Using Valuation Skills to Help Prepare a Business for Sale
A proactive approach pays off for selling shareholders
A business valuation analyst has the training, valuation skills, and experience to provide meaningful feedback to owners seeking to exit their businesses. When and how to conduct the pre-sale valuation is crucial to maximizing profit potential. This article will provide insight into using your valuation skills to help prepare a business for sale.
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After spending a lifetime building a business, some business owners, due to a lack of planning, don’t have a business that can be sold.Â Sadly, this is the sort of fact that is likely to be discovered after it is too late.Â Once the business owner has finally decided to sell the business, he or she does not want to wait another three to five years to prepare the business for sale.Â Thus, the owner is forced to either work several years longer than desired or to get rid of the business for an amount that is much less than expected.
Business valuation professionals are well-suited for developing a practice that helps their small business owners avoid this predicament.Â Many of the skills used in valuing a business can be similarly applied in helping business owners prepare their company for a sale.
A valuation analyst can help the company prepare for a sale by analyzing the financial statements for normalization adjustments.Â Because a buyer will typically review the historical financial statements for the three to five years preceding the transaction, it is important that this exercise be performed at least three years in advance of the business ownerâ€™s desire to sell.Â The purpose of this exercise is not only to identify adjustments, but for the company to make the adjustments going forward in anticipation of a future transaction.Â In other words, to the extent possible, change the accounting so that the profit and loss statement and balance sheet need as few â€śnormalization adjustmentsâ€ť as possible.
Using the same skills as are used when performing a business valuation, the analyst should consider any adjustments to revenue and expenses that are necessary in order to accurately reflect the ongoing operations of the business.Â Frequently encountered adjustments include: owner salaries (either too low, in the case of an S corporation, or too high, in the case of a C corporation), rent expense and personal expenses.
- Ownerâ€™s Salary.Â Valuation analysts frequently encounter owners who pay themselves too much or too little.Â With a thorough review of the companyâ€™s payroll and through experience with other valuation projects, the analyst can assist the company in determining whether the salary is at a market rate and what adjustment, if any, may be necessary.
- Rent Expense.Â It is not uncommon to encounter companies which pay rent to related parties.Â The rent payments agreed to between these related parties may not be representative of armâ€™s-length rent agreements.Â To the extent this is the case, adjusting the rent expense to a market rate is appropriate.
- Personal Expenses.Â Analysts will often work with companies which pay certain personal expenses of the owner.Â Removing these expenses from the businessâ€™ financials has the ability to increase the value of the company through increased cash flow.
Finally, although less common, the analyst should consider potential adjustments to revenue.Â The most common revenue adjustments are found in the form of revenue streams unrelated to the business that the owner would not sell.Â However, if such a revenue stream is to be removed, all associated expenses must also be removed.Â Although many of these adjustments to the income statement can increase or decrease cash flow, they all strengthen the quality of the companyâ€™s financial statements, thereby reducing risk and increasing value.
In addition to the normalization adjustments performed on the income statement, valuation analysts should consider adjustments to the balance sheet.Â These adjustments are frequently seen in the form of non-operating assets and shareholder loans.Â The analyst can assist the owner in identifying these types of assets.Â Non-operating assets should be sold or distributed and shareholder loans should be repaid or written off.Â Similar to the normalization adjustments described above, these balance sheet adjustments increase the value of the company because they increase the quality of the financial statements.Â To reiterate an essential point made earlier, these changes should be made at least three years in advance of a transaction in order to strengthen the financial statements and avoid unnecessary questions from potential buyers.Â Financial statements that donâ€™t need adjustment convey reliability.
At this stage, the analyst should consider running a diagnostic check of the firm to compare it with guideline firms.Â In this case, just as when employing the market approach to business valuation, the guideline firms are those firms in the marketplace of reasonably similar market focus, size, stage of development, industry, etc.Â However, as opposed to providing an indication of value, in this case, the guideline firms will provide valuable insight to the seller for maximizing the value of its firm.Â Thus, the data that is gathered is somewhat different than the data gathered when valuing the firm.Â In this case, the data is intended to act as a benchmark for performance rather than an indication of value.
As with a traditional business valuation, the analyst should gather data in the form of financial ratios of the guideline firms.Â However, for these purposes, it is often useful to gather data from firms that are not necessarily directly comparable today as much as firms that are operating within the same industry and are within reach of being comparable by the anticipated sale date.Â Too often, analysts only think of firms as growing through an increase in revenue, so they only identify larger firms as being good role models.Â Firms that have similar revenues but better profit margins should be sought after with earnest.Â It is also useful to err on the side of too many firms rather than too few.Â In fact, for this step, it is generally true that the more firms identified for study the better.Â Since no project has an unlimited budget, some screening must take place.Â It is generally best to remove from this process firms that are multiple stages of development away from being comparable.Â For example, if preparing a regional business, the analyst may consider firms that are on a national level, but are not international.
Following these assessments, the analyst should perform the typical ratio analysis that is conducted in a business valuation by comparing the financial ratios of the guideline firms with the subject.Â However, as opposed to a valuation assignment, when preparing a firm for sale, the companies least like the subject are the ones that will need to be identified.Â This is because the point of this analysis is to identify the strengths of the subject and its weaknesses.Â The strengths and weaknesses should be scrutinized for various purposes.
Strengths.Â These are areas where the company is stronger than its immediate competitors.Â These areas should be analyzed to understand why this strength occurs and whether the it is sustainable.Â In the case where it is a result of intellectual property, the company should consult with intellectual property (IP) attorney(s) to make every effort to protect the IP with patents, trademarks, formalizing relationships, etc.Â It may be that the form of the IP is not protectable, such as a highly skilled workforce or trade secrets.Â In those instances, the broker must be informed of the strength and market the business in a way that protects the IP and also maximizes its value.
Strengths may also be the result of financial structure.Â For example, a firm may have a capital structure that utilizes less debt than its competitors, holds larger amounts of cash, owns buildings that competitors rent, etc.Â These differences cause firms to be worth more mostly because of the theoretical options the owners have because of this largesse.Â For example, a company with little or no debt is expected to be able to go get a loan like its competitors.Â Cash-abundant firms can issue a dividend.Â Real estate owners can sell their property and lease it back, etc.Â Firms that don’t prepare for a sale are forced to try and get the extra value from buyers.Â Firms that do prepare for a sale can restructure so that the owner extracts the value before the sale and can happily seek average pricing multiples.
Weaknesses.Â Analysts must learn to identify where the subject firm is weaker than its competitors. Â Management can use the time before a sale to focus on improving such weaknesses.Â For example, a firm may have gross margins too low because of a flaw in setting its prices or because of increased costs Â for its materials.Â Before either problem can be fixed, management must know that the problem exists.
Weaknesses should also be classified into two categories:Â improvable or un-improvable.Â Some weaknesses can be improved before the date of sale.Â Others either can’t be improved or are cost-prohibitive.Â Obviously, management should strive to improve any weaknesses it can before the time the company is put up for sale.Â However, understanding those weaknesses that cannot be changed can be even more valuable to management.Â These weaknesses are the dream of synergistic buyers.Â For example, imagine a firm that buys volumes which are too low as to get the best pricing for its raw materials.Â Further, assume the firm would have to increase by threefold to get better pricing.Â Once this weakness is evaluated, the analyst should make sure management and the broker understand that a firm twice as large as the subject is likely to pay the most for the business.Â In fact, they should pay more than fair market value!Â This is because a firm twice as large as the subject is also not receiving the best price.Â However, with the purchase, both firms’ cost of sales will decrease.Â The buyer can pay more than fair market value because the purchase will increase the value of its own firm.Â Consider that if the subject had not properly prepared for sale, it would have likely not identified the strategic buyer as being comparable (both having similarly substandard gross margins and being relatively close in size).Â Without preparing for the sale, the buyer would have left money on the table.
Sellers that prepare for a sale well ahead of time put themselves in a position to be fully rewarded for their years of hard work.Â Business valuation analysts are in a perfect position to assist in this preparation.Â This type of work is very rewarding as it improves the value of a firm rather than just measures it.
Rick Hoffman and Jeff Pickett are principals at the forensic consulting firm Lone Peak Valuation Group located in Salt Lake City, Utah.Â They both spend the majority of their time on business valuation related consulting projects such as damage calculations, business valuations and business consulting. Rick can be reached at email@example.com; Jeff can be reached at firstname.lastname@example.org.