Business Valuation as it relates to Business Sale Price Calculation and Working Capital

Business Valuation as it relates to Business Sale Price Calculation and Working Capital

Business Valuation as it relates to Business Sale Price Calculation and Working Capital

Deciphering a Business Valuation may take an experienced analyst.

 

General Definition:

{Current assets – Current Liabilities = Net Working Capital}

 

In most cases, the valuation of a business does not include the net working capital of the business at the time of the valuation. Working capital is often excluded from valuations so that business values can be compared to other similar businesses without the need to adjust for working capital. If 2 businesses are identical except one has $1,000,000 in excess cash it won’t affect the valuation comparison because the excess cash is not in the valuation price for the businesses.

However, the working capital can affect the actual selling price of a particular business if the working capital is included in the sale.

 

Example:

Let’s say Business A is valued at $5,000,000 and business B is valued at $5,000,000, both without working capital. If business A has $700,000 in net working capital and business B has $1,500,000 in net working capital, and the buyer wants to buy the working capital with the business, then business A will sell for $5,700,000 and business B will sell for $6,500,000 even though both were valued at $5,000,000.

 

Many buyers want to buy a business with adequate or normal working capital. By doing this the buyer has a set amount of capital to raise that allows them to purchase the business. This capital to buy the businesses is likely long-term capital. By including working capital in the purchase, after the sale, the business can operate on the purchased working capital.

The larger the transaction the more likely that working capital will be included in the business sale. The working capital target number (i.e., the amount specified in the LOI to be included in the purchase price) is an important negotiated element of a deal. In the LOI it might be a dollar amount or often an agreed to formula (since the working capital moves virtually every day the business is open) to use to get to a working capital number at closing. Make sure all elements of the working capital calculation is defined and understood.

 

Common Working Capital Elements

(with notes on the tricky ones)

Assets

  • Cash and cash equivalents
  • Accounts receivables
  • Inventory
  • Deposits (Deposits business has at vendors or other i.e., tax deposits, lease deposits, etc)
  • Work-in-Progress (Does your accounting system account for this properly? WIP can also be a liability depending on billing practices.)

Liabilities

  • Accounts payable
  • Accrued payroll
  • Vacation owed employees
  • Gift certificates (Does your accounting system track?)
  • Warranties (Outstanding for products or services)
  • Prepaid service or maintenance agreements
  • Deposits from customers
Selling a Business: The C Corp to S Corp Dilemma?

Selling a Business: The C Corp to S Corp Dilemma?

Selling a business set up as a C corporation can have some very painful tax consequences.

The following is not legal or tax advice. Consult with your CPA and/or attorney before taking any action

Is your business a C Corporation?

If yes, PLEASE READ THIS!

Do you want to pay 50% or more in taxes when you sell your business?

I didn’t think so. If you want to avoid that potential calamity? Read on.

But first, let’s talk a minute about the characteristics of a C corp. A C corp is a legal entity in which a business is operated. An S Corp and LLC are also entities used frequently to operate a business.

The primary difference from a tax perspective is the C Corp profits are subject to “Double Taxation”. Meaning the corporate entity is taxed and then the shareholders are taxed when what’s left is taken out of the C corp by the shareholders.

S Corps and LLCs are often set-up as “pass through” entities meaning there is only taxation at the shareholder or member level (we’ll use shareholder and member interchangeably but there are some differences). There are circumstances where LLCs are taxed as C Corps. Check with your CPA when you establish your LLC to make certain it’s set-up correctly.

Double taxation can be painful

Many business owners have been advised by their accountants over the years to switch from a C corp to an S corp but the business owners have ignored this advise too often. Timing the conversion can have an effect on the impact felt by the C to S conversion. If it comes time to sell your C Corp almost all buyers prefer an asset sale as opposed to buying the stock of your C corp. Therein lies the value trap caused by the double taxation at the C corp level.

Why is important to advisors like us (Mergers & Acquisition advisors and business brokers) who sell businesses for business owners? Because the same “double taxation” on your profits could be a problem upon sale of the business. How would you feel if you spent decades building a business and then when you sell it you get the privilege of paying 50% or more in taxes on the selling price?

How Long does it take to get the S Corp tax treatment after you convert?

There is a look back period in the tax law that is designed so that you can’t just convert your C corp to an S corp at the time of sale and reap the lower tax windfall. The IRS is way too smart for that trick.

The tax code “look back” period has varied in recent years from 10 years to 5 years to 7 years to the current 5 years. Who knows what it might be in the future?

Here are the pitfalls and options:
1) If you don’t plan to sell your business for at least 5 years consider converting from C to S now

2) If you do plan to sell your business in the next 5 years, seriously consider converting from a C to S now

Yes, the advice is the same. Why? Because the look back window starts when you make the conversion and the sooner the clock starts, the sooner you are out from under the C Corp tax burden if/when you sell your business.

Selling a business is more about how much you end up with, not how much you sold it for

What are the steps to convert?

An important first step recommended by most CPAs is to get a Business Valuation done for the C Corp. This valuation captures and locks in the potential C Corp tax burden. Then the value gained above that valuation will not be subject to C Corp taxes in the future. That 10 year or 5 year or 7 year window or whatever other look back period the IRS decides to impose on you.

At the very least talk to your CPA now about converting from your C Corp to an S Corp, I promise, you’ll be glad you did. This tax burden has negatively impacted many business owners because they didn’t act before the issue arose.

In order to convert a C corporation to an S corporation, the business entity must meet the five conditions below.

  1. The business must have been created in the United States — both legally and effectively. A business entity that was not legally incorporated in the US is not eligible for electing S corporation status.

  2. A C corp seeking to elect S status cannot have more than 100 shareholders. If shares are spread – in part or in whole – across a network of immediate family members, they are considered to be one shareholder.

  3. Each and every shareholder absolutely must be one of the following: an estate, a business entity classified as an S corp, a resident alien, or a full-on United States citizen. Further, a handful of types of trusts can also be considered eligible.

  4. If a business can obtain consent in writing from each and every shareholder to flip-flop the status of a C corp to an S corp, the C corporation business entity can be considered eligible to elect the status of an S corporation.

  5. Lastly, the business entity in question can only have one type of stock up for grabs – this means an entity can’t have both preferred and common shares, for example.

Here’s how to elect S corp status:

First, the owner of a business must file Internal Revenue Code Form 2553 — titled the Election by Small Business Corporation. All shareholders and the chief executive officer or president — whoever signs the tax returns once they’re completed — must sign the aforementioned form.

Finally, simply deliver the completed form to an IRS office.

Remember, the preceding advice is no substitute for talking to your CPA or attorney about your particular situation and whether changing your type of business corporation is right for you. But in certain situations, converting your company’s tax status from a C corp to an S corp can save you a lot of money!

Business Sale: Tangible vs Intangible Assets a Quick Analysis

Business Sale: Tangible vs Intangible Assets a Quick Analysis

A mysterious part of buying a business is the intangible asset sale. We find a wide variety of views and preconceived notions about business value from individuals as they review a business sale. Most the time, the discussion turns quickly to the business assets. That inevitably leads to a discussion of Tangible and Intangible Assets.

Investors involved in a business sale generally have a reasonable understanding of tangible assets but usually a less than good understanding of an intangible asset. They have a tendency to use disparaging terms like “Blue Sky” or “air ball” when they don’t understand the true value of intangible assets.

First let’s try to reach common ground on some basic definitions that are commonly used but not always understood.

Tangible Assets

Tangible assets are really based on banking and lending definitions. A general definition is an asset that has a physical form. For instance a truck is a tangible asset. You can touch it, feel it and more importantly sell it. While a truck is a tangible asset that may be salable, there are other tangible assets that might have different characteristics. Suppose you own a widget shop and you have a special machine you invented that bends the widget a special way. You love the machine but it’s of no use to anyone but you. That is still a tangible asset but it has relatively low value to the outside world. The truck you can likely sell pretty easily but finding a buyer for the widget machine might be a whole different problem.

Intangible Assets

These are assets that don’t have a physical form. For instance the trademarked Nike swoosh is a very high value intangible asset. One way to think about tangible vs intangible assets is tangible assets are used to make or deliver the product or service and intangible assets are what are used to generate the demand for the product or service or create the system to produce the product or service efficiently.

A very well known intangible asset is the secret formula for Coca-Cola. That formula has no tangible form, it’s basically words written down somewhere (likely different parts of the formula in different places). But that intangible asset is worth much more than the cost of the machines (tangible assets) used to produce Coke.

Now that we have a basic idea of the assets, let’s talk about why we have assets at all and how they effect a business sale.

Assets in a business have only one purpose (or one purpose that makes sense), to generate profits.

So what value can be created in a transaction? A Tangible Asset Sale or an Intangible Asset Sale?

I’ll give you 2 simple but real life situations.

1) Let’s say you can buy a machine for $100 that will generate $25 more per year in profits. You decide that’s a good investment, so you invest the $100 and you’ll get your $25 per year profits for as long as the machine works. So now you have a $100 tangible asset (the machine) and a $25 cash flow from it.

2) Now let’s say you add an email capture tool to your website, it captures visitors’ email addresses which you can use to automatically send out specials and mailers. The email tool costs $100 and generates $25 in cash flow.

In this case you created 2 intangible assets:

a) the email tool on your website and b) the list of emails of people interested in your products.

The intangible asset sale with the highest value is the list of emails for people interested in your products. Anybody can buy the email tool for $100 but you have the specific list of people’s email addresses that represent potential sales, this list is an intangible asset.

Think of it this way. Two businesses are exactly the same except one has the email addresses for these customers and one business doesn’t, which business is worth more?

The moral of this story is that when investigating a business sale and determining the value of the business for purchase, the assets that have real value are the assets responsible for generating the business profit, regardless of if they are tangible or intangible asset sale. A smart buyer knows how to identify those assets and isn’t blinded by the tangible asset mantra preached by the bankers.

Selling a Business in the NEXT Energy Boom

Selling a Business in the NEXT Energy Boom

Those of us who work regularly in and around the oil & gas energy industry recognize the difficulties presented by the current depressed energy prices and its effect on energy services, production and exploration companies. We view the world through the process of Mergers & Acquisitions as we work with business owners to sell their companies. Many Texas businesses are heavily impacted by the swings in energy prices. We see machine shops, water disposal, inspections, welding, tank, vessels, trucking, temporary housing and many other energy related businesses that suffer the financial pain when energy prices and production declines. We also see these same companies reap the benefits of rising energy prices and production cycles. Unfortunately, too many business owners have short memories.

“When the energy business is good many business owners think it will last forever. It won’t.” ~ Dan Elliott

Like you, we have seen this play out before in different cycles and many energy companies (and related businesses) always seem to recover. Selling a business for the highest value is often driven by timing. Will you be ready when the market is?

If your goal is to sell your business in the next energy boom here are 3 things you can focus on now to make sure your business achieves its highest value in the next energy recovery cycle.

1. Get your financial reporting up to standards that will one day survive a buyer’s due diligence.

Excellent financial records increase the value of your business because it reduces the buyer’s perceived risk that poorly maintained financials mean more financial room for error. Make sure your accounting is done consistently from year to year and make sure your current tax structure (C, S, LLC, etc) is what will create the highest value transaction. Look at your financials as a buyer would or better yet give us a call and we can review your information and give you a report that identifies the areas for improvement.

Tip: To most buyers Reviewed financial statements are almost as good as audited financials and a lot less expensive. If you have audited great, but if you just have compiled statements find a good business accountant to do reviewed statements.

2. Work hard on Customer Concentration Issues

A buyer often perceives risks if 1 or 2 customers dominate the revenue of your business. Ideally your largest customer should be less than 20% of your annual revenue (unless you have long term contracts which assure buyer purchases). Shifting customer concentration is often a long process, start now.

Tip: Look at your commission plans for your sales people. Are you rewarding salespeople who diversify their customer base?

3. Review your insurance to be sure you are adequately covered for your business risks

An underinsured claim is a nightmare for a business owner and can interfere with the sale of the business for many, many years. Do you have enough coverage? Do you have the right coverage? The “right coverage” question is even more important than how much coverage. We had a client get hit with a $2 million claim that he thought he had insurance coverage for. He didn’t. The deal to sell his business that we had on the table for millions of dollars was delayed until he found out he wasn’t covered, then that deal disappeared altogether. Talk to more than one agent and certainly more than just your regular insurance agent who may think they know your business but really don’t. Many commercial insurance agents will be more than happy to give you a review.

Tip: Talk to an insurance agent who specializes in your industry. Your trade association knows who they are.

Far too many business owners don’t plan ahead for an opportunity that could arise without much notice. Selling a business for the highest value and best terms is never an accident. The value goes to the prepared.

Buying a Business in Texas – Define Earnings and Profits First

Buying a Business in Texas – Define Earnings and Profits First

When looking at buying a business in Texas and other parts of the U.S. there are many different terms used and the same term can be defined differently depending on who is using the term.

In this post I’ll try to define some of the terms commonly used to represent the “earnings” or “profit” the business generates.

The terms below are attempting to describe the operating profit available to the new business owner when the selling business owner, and all of the selling business owner’s non-business expenses, leave the business. Keep in mind that the vast majority of small business owners do their accounting with a single intent, minimizing taxes owed.

Here are some common terms you will see when looking at businesses for sale:

Cash Flow (CF or C/F) – This is a commonly used term for representing the “earnings” of the business and is definitely not the same definition of cash flow that a CPA would use. A CPA would include changes in accounts receivables, accounts payable, capital expenditures and a number of other items when calculating the true “cash flow” of a business. When you see the term “cash flow” used on Business for Sale sites what they likely mean is the “Earnings Before Interest Taxes Depreciation and Amortization” (EBITDA) plus Owner’s Compensation. Once you understand EBITDA and Owner’s Compensation you’ll have the code for the other definitions.

Net Income – Net income is a fuzzy one because lots of people include and exclude items that others might not find appropriate. You’ll have to have the person claiming the net income number explain EXACTLY what the source of the information is and what is included and excluded.

EBITDOC – This is a term I have created that I’m hoping the industry adopts. This was explained above when you piece together EBITDA and Owner’s Compensation. It’s the business earnings before interest, taxes, depreciation/amortization and owner’s compensation. With this definition it allows you to focus on the most critical of the elements which is proving the claims of the Owner’s Compensation, in all it’s forms. Many small business owners are very creative with their accounting. Make certain you understand the source and veracity of the numbers before you make any decisions.

EBITDA – This is a common measure of earnings in larger businesses but is less useful when buying a business in Texas. This earnings definition assumes that the “owner” or CEO of the company is receiving fair compensation for the job being performed and therefore no adjustments need to be made. This is rarely the case in small businesses for sale and therefore EBITDA, without Owner Compensation adjustment, is generally useless in evaluating the small businesses earnings. You will however see some representations of ebitda that make total sense as a stand alone number if embedded in that EBITDA number is an reconciliation for owners compensation. This number is often called Adjusted EBITDA.

Pre-Tax Income – This term is generally useless when evaluating the earnings of a small business. The problem is all of the non-cash entries and the owner compensation entries that happen before the pre-tax number is established. Often times this pre-tax number is manipulated so that the business owner reduces his taxable income.

The takeaway for this is that when evaluating buying a business in Texas or other places in the U.S. you need to take the time to understand how the advertised earnings were established and understand the items included. Don’t assume one business broker’s earnings is calculated the same way as another business broker, do your homework.

The Value Goes to the Prepared.

earnings of a small business.