To ensure you get the best price for your business if you decide to sell, you need to start planning for such a sale well in advance. You also need to consider the issues that could cause you problems. Typically,
you’ll feel your business is worth more than is justified by the marketplace
your books and records may fail to reflect the true worth of the business
you may have no audited financial statements available because you’ve never found any need for them
your purchaser may want you to stay on and operate the business.
Sale timing
Too frequently, businesses are sold under duress. This results in the need to obtain the best possible price to settle your affairs. Buyers want bargains. A lack of proper planning by an entrepreneur can throw just such a bargain into their laps. Consider your sale as a long-range process. Today’s good planning can result in a higher price two or three years down the track. To prepare for a sale, you should:
get the books in shape; prepare audited financial statements for two or three years and make sure those statements reflect the true worth of the business (that is, neither overstating nor understating its value)
improve the portability of the business by hiring and training professional managers and gradually transferring more of the day-to-day control to these people. Professional management in place creates new options for the owner
identify potential purchasers and analyse their requirements. Prepare, or have prepared professionally, an information package on your business explaining its history, value and potential
begin establishing, or re-establishing, lines of credit. Lines of credit that have been negotiated and settled can make a business much more attractive to potential purchasers.
Retirement
As retirement approaches, you may feel that you’d like to remain involved in your business, but remember that that feeling may change as the years go by. When a business is sold on retirement the proceeds can be safely invested in a way that will ensure a sustained income for the remainder of your life.
Consider that pensions are assets tested. Thus, continued ownership of the business could have an impact on your pension entitlements. The funds from the sale of your business could be invested in a way to minimise this problem.
It may be difficult to sell your business without your involvement. If this can be planned for, it need not be a problem. However, if retirement is forced on you, the sale price could be so adversely affected that passing a going concern to children might be a better option.
The decision to sell
When you decide to sell your business you need to consider the following issues.
Is it the best time to sell?
Is the business performing poorly?
Have current economic conditions affected the business?
Does the business have any contingent liabilities such as impending legal problems?
How will the sale affect your personal finances?
How will the sale affect your employees?
Why are you really selling? Is it due to the workload; the desire for a new challenge; retirement due to ill health or old age or financial reasons?
Have you considered alternatives such as merging with another business; establishing a partnership or joint venture; partial retirement; or raising funds through a company structure?
It’s a good idea to get professional advice from a lawyer, accountant or business broker. Professional advice can assist to determine what should be sold (eg the business as a going concern or in some other form), taxation aspects (including the timing of the sale for income tax and capital gains tax purposes), valuing the business and deciding the best way to market it.
The following handy checklist will help you to consider all the issues.
Checklist
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Records, information and lists
Critical questions for you to consider are:
What am I selling?
Is the business vehicle to be sold alone?
Are assets to be sold with the business or separately?
Is goodwill included?
You should make a detailed list of exactly what is being sold and in what form. This will prompt you to check that proper title to assets is held. You must also decide what information should be given to the purchaser and how that information will be presented.
Your business plan is a good starting point; however, this may need to be altered to be appropriate for use in a sale. Accounting records will always be extremely important. In all cases you should take extreme care that statements made are not false or misleading. There have been a great many cases where vendors have had to pay substantial damages because of statements made in the course of selling a business.
| Checklist Plant, equipment and chattels Each of the following matters will affect the eventual purchase price, and should be considered prior to sale.
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Goodwill
Most business sales include the business’ goodwill. In many cases the majority of the purchase price goes towards buying goodwill. Goodwill is usually regarded as the excess in the value of the business beyond the value of its tangible assets.
To protect both vendor and purchaser, it’s necessary to define rights and obligations expressly in the agreement for sale. Most standard agreements make some provision for goodwill but it’s necessary to consult a solicitor. Goodwill (and its proper protection) includes: Name, Intellectual property, Competition, Maintenance until sale, Tuition, Clients and customers, and Contracts.
The following checklist lists matters to incorporate in the valuation of goodwill. Where appropriate, these matters should also be identified in the contract for sale.
| Checklist Measuring goodwill Each of the following matters will affect the eventual purchase price, and should be considered prior to sale.
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Restraint of trade
In most business sales the giving of a restraint of trade agreement by, or on behalf of, the vendor is an important part of vesting goodwill in the purchaser. Restraints are almost invariably provided by the vendor. However, particularly when the vendor is a corporation, it may also be necessary to secure restraints of trade from directors or shareholders of the vendor. Occasionally, it’s also necessary to secure some restraint from managers and other key employees of the vendor to protect the purchaser against loss of customers in the period after the sale.
There are several difficulties in drafting effective restraints of trade. The complexity of these problems necessitates reference to an experienced specialist. A badly framed restraint of trade agreement can become unenforceable which will, in turn, dramatically devalue the goodwill.
Generally, to be enforceable, a restraint of trade must be in the parties’ interests and not against the public interest. The restraint should only be wide enough to protect the goodwill sold by the vendor. It should be confined both geographically and in time.
Normally restraints will deal with areas such as:
competing business activities – buying, selling, importing, exporting or manufacturing in competition with the business sold.
assisting a competitor – this includes both financial and physical or intellectual assistance.
acting for clients – not to act for clients of the business.
soliciting past or existing customers.
disclosing confidential information; and
interference with employees – not to interfere with, entice, or attempt to entice the purchaser’s employees.
| Checklist Restraint of trade Each of the following matters will affect the eventual purchase price, and should be considered prior to sale.
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Trading stock
The sale of most businesses includes the stock-in-trade, in addition to plant, furniture, fittings and chattels. Trading stock generally does not include packaging, stationery, advertising material, letterheads, invoice books, receipts, or logos. If any of these should be included in the sale, that should be specified in the agreement and a price (if any) should be decided on.
The price of trading stock included in the sale must be specified. There are different methods of ascertaining the price of trading stock, including:
wholesale cost to vendor
retail price
either of the above with a percentage discount; or
separately agreed prices for each item.
There are professional valuers and stocktakers who can inform parties of the objective value of stock. A number of other issues relating to trading stock should be considered, including:
the vendor’s entitlement to acquire additional trading stock before completion
the maximum and minimum trading stock the purchaser will accept
the price at which the vendor can dispose of trading stock before completion (eg whether the vendor can hold a closing down sale), and
whether the vendor has full and unencumbered legal title to the stock.
| Checklist Trading stock Each of the following matters will affect the eventual purchase price. It’s important to consider the following:
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Making the business a better buy
There are a number of factors which a prospective purchaser will look for in a business. You should be aware of these factors and be prepared to inform the purchaser about them. You can make your business more attractive by improving these factors (always bearing in mind the regulations against misleading or deceptive conduct). The following identifies what the purchaser will look for and provides suggestions for ways in which saleability can be improved.
Transition
Buyers will want to be assured that they can take over the business and keep it running successfully. You should be able to demonstrate that the business can be run during the ownership transition period.
Improving saleability
You can:
offer to train the buyer before or after the sale
introduce key employees; and
ensure that training documentation is available.
Company history
A purchaser will look at the company’s history. The longer the business has been successfully run, the better the chance of the business continuing successfully. Statistics show that the majority of new businesses fail within the first five years. The longer a business has been running the more saleable it is.
You can keep the business until it has a more substantial history. Or, prepare a detailed plan of the business’s potential and how the business will survive past the five-year mark.
Products and services
A business’s product or service must be examined for quality, price, delivery, reputation, recognition, competitiveness and potential. Any money that’s spent on these factors will improve the business’s product or service and result in a better asking price. Any improvements that reduce the risk to the buyer or increase the product’s potential should be considered.
Improving saleability
One simple way to improve saleability is to increase advertising in the period leading up to putting the business on the market. Increased advertising will increase sales. If buyers are aware of the product or service they’ll be more willing to buy the business which produces it.
Some superficial problems may enhance the chance of a sale if left unresolved. For example, if a reason for low sales is unattractive packaging it would be a simple matter for the owner to alter the packaging but the increase in sales may take time and the change may not be apparent to a prospective buyer. However, if buyers can be made subtly aware of the problem and how easily it could be resolved, they may feel that they’re getting a bargain.
Production
The way that the product is produced, or the service is offered, is fundamental to the business. This can be hard to evaluate because it draws in all the various functions performed by the business
In general, reducing risk and increasing potential are important, but small inefficiencies may be worth more uncured than cured.
Employees
Employees can be extremely important to a business’s saleability. A purchaser will be reluctant to buy if it seems that employee problems are looming or that key personnel will leave if the business changes hands.
To improve your company’s saleability as far as staff are concerned:
Either change the workforce or train employees to the necessary level of competence.
Change the management structures as necessary.
If key employees may leave the business, consider offering them incentives to stay.
If the business is heavily reliant on you, train employees to fulfil tasks so that the purchaser doesn’t feel that the business is too dependent on your involvement.
Equipment
Buyers’ impressions of a business’s equipment will be very important – particularly their first impression.
Equipment should look clean and well maintained.
Training for operating the equipment should be readily available and/or key operators should be introduced to the buyer.
Apart from the physical appearance of the equipment it’s often a good idea to prepare a list outlining its age, where it was obtained, whether it is purchased or leased, how it is maintained and any other relevant factors.
Financial performance
The bottom line in the sale of a business is its financial performance. Any purchaser will want to see detailed financial accounts and projections. Great care must be taken to ensure that accounts and, in particular, projections, are not misleading or deceptive.
Prepare detailed and accurate financial records that present hard facts, not generalised statements.
Minimise the amount of independent research which the purchaser must undertake – this leaves less to chance and encourages the purchaser.
Tidy up the financial situation – write off bad debts, pay accounts, collect overdue accounts, and extract yourself from any complex transactions between you and the business.
Put any cash or sales that are being held out of the business back in.
Ensure salaries are fair and reasonable. This is particularly important in relation to your remuneration.
Ensure that the business’s finances are being efficiently managed.
Record keeping systems
Apart from the books and records specifically made up for the sale, a buyer is eventually going to want to see the everyday records of the business. Well-kept records will make the business appear efficient and create confidence in the buyer that the accounts presented for the sale are accurate.
Ensure that records are available and are clear and legible.
Ensure that an efficient record keeping system is in place so that buyers can assure themselves that records will be maintained during the ownership transition – this is particularly important in relation to customer lists and accounts.
Computer systems should have documentation accompanying them to show how they work, or you should be able to assure the buyer that a competent employee can work the system or that training is available.
Finance
Buyers will be interested in money owed by the business. In particular they will want to know:
how much is owed
to whom it’s owed
for what it’s owed
how it’s secured; and
if they’ll assume the debt with the business.
Improving saleability
Consolidate loans and leases so that the debt situation doesn’t appear too complex or burdensome. Or, obtain an extra line of credit (such as an overdraft) and don’t use it, thus demonstrating the business’s capacity to service debts.
Working conditions
The purchaser is going to be extremely interested in how much work is involved in running the business.
Improving saleability
Improve working conditions by training employees to take some of the work load. This will also reassure the buyer that the ownership transition will be smooth and less reliant on the vendor’s expertise.
Location, market and competitors
Buyers want to know what the business’ market and competition is like and whether it’s well situated. This will be partly, but not wholly, answered by the business’s success or failure to date.
Improving saleability
Provide as much information as possible. If, on collecting information, you see that there’s a problem with a factor, such as market, the sale should be postponed until the problem can be remedied.
Valuation issues
The value of a business is the price arrived at after negotiations conducted by the vendor and purchaser are concluded to their mutual satisfaction. Valuations are necessary to settle court proceedings (when these occur) and in whenever you want to sell your business to another person. Every purchaser wants to know whether or not a vendor’s asking for a fair price.
This is especially important when the purchaser is applying for a loan. Lenders want to know if the business is a worthwhile security. A valuation should be carried out by someone with the necessary qualifications and experience. Their valuation should include the calculation of:
true profit
net tangible assets; and
future maintainable profit.
True profit
A good valuer must determine the level of the true profit as this is usually the foundation on which the value of the business is determined. “True profit” is defined for valuation purposes as the sum of money a person buying a business should expect to receive before paying their borrowing or leasing expenses (if any); their living expenses (if the business is to become their sole source of income); and before meeting their income tax obligations.
| Example Assume a coffee lounge is advertised for sale with an asking price (excluding stock) of $100,000 and a net annual income for accountancy purposes of $50,000. An examination of the profit and loss account reveals the business had the following operating expenses: Depreciation $5,000 Interest $15,000 Leasing $5,000 On the assumption that all three items are added, the “true profit” of the business would now be: Accounting profit $50,000 Items added back $25,000 True profit $75,000 |
Reason items are added
Depreciation is a non-cash item, it’s usually added to the accounting profit figure as are both interest and leasing items.
Interest is added because the amount paid is expenditure relating to the vendor.
The amount paid in leases is added because when a business is sold, the plant and equipment passes to the purchaser free of any encumbrance requiring any lease contracts to be paid out on or before settlement. If the purchaser is expected to take over the lease payments, a lower purchase price for the business will be negotiated taking the sum required to discharge the leases into account.
Decision to buy
The purchaser must now decide whether or not the sum is sufficient to meet payments. If it proves to be insufficient then, irrespective of the value attaching to the business, it may prove unwise for the sale to proceed.
Net tangible assets
After determining the true profit of the business the next step is to ascertain the value of the net tangible assets. When valuing the shares of a company, for example, this information is obtained from the balance sheet of the company, with the difference between the tangible assets and the various liability accounts giving the value of the net tangible assets.
The net tangible assets are taken as being the value of the plant and equipment found in, and used by, the business. These are the items that pass to the purchaser on completion of the sale.
The valuer must determine whether the value placed on the items is on the going concern basis or auction value. If a business is being sold, the going concern basis will normally be the more appropriate basis. So, assume the written down value of plant and equipment in a coffee lounge is $20,000 according to the balance sheet presented to the purchaser by the vendor.
After inspecting the items, the valuer may determine that, on the going concern basis, the plant and equipment has a value of, say, $50,000. If the auction value was taken, the value may prove to be well under this sum.
Stocks are excluded from the value of net tangible assets because stock levels fluctuate daily and therefore value changes very quickly. The value of stocks should be determined at a properly conducted stocktake, and the sum involved added to the amount to be paid to the vendor.
In the coffee lounge example, the stocktake determines the value of the stock as being, say, $12,500 – the purchase price will now be:
| Purchase price $100,000 Stocks on hand $ 12,500 Total $112,500 |
Estimation of future maintainable profit
Before actually calculating the value of the business, it’s necessary to obtain an estimate of the future maintainable profit. The true profit of our coffee lounge example is $75,000; however, we now must consider those items which could lead to deciding whether or not this profit figure is reasonable, too high or too low. The list of possible influences can include
Competition present and future – are any similar businesses about to open in the immediate vicinity or is a shopping centre going to open nearby?
Has the local Council issued any orders against the business which may curtail its activities or, in the event of unclean premises, issued orders forcing the business to close?
Is the purchaser experienced in running such a business and how good was the vendor?
The lease on the premises must be examined – a 12 months’ lease affects both the purchase price as well as the term available to the purchaser to gain the profits shown to now exist.
Are there key staff who are about to leave?
What hours does the business operate – if they can be extended, would sales and profits increase?
Assume that there are no factors that will influence the profits of the coffee lounge, will the profit now being derived ($75,000) be a reasonable estimate of the future maintainable profit, and be used for valuation purposes.
Valuation methods
Several methods can be applied to provide you with a value for your business.
Arbitrary method
This is a very nebulous method of assessment. The business owners determines a selling price which they consider fair. This so-called “fair price” may or may not have any basis in fact. Many people think that just because they earn, say, $25,000 a year from their business, the goodwill must be worth $50,000 – they overlook the fact that had they paid a manager to run the business for them, the wages expense could have taken all, if not more, of these profits. Given such circumstances, there could be no goodwill attaching to the business.
Rule of thumb method
This method isn’t recommended. Typical businesses that use this method are newsagencies where, in the past, the value attaching to a newsagent was 2.5 x annual net profit. So, an agency with a net annual profit of $60,000 would have a goodwill content of $150,000. Experience shows that this method more often than not overstates the goodwill apparent in the business.
Capitalisation of returns method
This method of valuing a business involves determining the true profit of the business and, deducting from this sum, a reasonable return for the owner. Or, if the owner isn’t working in the business, determining the remuneration payable to staff to manage and operate the business on behalf of the owner.
The difficulty in using this method is that the valuer has to determine the rate of return – if there’s very little risk attaching to the purchase of the business, a rate of, say, 15% may be deemed appropriate but, if it’s a high risk business, a rate of 50% or even 100% may be used.
Assuming that a business is considered to be high risk, the capitalisation rate applicable would be 50%. Assume further that the asking price for the business is $150,000, with the business having a true profit of $70,000 and plant and equipment worth $30,000 on the going concern basis. The value of this business, using capitalisation, could prove to be as follows:
| Example Calculation True profit $70,000 Less: Owner’s remuneration (35,000) Adjusted income $35,000 Capitalisation rate 50% Capitalised value $70,000 Break-up of value would be: Plant and equipment $30,000 Goodwill $40,000 Total $70,000 |
If the asking price was $150,000, then it would appear that the vendor is asking for $80,000 more than the business appears to be worth.
Super profits method
This method is useful in a wide variety of circumstances. There are two important points to note:
(1) this method approaches the value of the business more from the point of view of the purchaser (although it is still relevant for a seller); and
(2) the user of this method has to determine a reasonable return for the owner of the business (or staff to take their place as appropriate) and determine the number of years the extra profits of the business will continue to be received.
Experienced valuers are more likely to be comfortable determining future profits. Although others can use this method, they are cautioned to be sure of the overall figure they may come up with.
There are seven steps in using this method. These steps are:
Step 1.
Total value of the net tangible assets of the business to be determined, ie total assets less any liabilities, or if fittings and equipment are to pass in the sale, the value of such items.
Step 2.
An appropriate interest rate is to be decided upon, keeping in mind that, had the purchaser decided to put these funds into a bank, a building society, or credit union, interest would be received. Allowance for this should now be made. For example, it may be possible to obtain, say, 10% per annum on savings in many institutions, and thus it would be appropriate to allow a rate of 10% per annum in the valuation.
Step 3.
A salary for an owner-operator should be established by reference to current award rates, newspaper employment advertisements or whatever means available. The sum that’s determined is then added to the interest return established in Step 2. The total of the two is the amount purchasers could earn elsewhere had they decided not to purchase the business.
Step 4.
Now comes the difficult part. In this step, records for the business over the past, say, three years are needed, as it’s necessary to determine the average annual net earnings of the business. Should it be found that the owner’s drawings have already been deducted, they should be added, as it’s important to determine the net earnings prior to making any allowance for the owner’s effort. Again, this figure must be taken before allowing for taxation or other considerations, with due allowance being made in case it’s found that profits have been falling from year to year.
Step 5.
This step determines the extra earning power of the business and is the figure arrived at in Step 4, less the combined total of Steps 2 and 3.
Step 6.
It’s now necessary to establish the value of the intangibles. To arrive at this figure, the amount shown in Step 5 is multiplied by the number of years it would reasonably be expected that this amount should continue to be received. This amount is also known as the “years of profit” figure, with many factors to be considered, some of which could be:
(i) How well established and well known is the business?
(ii) Are there particular advantages attaching to the business (trade marks, patents)?
(iii) Does it hold a unique market share and, if so, would the vendor sign an agreement not to compete for so many years?
(iv) Could a competitor quickly set up in opposition nearby and so on? After considering these factors, it may be concluded there is, say, three years applicable to a good, well established firm, but only six months for a takeaway food outlet facing strong competition. There’s no “magic” formula in determining the number of years of profit multiplier.
Step 7.
To determine the final price of the business, the value of the net tangible assets as shown in Step 1 is added to the value as determined in Step 6.
| Example Determining value of coffee lounge The following has been determined: 1. Vendor’s asking price $100,000 plus stocks 2. Value of the net tangible assets $50,000 3. Value of stocks on hand $12,500 4. Estimated future profits $75,000 If the seven steps outlined in the super profits method are used, the results are as follows: Step 1: Value of the net tangible assets, being plant and equipment, but excluding stocks $50,000Step 2: Return on above funds if they were to be invested in a bank or other institution, achieving a return of, say, 10% 5,000 Step 3: Owner’s remuneration or wages to be paid to staff if the owner/s were not to work in the business (balance only applicable now) 32,000 Step 4: Estimated future maintainable profit as previously determined 75,000 Step 5: Being the sum shown in Step 4 less the total of the amounts shown in Steps 2 and 3 38,000 Step 6: Value of goodwill – being two years’ purchases of the amount as shown for Step 5 76,000 Step 7: Overall value of the business (being the total of Steps 1 and 6) $126,000 If the value of the stocks on hand ($12,500) were to be added, this would increase the value of the business to $138,500. |
In this example, the valuation determines that the business is worth more than the sum being asked for it by the vendor – a situation which does sometimes come about (but not very often). Rather the opposite is usually found – the value is less than the amount being asked for it. When this occurs, the purchase price is renegotiated unless, of course, the purchaser is happy to pay the extra amount involved.
Negotiating the sale
If you’ve chosen an intermediary, the negotiation of the sale may not present a problem. However, if you’re handling the sale then negotiation may cause some difficulties.
The most common sources of contention are the price of the business and exactly what should be included in the sale. In almost all cases, you’re going to have to be prepared to compromise. However, you should not compromise too far. It’s for this reason that you need to know as much as possible about the purchaser. With information you can assess just how far to compromise.
One way of proceeding is to compromise with intangibles rather than the price. You could offer to stay on and help run the business for a while or offer to extend any restraint of trade.
A common negotiation strategy is to first put yourself in a position contrary to that which you’re prepared to accept and then as a concession agree to the acceptable position. Once you’ve made a concession most purchasers will feel compelled to also make a concession.
| Example Make a concession You could maintain that you’re not prepared to train the purchaser (even though in reality, you’re quite prepared to do this). You could then, if the negotiations become difficult, agree to undertake to train the purchaser. You’ve lost nothing and forced the purchaser into a position where he or she will feel compelled to match the vendor’s concession. |
Good negotiating advice is to always remain polite, professional and businesslike. Also, always keep the negotiations moving at a pace to suit you – do not let them get out of control so that you cannot recognise gamesmanship or negotiating ploys.
Payment and transfer
Once the contract of sale has been agreed on the purchaser will usually pay you a deposit to seal the sale. The deposit is security that the purchaser will proceed with the sale. On completion of the sale the deposit is treated as part of the purchase price.
To protect the purchaser the deposit is usually paid to a third party (normally the business broker, real estate agent or solicitor) to be retained until the completion of the sale. Generally, the deposit is payable when the parties become bound by the contract of sale. The contract should specify the amount of the deposit and when it’s payable. If the purchaser defaults on the sale, the deposit is forfeited to the vendor.
The balance of the price
The agreement for sale should detail when and how the balance of the purchase price should be paid. The consequences of late payment, such as additional interest, should also be provided for.
Sometimes the purchase price is paid by instalments and the vendor retains title to the business as guarantee of repayment. This is an unsatisfactory position for the vendor to be in as you’re at the mercy of the purchaser who’s running the business. Most business advisers will strongly advise their clients not to enter into an agreement to sell a business by instalments. Most business contracts require settlement within 30 days and are unconditional.
Transfer of the business
On the sale of a business, title to and property in each of the business’s assets usually transfers to the purchaser on payment of the purchase price. Risk should pass at the same time. The risk refers to the destruction or loss of the assets through events such as fire, flood, storm damage or theft.
Consequences of default
If you’re unable or unwilling to complete the sale the purchaser will usually terminate the agreement and obtain a refund of the deposit. The purchaser can also claim damages for breach of contract. If the purchaser defaults the vendor can elect to enforce the contract or terminate it. Except in rare situations the vendor’s preferable option will be to terminate the contract. When this occurs:
the deposit is forfeited;
the vendor elects whether to keep the business or to resell it; and
the purchaser is liable for damages including the expenses incurred by the vendor.
