Valuations in Private Buy/Sell Transactions
Factors to Arrive at a Value that are Beyond the Three Approaches
This article addresses valuations for buy/sell transactions with private buyers and private sellers.
A business owner calls and says: I want to sell my business. Can you tell me what it’s worth? Thousands of these transactions are occurring daily. But before you go any further, stop and ask more questions. As business valuators, we are conditioned to crank out conclusions of value based on a pre-set series of steps like the hitch-hiker’s guide to the galaxy; the meaning of life, the universe, and everything is 42! But what was the question? What is the client asking for? Valuations are not compliance like tax returns. Without understanding thoroughly what is to be valued, the valuator could be doing irreparable harm to that client’s financial well-being.
Recently, I got a call from a dealer who was trying to buy a competitor down the road and wanted to know what he should pay for it. First question: What are you buying? At first, he said he was buying the other dealership. After a couple more discussions, he was not buying the dealership; he was just buying one line of boats the other dealer carried. Upon further discussion, it turned out the manufacturer was taking the boat line away from the “seller” and wanted the “buyer” to pay the seller something to preserve the goodwill toward the brand from the seller and his former customers. The seller called his accountant, a credentialed valuator, who then penciled out a note saying 5x EBITDA and an amount for his client. Certainly not a value for a right to sell a line where no tools, no talent, no inventory, and no assets were changing hands. And the line was being taken away due to poor performance, so any goodwill value was very limited.
We worked out an amount based on a factor of gross margin of the specific line’s sales and the buyer presented it to the seller. The seller was outraged; married to the exorbitant “value” his accountant had given him. Ultimately, the buyer was not able to strike a deal with the seller, and the manufacturer just took the line away from the seller and gave it to the buyer; the seller got nothing. That seller’s valuator did not understand the scenario thoroughly and it ultimately cost his client what was, to him, a material sum of money.
It is essential to understand exactly what you are valuing. When a client is asking for a valuation in contemplation of a sale, what does he want? Private businesses are commonly sold as asset sales. You can see this by opening a sample of any industry in DealStats, for example. So, does this client want a conclusion of value or does he want to know what price to ask for some assets of the business? An asset sale in private transactions commonly includes goodwill, fixed assets, inventory, and sometimes, working capital. It might be very small mom and pop shops, and it may also be large auto dealership conglomerates. When a valuator is being asked for a “value” by a client who wants to sell his business, he is usually asking for an asset selling price. He wants to know what price to ask and how much money he is likely to get from a buyer for those assets. A standard conclusion of value will not give the client what he wants. Moreover, if he relies on that result, the valuator may cause serious harm to the client. Why? Like selling a house, if a business is priced too high and sits on the market two things happen:
- Buyers start to wonder what is wrong with the business. Buyers commonly ask how long it has been for sale. The longer it sits, the more likely the eventual selling price will also decline.
- Have you ever heard of “short-timers syndrome”? When an owner puts their business up for sale, their enthusiasm starts to wane. Their effort declines as they daydream about their next adventure. The business starts to slow and before you know it, revenue and net income start to decline, which drives down the price a buyer will pay.
Even a small downturn in results will cause a much larger downturn in price because buyers have no certainty whether the downturn is caused by a tired seller or some unknown risk factor at play. Perceived risk increases dramatically and selling price falls.
Bad valuation advice can have devastating consequences to clients who hold out for an unlikely valuator’s “value”. The business declines and ultimately the seller shuts down, what was at the beginning, a perfectly saleable business had the price been set appropriately. So, what is appropriate? And how do we get there? A conclusion of value is at a point in time and includes all elements of a business. When you are being asked to opine on an eventual selling price, it is at an unknown point in time and likely includes only some of the business’ elements. Without all the facts, for example a valuation date, it is a limited scope engagement. It should be presented as a range of values. It is essential to clearly specify what is being included and excluded in the estimate and why. It is essential to further specify what factors could possibly affect the outcome; that is: future results, future economic conditions, future competitive forces, future interest rates, and so on.
Subject Enterprises
A key factor in assessing private enterprises of all types is to understand their marketability. Let’s consider two “types” of businesses. First, the “strategic acquisition target”. This might be in any industry. It has great results; usually well above industry average EBITDA %. It has built some sort of strategic “moat” that is not easily replicated. And it often has realized scale that limits competition. Often these have skilled managers in place. These enterprises are sought-after by private equity firms or other similarly well capitalized strategic buyers. Often there are offers from multiple acquirers. These realize much higher multiples/lower capitalization rates. Most notably, these are rare compared with the volume of all buy/sell transactions. Good examples are a well-run Ford dealership with the perfect location in the most desirable state and city; or a sizeable manufacturing firm with a highly specific product or process that keeps the competition away.
The second group is everyone else. These businesses sell every day at “ordinary” multiples driven by ordinary risks these businesses face.
Frame of Reference
When evaluating these businesses, it is essential to look at it from the buyers’ perspective. Why would someone buy this particular business? What are the risks they see? Why would they pay my assessed value and why wouldn’t they pay my assessed value?
Risks
Two factors matter in valuing an enterprise: the reward and the risk. Calculating or forecasting the reward is beyond the scope of this article. Identifying and quantifying the risk is the essence of valuations. It is analogous to reading tea leaves. Looking at a subject enterprise to identify and quantify those pros and cons, an unknown buyer will see that will influence the decision to buy, and then the decision of how much to pay is the art of determining the “value” of an enterprise. Some of the key risks that influence transactions are:
Industry
Recently, I was working with a dealer who is excellent. Literally outperforming almost every other dealer. The industry requires approvals from manufacturers and floorplan lenders, so it is almost certain a buyer has to come from the pool of existing dealers. At the time of writing, the economy is experiencing high interest rates, and many dealers are overloaded with inventory and facing a cash crunch paying interest to the floorplan companies on that inventory. While the seller is outstanding, there are very few buyers who have the resources to acquire at this time. The old law of supply and demand applies: fewer buyers means prices will be lower than at a different time. It is essential to understand the dynamics of the industry.
Location
Recently, I worked with a seller with physically clean and tidy premises, above average EBITDA %, a long-term trained and skilled team in place, and located in a remote vacation destination. It was almost impossible to find a buyer and the price was much lower than the same business in a different location. When you are faced with an enterprise in a remote location, consider: What does it take for someone to leave their extended family, friends, schools, activities, and amenities to buy a business? Supply and demand: fewer buyers means that the agreed price will be lower.
People Are the Business
Staffing that matches the size of the business is highly relevant. In a small owner operator business, a general manager may be a detriment. On the other hand, a larger enterprise with a higher selling price requires a buyer with more financial resources. Those buyers are not typically interested in or have the time available to run the operation themselves. To realize the highest selling price, the seller needs staff in place who can run it without a hands-on entrepreneur.
Quality of Staff in Place
Recently, I talked to a large publicly traded aggregator about acquiring a smaller chain of outlets. The chain had excellent locations, excellent products, and it could likely be acquired at a bargain price due to current economic conditions. The aggregator declined because the target chain had a notoriously poor corporate culture among the staff. His point: It is very hard to fix corporate culture. Long-term, trained, skilled staff in place matters to buyers. High turnover and employee morale problems reduce value quickly.
Turnarounds
“The juice ain’t worth the squeeze.” Something that is not making money has little to no goodwill. If it can become profitable again, it might have some goodwill. Buyers are evaluating whether the time, talent, and money to turn it around is worth what it will eventually produce. In addition, and we do not think about this very often, buyers consider what else they could do with their money. Can they make as much return from their money without the hassle of the turnaround? The value of goodwill, and to some degree the value of the hard assets themselves, hinges on the number of buyers who might be interested in such a target. The hassle or lack thereof has a significant impact.
Reliability of the Financial Information
I faced a valuation once where the seller had dozens and dozens of GL accounts with little balances like $40. The information was so over-detailed, no buyer would ever be able to use it for decision making. Ultimately, the broker on that deal could not sell the business. In other instances, the seller had changed accounting software several times over the past few years and the result was a hodge podge of mystery balances where no one knew what was in them. No one would touch that business.
Cyclicality
I was recently asked if I could sell a large construction enterprise. We are currently in a construction slowdown as interest rates are high for residential and commercial properties, and many offices are empty. Who would buy it at all? Everyone else in the industry who could buy it is facing the same slowdown.
Seasonality
In another situation, I was sitting across the table from a large multi-point accounting firm valuator on a particular transaction. The subject enterprise was located in a highly seasonal tourist destination, which meant they had very short seasonal windows to earn all their income. The opposing valuator came up with a too high “valuation” and, when his comparable transactions were reviewed, 100% of them were from Florida where there was little or no seasonality in the industry. Again, the seller fell in love with the valuator’s number and no deal was struck; that business is still for sale today.
Selling Price and Debt Service
In a high interest economy, buyers will pay less because debt service consumes a much higher share of the cash flow. In other words, a buyer (and often lenders) wants to see expected cash flow that services acquisition debt as well as provides a return or cushion to the buyer over the future years. Insufficient cash flow means value/price is too high. Alternatively, overly high cash flow means the price is too low. A good sanity check to apply is, once a value is calculated, estimate what debt service will be at current interest rates and evaluate whether the residual cash flow is sufficient to attract any buyer, some buyers, or lots of buyers. The fewer the buyers, the more power they have to bid down the price. Note: defining the buyer is critical. Interest rates are very different for different buyers. A small entrepreneur using SBA financing may be paying as high as 12% right now. Whereas a larger private equity group or high net-worth buyer may be getting funds as low as the AFR, or about 4% today.
Business Valuation Approaches
Whether preparing a conclusion of value or a limited scope estimate of selling price report, all three approaches are useful.
Income Approach
The income approach can be used, but bear in mind that the resulting value includes the entire entity, so it will be essential to deduct/add the elements that are not expected to be included in a sale. At a minimum, split the total value into the components (expected to be sold and expected to be retained by seller) so that the seller/client understands what they can expect to receive from a buyer and what they will keep.
Market Approach
The market approach was designed for this scenario. It is noteworthy that if you are preparing a valuation for the entire entity, in instances such as divorce or succession, carefully analyze the comparable transactions selected. If you are using a database of private transactions such as DealStats or PeerComps as noted above, they are almost all asset sales which include the goodwill, fixed assets, and inventory only. As a result, to compare the derived market value to the income approach value, the additional components included in the income approach value should be added/deducted from the market approach value at market value.
In a valuation of the complete enterprise, the market approach result (based on asset sale comps) should never approximate the income approach value unless the entity’s current assets – current liabilities = inventory value, and there is no long-term debt or long-term assets other than fixed assets. The main issue that arises in the market approach is consistency of comparables. The available databases typically have a summary of averages along with the comparable transactions themselves, yet each of these businesses is incredibly unique so an average will never be useful. To use comparable transactions, it is essential to delve into the transactions themselves and adjust if necessary. This requires a thorough understanding of the industry.
In the case of dealerships for example, some transactions include serialized unit inventory, and some do not; the difference is millions of dollars. The valuator needs to understand the numbers and how they relate to the subject enterprise. In the case of unit inventory included with parts inventory, we back out the estimated amount of that unit inventory and recalculate the multiples. Look for real estate included in comparable transactions. If most do not include real estate and one does include real estate, that real estate must be pulled out and the multiples recalculated. Look for other anomalies and adjust or exclude the transaction.
The Asset Approach
This is the best approach for private buy/sell transactions because each organization is highly unique. Consider two similar-sized restaurants, same number of seats, similarly popular locations, similarly popular food offerings, each beautifully finished and decorated. Now one incorporates several bowling lanes into the premises which significantly increases the fixed asset value. Can you apply the same multiple to these two otherwise similar operations? You cannot. Consider two similar franchises; one is due for a required image update, the other just had it done. Consider two similar-sized boat dealerships; one is sales oriented and has $200,000 in parts, and the other has $600,000 in parts because it focuses heavily on the Service department. In order to value a private enterprise, the best approach is the asset approach using a build-up method.
PeerComps now offers comparable transactions drawn from SBA loans. It is consistent, easy to use data and presented in such a way that the value of goodwill is a quick and easy calculation. DealStats provides similar information. All the multiples for goodwill can easily be calculated (revenue, EBITDA, SDE, gross margin, etc.). As a result, the market value of goodwill can be obtained. Then the market value of the various other components included in the sale are added to the goodwill to determine the asset value, or the total of goodwill, FF&E, and inventory.
When valuing fixed assets, it may be necessary to obtain the services of real estate and fixed asset appraisers. By analyzing additional information from the business, it may be possible to derive a reasonable market value of inventory and fixed assets to make an estimate. When including inventory, it is recommended to evaluate the salability of the inventory through analysis of inventory aging report, turnover rates, and other information deemed relevant.
Working Capital and Share/Stock Sales
In the event working capital is included in a transaction or valuation, the asset approach can be used by adding working capital dollar for dollar after evaluating for the risks in the related items. For example, the valuator may apply a discount for the risk of uncollectible accounts receivable, or a premium for including working capital. When considering a share or stock sale, the asset approach can be applied to the elements left in the corporation; and if deemed appropriate, adjust for the risks inherited/benefits of transacting a stock/share sale as opposed to an asset sale.
Terms and Conditions
Terms and conditions will also affect the transaction price. For example, an entirely seller financed transaction is often a higher price than a cash deal to compensate the seller for the risk of non-collection. However, until there is an offer, the terms are unknown. This further supports the need for a range of values when estimating a future selling price.
Conclusion
There are thousands of private buy/sells occurring every day. Developing the skill of providing buyers and sellers with estimated selling prices for goodwill, or a combination of goodwill, fixed assets, and inventory is a sought-after product. The corollary is providing a conclusion of value when a client wants to know what price he should ask or accept for a collection of assets at a future date will very likely result in a disservice to that client.
Take the time to thoroughly understand what the client wants and needs, and once complete, take the time to explain the result to the client. Business owners rarely obtain valuations; often the day they decide to sell their business or get a divorce is the first time they have ever been faced with the language and concepts embodied in a valuation; we need to act as both interpreter and advisor.
Carrie Stacey, CPA, CVA, CGA, CPA (CDN), is a CPA in the U.S. and Canada. She holds a bachelor of commerce degree and an associate degree in sales and marketing management. She spent time at KPMG, Dow Chemical, and Daimler Trucks North America before owning and operating two of her own Powersports dealerships, and working as GM of a boat dealership and RV dealership. Ms. Stacey now owns and operates Stacey International LLC, a M&A and business valuation firm specializing in M&A for dealerships in the U.S. and Canada. She is involved in various industry associations and has been a speaker at several MRAA Dealerweek conferences, the 2023 RVDA conference.
Ms. Stacey may be contacted at (208) 290-2289 (US), (778) 214-9988 (CDN), or by e-mail to carrie.stacey@staceyintl.com or staceyintl@outlook.com.
