heard before. It is a way of establishing a hypothetical value without really proving anything. For instance, an owner of a business may say “ I have heard companies like mine are easily worth 1 times gross sales. After all, a friend sold his company for $25 million, and his sales were all of $27 million. So, I will take the same offer.” That comparison may be ( and often is) a complete mismatch.
While rules of thumb do exist, they must be applied to very specific situations, and the comparisons must be very close. You cannot value a manufacturing company with $27 million in sales, a large sales force, exclusive product lines, ties to major customers, which is highly profitable, and then compare that to a corner bar or restaurant doing $1 million in sales and breaking even at best.
This kind of “puffing” or exaggeration is a turn-off when we negotiate, and can sometimes be a basis for walking from a deal because the owner is unrealistic or even worse, irrational. Most operating companies ( excluding companies like Facebook or real estate deals, which are a completely different animal) are valued at some multiple of EBITDA. EBITDA means earnings before interest, taxes, depreciation and amortization.
This acronym is another way of saying debt-free cash-flow. The multiple applied to EBITDA is based on the riskiness or frailty of the business. Small, risky businesses like bars and restaurants may sell at 3 to 4 times EBITDA, while larger successful manufacturers may sell at 5 to 7 times EBITDA.
These are reasonable starting points as benchmarks, but by no means are they written in stone, since there are many other aspects that impact risk. An example of added risk might include being tied to one major customer who represents a concentration of 50% of sales. Lose that one, and you could be out of business.
Sellers should pre-evaluate the risks of the business so they can have answers ready for such hard questions.
Buyers need to be very careful about giving away future profits.
First-timers often are tempted to give a seller extra money in a purchase price based on the hope that the new owner will be more successful. The wastefulness of this type of thinking should be obvious. First, the new buyer should question why he or she thinks the company could be more successful under their leadership than under a person who has built the business from scratch, and who knows every aspect of that company, including all the customers and employees by name. Secondly, why should a seller be entitled to a piece of future profits?
The future belongs to the owner at that period in time. The past successes or sins of the past belong to the seller. A buyer might, however, offer something called an “earn-out”. In such a case, the buyer may offer a lower multiple of EBITDA, but than counter with an upside profit split for a short period of years ( 1 to 5 years) after the new owner takes over. An earn-out effectively ties the buyer and seller together towards a common goal, which is increased profit and success of the company.
Rule 5 means that no business fits into a standard valuation model.
Each deal stands on its own merits, and no two deals are the same.
Finally, Rule 6: The great lie.
One of the most delusional comments ever uttered by a business owner is “Small businesses are expected to lose money in the first three years”. This is often the words of a person who either owns a failing company or one who is trying to justify in his or her own mind that a failing business is worth buying. The first sign of a successful business is that it makes recurring profits. Profit and cash-flow are the engine by which a buyer gets money to pay a seller. Never forget the phrase that attempts to justify failure by masking it as the norm. That is a falsehood , and failure should not be expected or accepted by the SBE, its owners and its potential buyers.
Related articles:
So You Want to Buy (or Sell) the Business? Rules of Engagement
Acquisition? What’s Your Company’s Valuation?
Eli Mendoza on Equity and Financing
