Do you own a business?
Are you ready to cash in, sell your company to a big corporate entity, and retire?
Sounds great, but what is your business really worth? Who will buy it? What are the next steps?
I have spent years buying, selling, and valuing businesses as a consultant, running in-house M&A, and as a business leader.
My first job after graduating from business school was working for a Big 6 accounting firm in the financial advisory consulting group providing business valuation.
Let’s spend some time discussing not just how to value a business, but some of the other criteria that will impact your decision to sell.
I Want to Sell My Business
For those that are not familiar, business valuation entails analyzing a company and determining a fair market value. You typically use multiple approaches including applying a market multiple to the free cash flow, estimating the cost to recreate the business, and applying the discounted cash flow (DCF) approach.
In most of my experience, the DCF approach is typically the highest weighted of the three. You can argue that DCF is the most accurate as it takes into account not just current cash flow from the business, but the timing of future projected cash flows, and the risk of generating those future cash flows, which is what a buyer is acquiring.
The mechanics of calculating the DCF of a business are relatively simple. The first step is to prepare a projection of the annual cash flows expected from the business over a specific period (often 5 years). Next you discount the annual cash flows using an appropriate weighted average cost of capital (WACC). And lastly, you calculate an appropriate terminal value and discount that value using the WACC. The sum of the discounted annual cash flows and discounted terminal value equals the current enterprise value of the business.
Pretty simple in theory, but there is much more that goes into determining these inputs, and that is why it’s a good idea to hire an expert if you don’t have much experience in this area. But that will work for our discussion.
Should I Sell My Business or Keep It?
Up to this point, everything is academic. You can use different approaches to calculate a supportable valuation, but in the end, the true value is what someone is willing to pay for the business.
When I left consulting and began running M&A for a private company, this became clear. Just because my DCF indicated a business was worth X, didn’t mean the owner was going to sell for X. Especially with a closely held business, the owner’s expectation of value is typically greater than a corporate buyer’s. A closely held business has nearly as much standing as another child to the owner. And they won’t just sell their baby to just anyone.
In my experience,
“Most successful businesses only sell when they are in trouble, when they want to retire, or when they get stupid money.”
To understand why this is the case, let’s start with the economics and look at an example of a small business that generates $1 million in sales and generates $200,000 in profit.
Most small businesses allow for the owner to deduct certain expenses that are used for both personal and business (cell phones, travel, etc.). This is a perk that goes away if you sell the business.
And although nice to have, those deductions are small in comparison to the cash flow generated by the business.
Most small businesses will sell for 4 to 6 times annual cash flow. In this case, the business in question would sell for $800,000 to $1.2 million. In the best case, even if we exclude any taxes that might be owed on the sale, assume the seller now has $1.2 million to invest. Now let’s say the seller can find an investment paying out a 6% yield. Not bad in this market where the 10 year treasury is at 2.18%.
So our seller has gone from making $200,000 per year plus being able to deduct some of his personal expenses to now making $72,000 per year.
But what about the after-tax impact? Aren’t taxes less on a financial investment as compared to a small business?
As a small business owner, let’s say the seller was paying full self-employment taxes of 15% plus another 30% in federal income taxes. He was left with $119,000 after tax.
After the sale, his investment earnings are no longer subject to self-employment taxes and he is now only paying 15% federal taxes on the investment earnings. His after-tax earnings are now $61,200.
It is true that our seller has monetized his equity in the business, but most small businesses aren’t valuable enough to allow the owner to cash out and retire. As such, now he must find an additional $57,800 in after-tax income. And this often means going to work for the company you sold your business to.
Should I Sell My Business or Not?
Sure as an employee, the seller no longer has to worry about making payroll and managing every aspect of the business as he did as an owner. But now he has a boss. And having a boss after years of not having a boss can be a difficult transition.
To give you perspective, when I was running physician practice acquisitions, we might see 1 out of every 20 transactions result in an owner becoming an employee and staying with the company for more than two years.
So unless an owner has adequate assets to retire, is ready to scale back their spending, or is ready to enter the workforce, it can be difficult for them to see the value in selling their business.
An owner can be convinced to sell if there is a real threat to their survival – i.e., opening a store next door. I have also seen owners mismanage their business so bad that they didn’t have a choice but to sell – i.e., failing to pay payroll taxes for five years.
As a corporate buyer (and not willing to overpay), those were two scenarios that I looked for when trying to buy a company, otherwise it was difficult to close a deal.
If you own a business I would love to hear your thoughts on what might motivate you to sell it..