Business owners have a lot to think about – from daily operations and employee management, to keeping up with the latest industry trends. And if you’re looking to sell your business in the future, there’s even more to consider.
Planning ahead is critical to getting the best price for your business. But with so many moving parts, it can be difficult to know where to start. This step-by-step guide covers everything you need to do to prepare your business for sale, from understanding the market to drafting a sales agreement.
By following these steps, you can ensure that you sell your business on your terms – and get the best possible price in the process.
The first step in selling a business – or any large asset for that matter – is getting an accurate valuation of its worth. This isn’t always an instantaneous process; most of the time, getting a credible number that you can bank your sale on requires the help of a valuation firm or third-party service. Such professionals will conduct an in-depth review of your business’ state, taking its inventories, sales, debts and assets into account before coming up with a calculated and realistic price.
Getting Realistic About Your Value Price
Given the fact that about 80% of an average business owner’s net worth is tied to their business, maximizing its valuation is certainly in their best interest for life after sale. The more it’s worth, the more they end up walking away with. However, it’s important to be realistic about what your business is actually worth – over- or under-valuing it can come back to bite you later on.
Experts say that as a rule of thumb, small businesses can generally be considered to be worth two to five times their yearly cash flow. Of course, the actual number can vary widely based on a range of factors, from local market size and demand to financial health, discretionary add-backs, value drivers and more.
And that’s not all – many buyers will make their decision based on less-tangible elements as well. Sure, cash flow is great, but does the seller have any plans or measures in place to ensure the business continues to thrive post-sale? Is key management likely to stick around or move on as soon as the deal goes through? What is the company’s competitive edge and how difficult would it be for a new owner to maintain or improve it? Answering all of these questions honestly and accurately is critical to formulating an asking price that will actually stick.
Getting Familiar With the Business Valuation Process
As already mentioned, the business valuation process typically starts with the help of a specialized firm or group of third-party professionals. The specific titles these individuals hold can vary, however generally include valuation experts, attorneys, accountants and business brokers.
The following is a look at each and their role in the process of business valuation.
Certified Valuation Appraiser (CVA): A Certified Valuation Appraiser, otherwise referred to as CVA, is professional who specializes in business evaluation. They have completed formal education and training in their field and hold credentials proving so. A CVA’s main role in the valuation process is to, of course, come up with a value for the business they’re assessing, as well as compile a formal report detailing the reasoning for their decision.
Accountant and/or Tax Preparer: While accountants and tax preparers technically aren’t the same, they play a relatively interchangeable role in the valuation process. They’re generally responsible for all things finance during an assessment, collecting and reviewing a business’ financial statements and documents so that the valuation appraiser has a clear understanding of its historical performance. This information is then used to help predict future income and cash flow.
Attorney: Attorneys also have a very relevant role to play in business valuation. As professionals specializing in law, they’re trusted by sellers to review existing contracts as well as prepare those for the business’ sale.
Business Broker: Business brokers arguably have the most important role in the business valuation and sale process. Not only are they responsible for connecting buyers and sellers, but they also play a major part in conducting negotiations, drawing up contracts and handling all the paperwork associated with the sale.
Business brokers add value to business sale in a number of ways, including:
- Assisting with pricing and valuation
- Conducting industry research for better market insight
- Using professional networks to find potential buyers
- Negotiating with buyers to maximize final sale price
The Hard Numbers: What Your Business’ Valuation Will Come Down To
As we’ve already covered, a business’ ultimate worth comes down to both financial and non-financial factors. However, it’s worth noting that although the latter is important, the focus will almost always be on the hard numbers.
Buyers determine their purchase through a range of metrics in order to get a comprehensive idea of what they’re actually spending their money on. Some may be more important to them than others, but all will play a role in their final decision. The following are some of the most important factors at play and what they indicate.
Earnings Before Interest, Tax, Depreciation and Amortization (EBITDA)
Earnings Before Interest, Tax, Depreciation and Amortization, sometimes referred to as EBITDA for short, is one of the most common metrics used in the business valuation process. It creates a holistic view of an enterprise’s financial wellbeing by defining its net income minus expenses incurred through interest, tax, depreciation and amortization. See below for a brief explanation of each.
Interest expense: Interest expense refers to the total amount of interest incurred on loan balances.
Tax expense: Tax expenses give assessors an idea of how much federal, state and local tax a business can be expected to pay on earnings.
Depreciation expense: Depreciation expense focuses on a business’ assets and their expected decline in value over time. For example, if a company owns a truck it uses for deliveries, that same vehicle won’t be worth as much in five years as it is today.
Amortization expense: Amortization expense is similar to depreciation expense in that it concerns a company’s assets, but rather than looking at an expected decline in value over time, it focuses on the cost of intangible assets. For instance, let’s say a business purchases a patent for $100,000 with an amortization of 20 years. That would mean it’s on the hook for $5,000 payments for the next two decades.
After taking all of the above into account, what’s left is a company’s EBITDA.
EBITDA = Net Income + Interest Expense + Tax Expense + Depreciation & Amortization
It’s thought that by using EBITDA, valuators can reasonably gauge a business’ overall financial state and potential for growth. This is the most important number when it comes to business valuation because it’s a strong indicator of both current and future earnings.
EBITDA’s Flaw and Stopgap Alternative
Although the EBITDA method is popular, it’s not the only means assessors use to determine a business’ value. It has some inherent flaws, mainly the fact that it overlooks certain important expenses, such as capital expenditures.
A capital expenditure (CAPEX) is money a company spends on physical assets like buildings, vehicles or equipment. They’re one-time costs as opposed to operational expenses, which are incurred on a regular basis. An example of an operational expense would be monthly rent payments, while an example of a CAPEX would be the purchase of a new delivery truck.
The flaw with the EBITDA method is that it doesn’t factor in CAPEX, which can be significant.
For instance, let’s say a business owns a delivery truck that’s starting to break down and needs to be replaced. The cost of the new truck would be a CAPEX, but it wouldn’t be included in the EBITDA calculation. This is because, although the new truck is a business expense, it’s not an ongoing one like rent payments. The EBITDA method only focuses on operational expenses.
The exclusion of CAPEX means the EBITDA metric isn’t always accurate. It can paint a rosier picture of a company’s financial state than reality warrants. This is why some assessors prefer to use an adjusted EBITDA (A-EBITDA) method, which factors in CAPEX expenditures.
Profit vs. Cash Flow
Money, money, money – that’s what it’s all about in business. But there’s a big difference between profit and cash flow, and it’s important to understand the distinction.
Profit is the revenue a company generates minus the expenses incurred in order to generate that revenue. In other words, it’s what’s left over after all the bills are paid. Cash flow, on the other hand, is the money that comes into and out of a company on a regular basis. It’s the lifeblood of businesses, and without it, they can’t survive.
Yes, profit is undoubtedly important, but it doesn’t immediately translate into financial health. Cash balance, determined by inflows and outflows of money, is what really matters in the short term.
For example, a company might be profitable but have very little cash on hand. This could be because it’s using its profits to reinvest in the business or because it has a lot of debt. In either case, the company might have trouble paying its bills in the near future. On the other hand, a company might not be profitable but have a strong cash flow. This could be because it’s new and hasn’t reached profitability yet, or because it’s using creative financing methods.
Sales and accounts receivable numbers can be very telling in terms of a business’ viability. If AR is climbing at a rate of 35% while sales only increase by 20%, it’s a clear indicator that a company will soon run into cash balance problems. This means that it faces the prospect of potentially having to take out loans or sell equity in order to stay afloat in the future.
Profit and Market Share Trends
Potential buyers assess multiple years of financial records to understand a business’ history, performance and ongoing trends. They’ll also consider its market, overall share size, product diversity and target audience.
The main goal here? To get a good idea of where the business has been and where it’s headed in the future.
Profitability is, of course, a key metric that potential buyers will look at. But they’ll also be interested in any trends in terms of revenue, margins and expenses. If a business has been steadily increasing its sales and profit margins over a period of years, that’s a good sign. It indicates that the company is doing something right and that it has a bright future.
The same is true for market share. If a company has been able to steadily grow its market share over time in a pool of competitors with no major lead, there’s potential for further expansion. This is especially true if the company has a diversified product line and a large target market. Really, the more possibilities, the better.
Other Key Valuation Metrics
In addition to the aforementioned metrics, there are a number of other indicators that can be used to better understand a business’ value. The following are some of the most relevant.
Return-on-investment (ROI) and relative risk: In making their decision, many buyers will calculate and compare the potential return on investment (ROI) with the relative risk of the purchase they’re considering.
Credit history: Sellers should demonstrate a good credit history over a period of years. This will show potential buyers that the business is financially responsible and has a good track record when it comes to paying its bills.
Management team: Staff are critical to any organization’s survival. As such, it’s important for businesses to have a strong and stable management team. This will give potential buyers confidence that the company will be able to continue running smoothly even after the sale.
Beyond the simple matter of profitability, today’s buyers are looking for businesses that exude long-term potential and viability. They’re not just looking for a quick return on their investment; they’re looking to buy a business that will continue to grow and be profitable for years to come.
Proving this starts with the organization of financial documents. You’ll need to work with a business consultant or accountant to gather every important record you have for the past three to five years. This includes things like financial statements, tax returns and more. You’ll also want to compile a list of assets like inventory and equipment, as well as intangibles such as intellectual property. It’s all information that will be extremely relevant to a buyer as they conduct their due diligence and make a final decision.
Employ an Organized Accounting Process
While this may be more of an afterthought for some, it’s still worth mentioning for the simple fact that it can make a big difference in the following ways.
Consistency: If you use the same accounting process every month, it’s more likely that you’re consistently producing accurate data. There’s less potential to accidentally miss a group of transactions or miscalculate something. This will give buyers more confidence in the numbers they’re seeing.
Comparability: Using a consistent accounting process means that your results are the sum of the same factors from month to month. As such, they can be directly compared to one another. This makes it much easier for buyers to identify any trends that may exist.
Support for an audit: Well-managed accounting processes can make things a lot simpler should you decide to have your financial documents audited. This is often a requirement for buyers, and being able to provide them with the necessary documentation in an efficient manner will reflect well on your business.
Use an Accounting Software
Still using Excel and Word documents as your go-to accounting tool? Stop.
We’re now well into the twenty-first century, and there are a number of excellent accounting software programs available that can streamline the process and make things much easier for you. Not only will this save you time, but it will also give you peace of mind knowing that your financial data is being accurately managed. This is crucial both for your own records and for when a potential buyer comes knocking.
There are many different accounting software programs on the market, so it’s important to do your research and find one that’s a good fit for your business. Once you’ve selected a program, be sure to take the time to learn how to use it effectively. This will pay off in the long run.
Create a Procedures Manual
A large part of successfully taking over a business is understanding its day-to-day functions and processes. This is essential for maintaining continuity and preventing any disruptions in operations.
As the owner of a business, you likely have a good understanding of how things work. But what happens when you’re no longer involved? How will a new owner be able to quickly and easily get up to speed on everything that’s required to run the business?
This is where a procedures manual comes in. This document should outline all of the important procedures and processes that are necessary for running the business on a day-to-day basis. It will give buyers the context and confidence they need to know that they’ll be able to successfully take over the reins.
Creating a procedures manual may seem like a daunting task, but it doesn’t have to be. Start by making a list of all of the important procedures and processes that take place within your business. Once you have this list, you can begin creating a document that outlines each one in detail.
If you need help putting everything together, there are a number of templates and resources available online.
Use Accrual Accounting
Accrual accounting is a method of accounting where revenue and expenses are recognized when they’re earned or incurred, regardless of when the actual cash is exchanged. This is in contrast to cash accounting, which only recognizes transactions when cash is exchanged.
While accrual accounting may seem more complicated than cash accounting, it’s actually the more accurate of the two methods. This is because it provides a more complete picture of your business’s financial health by including all revenue and expenses, regardless of when the cash is exchanged.
For buyers, this is an important consideration. They want to see a complete and accurate picture of your business and be able to compare it to other businesses on the market.
Aligning your documents with the Generally Accepted Accounting Principles (GAAP) of accrual accounting will give buyers the confidence they need to move forward with the purchase.
Adjusted Trial Balance
A trial balance is a type of financial report that lists the accounts businesses use to post transactions. Accountants often review these documents to verify the legitimacy of particular transactions, as well as assess a business’ overall financial condition.
In order to comply with the accrual method of accounting, business owners must post adjusting entries to their trial balances.
For instance, let’s say that you owe staff $3,000 in payroll for wages earned during the last week of December. You would need to post a $3,000 entry to wage expense and to wages payable on 12/31. The first would adjust your income statement for the current month, while the second would update your balance sheet to reflect the new liability.
Once you’ve made all of the necessary adjustments to your trial balance, you’ll be able to generate an accurate and up-to-date financial picture of your business. This will give buyers the information they need to make an informed decision about purchasing your company.
Normalizing Adjustments & Add-Backs
Not every expense a business has will comply with accounting standards. In such cases, these expenses will be removed in financial statements given to buyers in what is commonly referred to as ‘normalizing adjustments’ or ‘add-backs’.
For example, let’s say that you own a restaurant. A family member who works part time needs support getting to and from the restaurant, so you have the business cover their vehicle costs. Upon getting ready to sell, a CPA audits relevant financial records and determines that this expense is not consistent with Generally Accepted Accounting Principles (GAAP) and therefore removes it from statements. This in turn, gives buyers a clearer financial picture of the business.
Other common examples of normalizing adjustments or common add-backs include…
Owner’s salary: In many small businesses, the owner draws a salary that is significantly higher than what would be paid to a replacement. For buyers, this number is often adjusted downward to a more realistic level.
Discretionary expenses: Things like business lunches, company parties, and other non-essential expenses are often removed from financial statements given to buyers.
One-time items: One-time items, such as the cost of relocating the business or legal settlements, are not included in financial statements given to buyers.
Other Accounting Fundamentals to Know for This Phase
Having a solid understanding of the following standards will also be helpful as you get your business ready for sale.
Although we’ve touched on this one already, it’s worth delving further into detail on. Financial statements give buyers a snapshot of your business’s financial health and performance over a specific period of time.
There are three main types of financial statements:
The balance sheet
The income statement
The cash flow statement
Generally Accepted Accounting Principles (GAAP)
As we’ve mentioned, it’s important that your financial statements align with GAAP in order to give buyers the confidence they need to move forward with the purchase.
There are a number of different GAAP, but some of the most important ones to be aware of include:
The revenue recognition principle
The matching principle
The going concern principle
Goodwill refers to the price paid for an asset above its fair market value. For example, if a business purchases another business or one of its product lines, the dollar amount over its fair market value would be posted as goodwill in financial statements post-buy.
You’ll generally need to provide potential buyers with at least three years’ worth of tax returns. These documents will give buyers a better understanding of your business’s financial history and performance.
Even if you’re not ready to sell, taking the time to understand and implement the best practices above can go a long way in making your business easier to manage and more valuable in the long term.
Although audits are not absolutely mandatory when selling a business, they are largely considered best practice for the value and credibility they can bring to a transaction. In most cases, reputable buyers will request them, and it’s essential to have them in order to get top dollar for your business.
Defining the Audit Process
An audit is an objective, independent assessment of a company’s financial statements. The purpose of an audit is to give buyers assurance that the statements are free from falsehoods and accurately reflect the company’s financial position, results of operations, and cash flows.
When financial statements are audited, independent accounting firm conducts an in-depth review of their contents and accuracy. What they’re looking for is any proof of material misstatement, which refers to any errors that are large enough to sway the opinion of the financial statement reader.
For instance, assume that your business has a $1 million inventory balance. A $500 deviation in its records is relatively small in proportion to the total, and would likely not be considered material. On the other hand, if your inventory balance was only $50,000, a $500 error would be much more significant.
If the firm finds any material misstatements, they will make necessary corrections and issue an opinion on the financial statements. The two most common opinions are “unqualified” and “qualified.”
An unqualified opinion means that the financial statements have no material misstatements, while a qualified opinion highlights some problems associated with the audit. Although a qualified opinion is technically still a positive assessment, it can be cause for concern among buyers and make your business less attractive to them.
It’s important to note that audit opinions aren’t a clear yes and no to the question of error in financial statements. They simply serve as the auditor’s professional judgment on the level of risk and potential fraud associated with them.
Other important points that can be covered in a financial statement audit include…
Related party transactions: Related party transactions are any that occur between two entities that have a close relationship with each other. For example, if a business owner loans money to their business, that would be considered a related party transaction.
Auditors will take a closer look at related party transactions to make sure they’ve been recorded accurately and aren’t being used to artificially inflate or deflate the company’s financial statements.
Contingencies: Contingencies are events that have occurred in the past, are currently taking place, or may occur in the future that could have a material effect on the company’s financial position. For example, if your business is being sued, that would be considered a contingency.
The auditor’s job is to assess the risk associated with each contingency and determine whether it should be disclosed in the financial statements.
Qualify and Negotiate With Potential Business Buyers
Like most large purchases, new business acquisitions are usually funded through the help of third-party lenders. Buyers will rarely have the cash up front and will need to secure a loan in order to complete the transaction.
If you’re selling your business, it’s important to be aware of the role that lenders play in the process and how they can impact the sale. All too often, buyers will enter into an agreement with a seller only to have the deal fall through because they’re unable to secure financing.
As a result, it’s critical to qualify and negotiate with potential buyers early on in the process to make sure they’re actually able to follow through with the purchase.
There are a few key questions you should ask yourself when qualifying buyers:
Has the buyer secured financing? If not, do they have the capital necessary to complete the transaction?
Is the buyer’s financing contingent on the sale of your business?
What are the buyer’s lending requirements?
Does the buyer have the experience necessary to successfully operate your business?
Is the buyer’s timeframe reasonable?
Answering these questions will help you weed out buyers who aren’t serious about the purchase or who don’t have the means to follow through. While it may seem like an unnecessary extra step, it can save you a lot of time and hassle in the long run.
Once you’ve qualified potential buyers, it’s time to start negotiating the terms of the sale. The negotiation process can be complex, so it’s important to have a clear understanding of your objectives going into it.
Do you want to sell the business for the highest possible price? Are you more interested in a quick sale? Or are there other factors that are more important to you, such as maintaining a role in the business post-sale?
Your objectives will heavily shape the negotiation process, so it’s important to have a clear understanding of them before getting started.
Some other key points to keep in mind during the negotiation process include…
You’re in the driver’s seat: As the seller, you have the power to set the terms of the sale. The buyer may have their own objectives and may try to negotiate a lower price, but ultimately it’s up to you to decide whether or not to accept their offer.
It’s okay to walk away: If the buyer isn’t meeting your objectives, don’t be afraid to walk away from the deal. There will always be other buyers interested in purchasing your business, so don’t sell yourself short just to close a deal.
Know your BATNA: Your best alternative to a negotiated agreement (BATNA) is the course of action you’ll take if an agreement can’t be reached. For example, if you’re not able to sell your business for the price you want, your BATNA might be to keep running the business or bring on a partner.
Having a clear understanding of your BATNA will help you stay calm and focused during the negotiation process and will prevent you from making any rash decisions.
Tips to Maximize the Value of Your Business Sale
Following the process we just outlined step by step will take you through the functional process of selling your business. However, if you’re looking to get the highest possible price for your sale, there are a few extra steps you can take to ensure you’re getting the most value out of the transaction.
Plan Strategize and Time Your Exit
Most experts recommend that business owners plan their exit one to two years before they ultimately end up selling. The main reason for this is that it takes time to prep your business for sale and get it into peak condition.
Additionally, timing the sale of your business correctly can have a big impact on the price you ultimately receive. For example, if you wait until after a recession to sell, you may be able to get a higher price since buyers will be more confident in the future of the business.
Of course, there’s no perfect time to sell and you may not have the luxury of waiting a few years to put your business on the market. However, if you can, it’s worth taking the time to plan your exit and strategize the timing of the sale.
Increase Sales Prior to Listing
One of the best things you can do to increase the value of your business is to grow sales in the year or two leading up to the sale. This will show potential buyers that the business is healthy and growing, which will make them more likely to pay a higher price.
Easier said than done, right?
Luckily, there are a few things you can do to increase sales and drive growth in your business.
A few common strategies include…
Investing in marketing and advertising: This will help you reach more potential customers and grow awareness of your brand.
Focusing on customer retention: Keeping your existing customers happy is essential to growing sales. Make sure you’re doing everything you can to keep them coming back for more.
Upselling and cross-selling: Offering existing customers additional products and services is a great way to boost sales without having to find new customers.
By increasing sales in the years leading up to the sale, you’ll be able to both attract more buyers and ultimately command a higher price for your business.
Hire a Business Broker
As explained earlier, business brokers play a pivotal role in ensuring business exchanges occur both smoothly and profitably. As a seller, they’re your best bet to maximize the value of your business sale.
When working with a broker, you can expect them to…
Market your business to potential buyers: Your broker will have a database of buyers looking for businesses like yours and will work to match you with the right buyer.
Professional: Make sure your Business Broker has experienced, licensed, and is a member of the National Association of Business Brokers – NABB.
Manage the sale process: From start to finish, your broker will help you navigate the ins and outs of selling a business. This includes handling paperwork, negotiating with buyers, and more.
Conduct due diligence: Once you’ve found a buyer, your broker will help to ensure that they’re legitimate and that the deal is in your best interest.
If you’re serious about getting the best possible price for your business, working with a broker is a must.
As a business owner, you didn’t get to where you are by taking shortcuts. The same is true when it comes time to sell your business.
By following the strategies outlined in this post, you can give yourself the best chance at getting the maximum value for your business.
Take the time to plan your exit, grow sales, and work with a business broker, and you’ll be well on your way to getting the best price for your hard work.