Exit Strategies – Cashing In Part 2 – Business Valuation TRANSCRIPT

Dennis Zink: Welcome to SCORE Business TV. In this series, experts share their knowledge on a variety of topics. Today, we are presenting part two in a series of episodes addressing business succession. Today’s topic, valuing your business.

But before we begin, I’m happy to introduce two experts in the field. First we have Peter Gruits, having had a long diversified career and high-powered executive. Peter is a Volunteer SCORE Mentor, leading the Exit Strategy Program. SCORE is a resource partner for the SBA, helping small business owners in all 50 states start, grow, and exit their business. And we’re also happy to welcome Eric Robinson, Partner of Robinson, Gruters & Roberts, a Venice, Florida, CPA firm.

Peter, let’s start with you. When someone buys a business, what are they buying?

Peter Gruits: Well, every business is different, but what they’re really buying is, they can be buying the assets, they could be buying the customers, they could be buying the business process, they could be buying intellectual property, for that matter, but they’re buying. Typically, they’re looking to buy an ongoing business that they can do something with in the future. They’re not looking to buy something that’s going to close the next day.

Dennis Zink: And why should a business owner establish the value of their business?

Peter Gruits: Well, value means a lot of different things to a lot of different people, but in SCORE, our Exit Strategy Team focuses on trying to figure out where we’re going to fix the leaks that are in the business. The value leaks that occur within a business, and in effect, how can we look at that business, so we can retain value? Areas where the value will leak is possibly in having too much of your concentration in a few customers, having customers that don’t really work out to be profitable, spending most of your time with unprofitable customers.

Another area where there could be a leak, is you have some very bad employees. You have employees you should get rid of, that in effect, your good employees really are being compromised as a result of those bad employees. Could be you have too much dead inventory, you have inventory that’s obsolete, you’re paying for space to store it, that’s a leak.

You could have spare parts inventory for equipment that you don’t have anymore. That’s a leak. You could be doing too many of the things yourself, as the owner, and you’re not really holding yourself to the performance standards of the business, that’s a leak. So the SCORE Mentors are there to help you identify and fix those leaks.

Dennis Zink: Peter, what methods are used to value a business?

Peter Gruits: Well, there’s a variety of them. One of the standards is really looking at the North American Industry Code. Every business has a code that matches what their type of business is, and so across the country, you’ll see similar businesses with a similar code, and that there are tools that allow you to find out what the ratios are, and what the real value of those businesses are, based on size of the business, the kind of location of the business, that type of time.

Dennis Zink: And that’s a NAICS Code.

Peter Gruits: Yes.

Dennis Zink: Eric, are businesses in different industries valued differently?

Eric Robinson: Yes, for example, if you’re a manufacturing company, it’s been more of a duration of book value, so the return on assets, is going to be very important, and for a lot of service-based organizations, our business, in general, it’s going to be discounted cash flow.

So what do I mean by that? If someone’s going to pay you $50,000 a year over the course of 10 years, it’s not really $500,000 because the 10th payment of 50,000, because of inflation, because of the uncertainty of receiving that $50,000, it’s worth less than it is now.

So 10 payments of 50,000 may actually only be worth 375,000, so if someone’s offering you 10 payments of 50,000, or 450,000 now, you’d want to compare those two offers, using discounted cash flow method to see which one actually is bigger bang for its buck.

Dennis Zink: Eric, can you explain the concept of goodwill and how that factors into a purchase?

Eric Robinson: So goodwill is the difference between the price of the hard assets that you’re selling and the actual purchase price of the business. And that is what’s called goodwill, some people commonly call it blue sky, and they’ll be able to put that on their books, and depreciate it, amortize it actually, just like any other asset. But it would be straight line over a 15-year period.

Dennis Zink: What about same industry? Companies in the same industry, why would one be worth more than another?

Eric Robinson: So, for example, going back to Peter’s analogy about leakage, you could have two companies with the same revenue, but one has more leakage than the other, and so that will affect the profitability of it, it could affect the return on assets, it could affect the discount rate. And so all those things could affect the eventual sale or purchase price of the business.

Dennis Zink: Peter, how can the SCORE Team with the Exit Strategy Program increase the value of a business?

Peter Gruits: I don’t think the Exit Strategy Team increases the value, but what we do, is we bring reality to the transaction. And because our mentors are experienced, because they, in effect, operate under a confidential agreement, and because they’re free, it’s a great way for you to test the waters, in reference to the concepts that you’re looking for, in reference to selling your business.

Eric Robinson: Now I’d normally agree Peter, but I’m going to have to disagree. I think that SCORE can actually increase the value of a business by requiring you to plan, by making sure that you do your homework, by making sure that you look at, “What is driving the value of my firm?”

And then, you can make sure that you gear your actions towards that valuation, and that metric to increase the overall value of the firm. I think SCORE allows you the ability to focus in, because sometimes you’re an entrepreneur-

Peter Gruits: Well, that’s true.

Eric Robinson: And you’re very disjointed and very disorganized, and they allow you the ability to focus and hone in on what is really important and what is the seller going to be looking at? Because you’re looking at it as the entrepreneur, sometimes you got to look at it as the seller, and sometimes they’re always not, always looking at it the same way.

Dennis Zink: And when will you be joining the SCORE Exit Strategy Program? Eric, let me ask you about-

Eric Robinson: Sorry to disappoint.

Peter Gruits: Oh, that’s all right.

Dennis Zink: Let me ask you about owner benefits, how does that add to the value of the business?

Eric Robinson: Yeah, I’ve heard a rumor that some people have quasi business expenses on their sheets, in order to lower their tax burden. So that could be stuff like Tampa Bay Bucks tickets, want to drive a nicer car, and you [inaudible 00:07:20] the expense of the business. Anything that’s not ordinary or necessary in running the company, those kind of things, you probably with good planning, would probably want to take those out, and not have those show up on your income statement because it’s going to essentially increase the value of the firm.

If that person wants to go and get an SBA loan, or get a loan from the bank, it’s going to increase the chance that they’re going to be able to get a loan because

the bottom line’s going to be higher. And let’s face it, the bottom line’s higher, you probably actually get a better price for the business.

So just because you’re not expensing $20,000 for the car, because of the multiple factor, you may end up getting $60,000 more in your pocket, so you got to look at it. $20,000 in the car, it may create $8,000 savings in taxes. Would you rather have $8,000 or $60,000? It doesn’t take a CPA to figure out, “I’d rather have the 60,000.”

Dennis Zink: Eric, can you explain (the concept of) what EBITDA is?

Eric Robinson: So it’s Earnings Before Interest, Tax, Depreciation and Amortization, which is basically you’re free cash flow for the business, and that helps people determine what they’re going to use as a multiple to pay for the business because they’re going to look at, “Okay, if I want to borrow money from the bank, how much money am I going to have to spend for that? How much money am I going to have to spend to buy equipment, to amortize goodwill? And then basically, how much money am I going to have left to basically be my own benefit? What’s going to be the value to me?” Because at the end of the day, the bottom line’s the bottom line.

Dennis Zink: Can you explain a little bit, both of you chime in on this about multiples, and let’s start with you Eric.

Eric Robinson: So multiples are basically derived from multiple factors, is the stability of the cash flow. So if you have somebody who only has one client, you’re probably not going to give it as much of a multiple, because if that one client leaves, what do you really have? If it’s a high-growth company, then you’re going to give it a larger multiple because the income’s going to increase over time. If it’s a more stable company or a declining industry, you’re probably going to give it a lower multiple.

And basically what it is, is if you’ve determined that EBITDA is $50,000, and it’s a high-growth, you may give it a 30 times multiple, but if it’s a declining or stable industry, you may give it a two to three times multiple. So it’s the difference between getting 50 times three, or 50 times 30, and so that’s the difference.

Peter Gruits: A lot of that depends on really what market you’re in, and it depends on where you’re NAICS Code is.

Eric Robinson: I agree.

Peter Gruits: And in effect, do you have comparables in reference to those kind of multipliers? Back to Eric’s comment about discretionary income, if you pull money out to buy Buck’s tickets, why anybody would do that, I don’t know. But if you pulled tickets out, money for that purpose, you’re in effect, giving up a lot of your potential cash, as you go to sell it. Because the lending institutions, and the SBA, and whoever happens to be funding this, is going to, in effect, discount.

It’s going to say, that is not part of your return, and so they’re going to look at your tax returns over the last three years to determine, really, what your cash flow is. So you’re hurting your cash flow, you’re leaking cash off of something that doesn’t build value.

Dennis Zink: Right, but at the same time, Eric, a buyer is going to say, “Okay, I don’t need to buy those tickets, so I’m going to add it back, so now those tickets cost me $20,000, and if I’m going to get a multiple of four, then that’s worth 80,000 to me when I sell.”

Eric Robinson: Correct, except Peter’s point is a bank may not look at it like that. A bank may say, “This was on your tax return, this is your net income on tax returns, and that’s what we’re going to use to determine the multiple, and that’s going to determine how much we loan you.” So that $20,000 may make it so that someone may not be able to put the finances together to buy your business because of that.

Peter Gruits: Seller has to put on glasses that are reflective of what they would do if they were going to buy the business. And that means, you have to put so much money down, that means you have to, in effect, get a loan through some kind of lending institution, that means you may have to take back paper on that. It means you may have to enter into an employment agreement, so that comes down to the terms and conditions of your sale.

And the terms and conditions of your sale have as big an impact on what you’re trying to do as the price does. So as you’re setting the price, and you’re looking at terms and conditions, you’re going to open yourself up to many more potential buyers if, in effect, you can be flexible in that regard.

Dennis Zink: Since you mentioned loans, SCORE is a Resource Partner of the SBA, and they’re also a major, they guaranty loans when people are looking to buy businesses. Can you comment on how that works?

Peter Gruits: The SBA doesn’t loan money. The SBA guarantees a loan through a financial institution that’s qualified to be a financial institution. So you need to get a competent commercial lending officer to work with you in this regard. And sometimes they’ll decide that they can handle the transaction on a commercial loan basis.

Other times they’ll say, “Well, this really needs some help, and they’re not going to put that much money down,” and SBA will guarantee a much larger portion of the deal. But SBA has, SBA’s not giving money away either. The SBA is, in effect, saying, “There’s credit criteria that you have to meet, and we’re going to hold you to that.”

Dennis Zink: And Peter, they have different loan programs, what was it, 7A, and then there’s one for real estate, a 504?

Peter Gruits: Some loans are like a five (504), is in effect, related to real estate. A seven (7a) is to an operating going business. So there are a number of different ones to look at. The big key to recognize again, is that your tax return has to reflect what you’re business can do performance-wise. And if your performance is not reflected adequately in your tax returns, you got an uphill struggle, you’ve got to fix those leaks. You’ve got to make that, you got to improve that performance. That boat’s got to go a lot faster across the water than normal because you have a lot of competition.

There’s a lot of businesses out there that are for sale. And you have got to make yourself aware of that. Just like if you’re going to sell a house, you got to clean the house before you put it up for sale, and you got to make sure that the value of that house is commensurate with the comparative market analysis of the neighborhood. It doesn’t matter how much money you have in the house, if it doesn’t meet that assessment, the appraisal, it’s not going to, in effect, get that kind of money. So those are all parts of the steps that you have to take.

Those are all parts of the steps that you have to take. And our team members from SCORE have experience in that, and we’re going to ask you those kind of questions. And if you don’t know the answer to those questions, it’s time to roll up your sleeves and get to work on it. And that’s part of, this doesn’t happen in five minutes. You can’t have one or two calls, and all of the sudden, you’re ready to go out on the sea. You’ve got to, in effect, have a very good plan going forward, and that’s what we try to help you with at SCORE.

Dennis Zink: Eric, how much negotiating room is there in a deal?

Eric Robinson: I wouldn’t put it in terms of that. I would go back to what Peter was talking about, flexibility. So if you’re more flexible, if you’re willing to stay on, or some people may not want two owners there at one time, if you’re willing to stay on as a consultant, be an employee, all those things play into, it’s more of a mindset in flexibility, as far as that. And I think planning and homework goes a long way in creating the right paradigm of what range that you’re willing to take, are the marketers willing to bear for your sale of your business.

Peter Gruits: Selling your business is a very emotional experience. People who have spent their life trying to be independent, trying to be on top of everything, and many of the entrepreneurs are not employable.

Eric Robinson: Unemployable.

Peter Gruits: So in that particular case, they have to get past that emotion. They got to determine why are they selling this business, and realize there’s a lot of compromises they have to make to get there.

Dennis Zink: Let’s talk about earn outs. You talk about a seller staying on for a period of time. How typical is that? What kind of earn outs, maybe mention the percentage, or, is it all over the map?

Eric Robinson: It is all over the map, but it depends on the entity. If the person owns the relationship, if all the clients think that they’re doing business with the owner, and not with the company, then you’re going to want to make sure that you have earn out, so that there can be a transition time, to where people either know that they’re doing business with the company, or they know that they’re doing business with the new owner.

You’re going to want to make sure that you get non-compete, so that someone doesn’t sell, and they don’t start business across the street. You want to make sure you get non-competes from some of the key employees that you buy from. But it depends on what type of business that you’re going into.

Dennis Zink: Is that difficult to get the non-compete after the fact? They’re already working for you, they haven’t signed one, and now you’re asking them to do it?

Eric Robinson: You’re the key employer or the owner?

Dennis Zink: The key employees.

Eric Robinson: The key employees, it can be somewhat difficult to tie them up. What you can do is, because it’s such a chaotic time period, is you’re going to have to offer them some sort of stability, in making sure that they’re worried, “Am I going to lose my job, too?”

So there are ways to finesse it, you’re going to probably have to pay to get the non-compete, but the non-compete has value. Has value to you and to that employee, so you want to factor all that in when it comes time to purchase a business.

Dennis Zink: Peter, what should an owner not do, when selling his business?

Peter Gruits: Well, an owner should learn to keep their mouth shut. They should, in effect, get good advice from experienced and confidential people, like our SCORE Mentors. But they also have to be careful that they don’t spill the beans on the fact that they’re looking to sell their business, because loose lips sink ships, and it’s a very sensitive time. I mean, employees could hear that you’re trying to sell the business, and everybody goes away, and so the value of your business can be terrifically impacted.

It’s important to also realize that most owners, who have an ongoing enterprise, have friends who work for them. They treat those employees like their family. And under those circumstances, you have to negotiate in good faith to be representing them, as well, both for continued employment, but also maybe

you need to give them a piece of the pie, as you go to sell. So you’re negotiating for the people within the firm, as well as yourself.

Dennis Zink: Eric, do you have something to add?

Eric Robinson: Yeah, I wanted to add onto that. I wanted to add some things that the seller should do. They should make sure that they plan, something we talked about earlier, make sure you understand what it is that’s driving the sale price, and you maximize that. Give in to some of the quasi business, do your homework. But also, rely on some experts. That includes legal, good CPA, and possibly SCORE to seek out.

This is probably going to be one of the largest financial transactions you ever do in your life, and it’s going to be encompassed upon you to realize, “I don’t know everything, and I want to make sure I get this done right, because I’m only going to get one chance at it.” And so using people at school, or whoever, that knowledge and expertise, will in essence, increase the amount of money that you walk away in your pocket.

Dennis Zink: You said possibly SCORE. You meant definitely SCORE?

Eric Robinson: Definitely SCORE.

Dennis Zink: Okay.

Eric Robinson: It depends on the situation.

Dennis Zink: And is there anything else you’d like to add to the conversation before we close?

Eric Robinson: No, I just think that people need to be cognizant of what’s driving the situation, do your homework, plan, and don’t be afraid to reach out, and definitely call SCORE.

Dennis Zink: Peter, how about yourself?

Peter Gruits: I think it’s important to not go through this alone. It’s very important for you to recognize that there are all kinds of pitfalls to this, and it’s going to impact how much money you get. So you really need to talk to people who know what they’re doing. And the great advantage of dealing with us, is that we’re free, and we’re experienced, and we’re confidential. And so we would encourage you to, in effect, get involved.

Dennis Zink: And Peter, how can our viewers reach you?

Peter Gruits: Well, you just go to SCORE, www.score.org, and go through the process. Our chapter’s called Manasota SCORE.

Dennis Zink: Okay, great. And same for you, Eric?

Eric Robinson: My website’s www.robinsongruters.com, R-O-B-I-N-S-O-N-G-R-U-T-E-R-S.com. Or, you can email me at eric@robinsongruters.com.

Dennis Zink: Okay, please tune in for our next episode, when our experts will continue the discussion about exit strategies. Until then, this is Dennis Zink, saying thank you, and have a great day. I may be reached at dennis@Time4Exit.com