Business valuation and deal structures explained
with Pete Seligman
Buying a business needs a business valuation and deal structure
Business valuation and choosing the best deal structure can be complex and daunting when you are new to buying a business.
Brendan Barrow interviews Pete Seligman as part of our sub-series on Buying A Business.
Pete Seligman, explains how to arrive at a value for a business you’re looking to buy. We also discuss the various ways in which the deal might be structured.
We cover the concept of earnings and multiples to value a small to medium business along with three deal structures based on earnouts, options and royalties.
Links and resources for buying a business.
The final stage of the business buying process
In Episode 20 we explained the 555 system for choosing the right business to buy, along with the concept of due diligence.
That’s a great episode that explains how to use a funnel process to select a business to buy.
Assuming that you have selected a business to buy and carried out sufficient due diligence, the next stage would be to agree on a price and terms to purchase the business.
How do you close a business buying deal?
In smaller businesses closing the deal can be influenced by the emotions of the buyer and seller or vendor as they are sometimes called.
The sellers may have owned the business for a long time and have invested blood, sweat and tears along the way. They are likely to have an emotional attachment to their business.
Hopefully, you have formed a good relationship with the seller through the due diligence process, and the trick now is to negotiate a deal.
Writing down what you have agreed so far needs to be done, but this can cause some revaluation. Emotions and disagreements mean it’s not always smooth sailing to close the deal.
Writing everything down is however, a vital process in formalising your negotiation and agreement.
How do you value a business?
Establishing a business value can be complex, and there are specialist business valuers that can help you if you lack the experience or knowledge to do this.
We highly recommend getting professional help to establish the business valuation to negotiate with the vendor and fully appreciate what you are buying. Buying a business can involve substantial amounts of money so you need to get this right.
The type of industry, the stage in the business life cycle, the type of contracts are some things that can influence a business valuation.
One of the most common approaches to value a business is earnings and a multiple of earnings.
Several factors influence the profit and multiple chosen.
In essence, you establish the “normal” earnings of the business and apply a multiple of that profit to establish a value.
For example, a “normal” profit of $1million with a multiple of 4 would give a valuation of $4million.
There is more than one way of calculating profit or earnings which complicates things.
Which profitability figure do you use to value a business?
Using the financial accounts of the business, you can work out the “normal” business profitability. We may use a profit measurement called EBITDA (Earnings Before Interest Tax Depreciation and Amortisation).
Adjustments can account for abnormal circumstances (good or bad) as the goal is to calculate the “normal” profitability that the business can achieve.
What is a “multiple” when you are valuing a business?
A multiple is a factor that multiplies the profit to establish a business valuation.
The multiple is derived based upon several factors, including the industry and the risk of not achieving the ordinary profit.
The lower the risk to earnings, over time, the higher the multiple.
For example, if the company has a long-established, high-quality customer base, the likelihood of continued earnings is good, and the multiple would be higher. A business with a volatile customer base subject to constant price pressures might attract a lower multiple.
The multiple is therefore a risk indicator.
Are assets valued in addition to the multiple of profit when buying a business?
For a business to achieve its “normal profitability”, it also has a “normal amount of assets” to do that.
That could include buildings, machinery, stock, vehicles, etc., that might sit on the “balance sheet” of the business.
We suggest that these are not paid for separately as, without them, profitability could not be achieved.
In essence, the multiple of profit approach covers the purchase of these assets.
Misinformation can upset the vendor.
Some vendors are misinformed and expect to get a value based on a profit multiple plus assets.
How do you take account of working capital in the final settlement?
The cash or working capital needed to run a business fluctuates as it flows in and out of a business.
Working capital needs careful consideration and a clear mechanism of how it will be treated agreed between the business buyer and seller.
Working capital movements can be a significant proportion of the purchase price, and the value of working capital can fluctuate.
For example, a business with a value of $1 million might have a working capital movement of plus or minus $250,000.
A “locked box” working capital mechanism
For example, a “locked-box” mechanism or a working capital adjustment on the completion date could be good options.
Again we suggest that you get advice on this subject as the financial impact can be very significant.
Such a mechanism protects both the buyer and vendor.
Why is a fair business valuation so important?
You don’t want to overpay for a business but, equally, you don’t want to miss out on buying a great business because you undervalue its potential.
Establishing a fair value enables both the seller and buyer to benefit.
What are three common deal structures for buying a business?
1 What is an “earnout” when buying a business?
Earnouts are very common, and they are a risk management tool that avoids the need to spend a long time precisely forecasting the future.
In any negotiation, there is often a gap between what the buyer and seller want.
The earnout is a mechanism that allows the seller to prove its worth by the business earning a proportion of the final settlement price.
A headline price will be agreed, but only a portion is paid at settlement. Over a defined period, the balance can be paid if the agreed performance criteria are met.
Earnouts offer the seller the opportunity to contribute and achieve a higher business value.
Earnouts also allow the buyer to reduce their risk of over-paying for a business.
If appropriately structured, earnouts are a useful risk management tool for both the buyer and seller.
2 What does an “option” mean when buying a business?
For example, a percentage of shareholding may be bought at an agreed price, with the option to buy the remainder at a higher valuation.
An “option” allows the vendor to exit in the future for a known amount while attracting a buyer now, at a good value. The new owner has the option to take full control at a pre-agreed value when the conditions of the option are met.
3 What are royalties when buying a business?
Royalties work well when a business has significant intellectual property rights that could be exploited by a new owner, but the earnings of the existing business don’t warrant a good sales price.
Royalties allow you to disconnect the value of the existing business valuation from the potential earning of the “new” business.
The existing business can be bought for a price that reflects its earnings, and additionally, royalties could continue to be paid.
Royalties, for example, could be paid on product sales over the long term (5-10 years) period, so the seller benefits over a longer term.
How do you choose the right deal structure for buying a business?
Consider the underlying business and the objectives of the owner and buyer, along with the business risks or potential.
Then consider the various deal structuring tools that you could use to construct a package to reflect the objectives of both the buyer and seller.
What are the timescales in buying a business?
You can expect negotiating to take 2-6 months.
The overall duration of the deals could span several years.
Each deal is unique.
What are the things you need to prepare for on Day One of owning a new business?
In our next interview in this series, we will discuss new ownership and Day One.
The information contained in this podcast is general and does not take into account your situation. The content does not constitute business, legal or financial advice and should not be used as such. You should consider whether the information is appropriate to your needs, and where applicable, seek professional advice from a financial adviser or lawyer in your jurisdiction. To find out more, please go to www.ShouldIOwnABusiness.com