5 Reasons Why Businesses Do Not sell
#1 Blue Sky Valuation
One of the biggest reasons why businesses do not sell is an overly optimistic “valuation”. You might be thinking “well that is an obvious answer”. It is not so simple. Within this reason there are several factors at play. I shall go into detail one of them.
A common case is often a mismatch between what a business owner thinks or feels his business is worth vs what a buyer/investor thinks it is worth. The reason why is because both parties could be using different perceptions of valuation.
I use the word “perception” because the business owner may not be using a standard methodology or any at all for valuing a business. Most buyers use rules, formulas, and historical data to assess the value. Internally, they are also calculating their ROI. On the other hand, I have spoken to business owners who have qualitative methods in value perception. For example, I want to sell my business for a million dollars.
Here are some past conversations with business owners I had regarding business value:
- “I only work 15 hours a week and make $250k a year. If someone put in more effort, they could easily double the earnings. So I think my business is worth $1.5m instead of $750k.”
* Note: Buyers pay for the past but buy for the future. They won’t pay you for something they have to work to get.
- “The company owns a patent that would revolutionize this industry. If more capital was put in for expansion, we could grow much bigger.”
* Note: I came across one case where they had a patent for 5 years. A buyer would ask, if the patent was so good, why did sales not grow every year? Or a larger company strategically buy you out.
- Confusing valuation multiples (more on this later) of a capital intensive business. As an example, I came across an importer/distributor business for sale I wanted to buy. They made about $500k a year in earnings. However, in order to acquire inventory at the low price to remain competitive, the business had to stock $700k worth of goods. While there are options to finance working capital in large companies, it is not as easy for smaller business to do so. Especially when working capital is such a large portion of business value.
The main point of this is that qualitative (and some cases of methodological error) is too subjective to be used for valuation. In short, there must be some standard methodology in valuing business so that we can compare apples to apples.
Here’s a more detailed explanation about what methodologies is common practice in among buyers and sellers in the business BuySell industry. Heading into the market with a proper valuation that is defensible is the better way enter negotiations with potential buyers. Buyers are more informed than you think!
#2 You Are The Business
When people say business, the thing that comes to mind is an entity or “profit machine” that has some sort of human resource structure in place that allows it to operate.
What do I mean by this? Here are two contrasting types of businesses:
- A product design firm where the owner is the lead and only designer/engineer. Every other employee supports the owner or does administrative work. When meeting potential clients, the question I ask is “Are you The Business?”.
- A manufacturing company with 10-50 employees in place. There are employees to run production operations, sales and marketing, and administrative tasks. Typically there will be an operations manager who will look after the day to day operations. The owner oversees the business and may also do business development. The owner is NOT in production although he could.
There are many variations between these two but I hope you get an idea what I mean. It does not mean, however, that businesses where the owner is the sole value will never be able to sell. A deal could still be struck with the right price, key role succession plan (train a new person for the role or train the new owner), and other provisions that ensure that the new owner will be able to retain the skills and customers (thus earnings) of the business.
This is where finding a broker with real business experience and a problem solver comes into value.
#3 Using The Wrong Cash Flow To Determine Value
This is where even many business brokers fail when they try to do a business valuation let alone for sale by owner deals. It is not surprising because there are many brokers who enter the industry from real estate or from the corporate world that did not even go to business school. The 4 year degree equips a graduate with advanced finance and accounting fundamentals!
In most valuations of a profit entity as a going concern, the most important building block number that is used is the cash flow or the earnings.
It is important to use the right cash flow for private entities or you may end up with a significant difference in final value.
The rule of thumb though not set in stone is the use Seller Discretionary Earnings SDE (or Seller Discretionary Cash Flow SDCF) for businesses making $500k or less a year and Earnings Before Interest Taxes Depreciation Amortization EBITDA for businesses making more than $500k a year.
Less than $500k – SDE/SDCF
More than $500k – EBITDA
SDE ranges 1-3x
EBITDA ranges 3-6x
* Multiples are the result of actual valuation calculations not vice versa i.e. using multiples to find value.
Another deciding factor I use is when the business is able to run owner absent or partially owner absent and makes more than $200k but less than $500k, I may still use EBITDA in my calculations.
Yet another mistake made is using the EBITDA or SDE figures without accounting for capital expenditure (CAPEX). For example, a small manufacturing business that owns all the equipment that costs $500k and requires to be replaced every 10 years impacts the earnings with CAPEX of $50k each year (You do not need to account for financing cost).
Using the wrong cash flow may result in your asking price that is disconnected from the market value. Buyers either shy away from inquires or negotiations go nowhere because the seller (owner) is defending a valuation with the wrong premise.
#4 Marketing To The Wrong Buyer Type
Identifying the right buyer type for your business is critical in a valuation and the preparation of the sale structure. Business buyers fall into 3 broad categories of which each category may have further sub categories. For now, understanding these 3 categories shall suffice.
- Entrepreneur/Owner Operator
- This buyer type is looking to “go out on their own” and “work for themselves”. They can be people who have been retrenched, former business owners, quit their jobs to become entrepreneurial.
- Generally require bank financing (Canadian banks differ in lending policies than American commercial lenders, ask me about the difference).
- May calculate return on investment by number of years it takes to recoup their capital. Usually optimistic so includes growth from their planned expansion into account.
- Has highest emotional effects compared to the other 2 buyer types.
- Typically wants to work the business, thus SDE is used as cash flow.
- ** Looks at earnings of the company as their “salary”.
- Corporate Buyers
- Buys other businesses for strategic purposes lie expansion into new markets or locations.
- May pay a higher price than market if they feel the synergy outweighs the cost.
- May be a competitor, supplier, customer, or from an entirely different industry for diversification.
- Generally also require financing but may have a higher down payment.
- Looks at return on investment but more strategic focused.
- Has less emotional effects unless the target company is very valuable to their strategy.
- They either run the target business as a separate entity or merge with their current to save overheads.
- Will look at both types of businesses owner operated (SDE, smaller companies) or owner absent (EBITDA, larger companies).
- Main focus is on strategy, not investment or buying a “job”.
- Private Equity/Professional Investors
- Buys solely on ROI (return on investment).
- While their acquisition funds are leveraged/financed, it is on hand ready to be used. Usually do not require financing thus subject to financing clauses.
- Looks at ROI but also may have strategic mergers in mind. Amalgamation of two businesses in portfolio.
- Requires business to run owner absent but will be active in management, finances, and strategy. Sometimes bring industry contacts that allow business to get larger contract.
- The most professional of the 3 and may have sophisticated deal structures like claw back clauses, earn outs, incentives, etc.
- Only look at EBITDA companies and typically with pre-tax earnings of $1m and up.
While it is impossible to determine who the final buyer would be, there are some absolute choices that can be made so that this mistake is not made. For example, you would not market an owner operated grocery store to private equity using EBITDA. Similarly, you would not market a 60 employee company to a former working class buyer unless they were high net worth and had $5m in asssets.
Knowing who to market to kick starts the content of the marketing materials and even the transaction process.
#5 Not Using A Professional
This may sound self-serving, but it is true and statistically proven. Businesses sold using business brokers can achieve up to 20% more in the sale price and close a greater percentage of the time.
The information I have provided above and a quick look at my website on valuation should already give you an idea that such a huge undertaking should never be done alone.
There has been countless times where a business got damaged because the owner tried to sell it themselves or used the wrong professional like a real estate agent. There was once I met with a business owner who had it on the market before but it did not get sold after a year. They used a real estate agent to market the business and the realtor put the business address on the business listing!! You and I both know a business sale must be kept confidential from employees, customers, suppliers, and everyone else.
These are some of the reasons to use a business broker or consultant:
- It can take 400-600 hours to sell a business over a 4-12 month period using proper procedures and due diligence. Do you have the time?
- Good brokers have proper procedures and processes in place to protect your business, its confidentiality with contracts and disclosure documents.
- There will be times where decision grey areas may arise. Where you have an interested buyer that is requesting more sensitive information. How and when do you stop or proceed?
- What are the ways to financially qualify a buyer? A disaster waits when you accept an offer only to find out a buyer was nowhere near qualifying for a loan.
- At which part of the process do many deals fall apart? Is there a way to mitigate this risk?
- If it took 4-12 months to sell a business, which decision is a better choice for you? 1: Spend it selling the business on your own and have sales flat. 2: Engage a pro to get the highest sale price, and focus on growing sales (and thus valuation) by 10-20%.
* There was a business I sold where sales grew during the time it was marketed for sale. It ended up selling for much higher than the valuation. Valuations are real-time, it is possible to sell for higher.
There are many other reasons why businesses do not sell, but these are some of the main ones I know of.
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