According the BizBuySell a premier listing site for main street businesses, more than 85% of the businesses that list fail to sell. As a business broker I can tell you that even businesses we sell are frequently sold for less than the owner originally had in mind.
Why do so many businesses fail to make it across the finish line in a transaction?
Most of the time it is because the business is overpriced. As business brokers we see this in our business ALL THE TIME. I believe it is the number one reason after bad, (or nonexistent), financial records.
There are many reasons that owners are unable to recognize the true value of their business. What they frequently fail to understand is that in business and particularly in small business, investors are buying cashflow discounted for risk. The lower the cashflow (or the riskier the cashflow) the lower the value of the business. Our founder used to ask business owners, “If I were to buy your business today would I be able to make a comfortable living that is in proportion to my investment?” If they answer is “No” the business won’t sell at the owners’ desired price and the emotional toll of a realistic offer frequently causes the deal to fail.
No matter how much an owner has invested in a business, no matter how much they need the money for retirement or want to feel successful, small businesses (sold as businesses and not liquidated at auction) are purchased based on the lifestyle that they will provide for the new owner.
We once worked with a software app developer who spent almost $500,000 developing a niche product for the property management industry. At one point the product was producing over $400,000 per year in cashflow. Because the business was based on low cost subscriptions that created strong recurring revenue, the owner thought it would run itself and they stopped developing new functionality. Due to changes in the marketplace (including freemium competitors) their customer base declined. As the business started to fall off, the owners decided to sell. The issue is that the owner was emotionally committed to a price that the cashflow of the business no longer supported.
The seller at least wanted to recover the cost of development. But at the time of this transaction, only a few years after the product was rolled out, developments in technology, processes and labor markets meant that the acquiring company could likely have developed a substitute product for a fraction of the original cost. According to John Warrillow of the Value Builder System, “The number one rule of buying a business is don’t buy anything that you can build for less.” Even though the prospective investors had no intention of redeveloping the idea, there was no reason to overpay for technology.
In the end there was a knowledgeable buyer who was willing to purchase at a price that was about half what the owner was asking. The owner insulted by the offer, walked away from the table.
The story of our frustrated business owner above illustrates the second reason that businesses overestimate the value of their business. They wait too long. Stewart Guthrie, Broker at The Liberty Group of Nevada has a saying. “The best time to sell your business is when things are going GREAT.” In truth growing revenues over a three-year period make your business very attractive to potential buyers.
The problem is the owner develops an expectation of value at the peak of the market when the business has been growing and they believe that investors should pay for what the business is capable of in the future (when they turn things around and return to or exceed the previous cashflow). The truth is that the business may have been worth $1,000,000 when it was at its peak but once the business begins to decline your value will fall off 2x to 3x times as fast as your profitability. This is due to the common practice of using a multiplier of earnings to value a business. If your earnings fall $50,000; your business has lost $100,000-$150,000 of value. Investors rarely pay for unrealized potential.
Potential buyers want to know not only that you have been successful growing the business but that there is more room to grow. An owner with plans for how they would continue to grow the business is in a much better position to sell the business than an owner who is at the end of their ideas and skill set.
Owners frequently believe that their business is worth more because they “know” they make more money than is reflected in their books. They believe that people will take their word for the profitability of their business. But the truth is bad bookkeeping = more risk and a greater discount on multiple that a prospective buyer is willing to pay.
We once had a business listed. It was a nice sellable small business with a value of around $300,000. The owner called us one day and proudly advised us that he had converted his two largest customers to cash which was going to reduce his taxes by $10,000. This means that he removed around 60,000 from his earnings. Worse he removed it from his earnings on record. NO smart business buyer is going to take your word for your earnings. Hiding the cash and saving $10,000 in tax cost him $120,000 -$180,000 in the value of his business.
Saving money on taxes is one of the primary benefits of owning a business. The problem is that a business that is serving as a piggy bank for the owner is unattractive to lenders and buyers alike. Clean books make your business worth more. We recommend that our owners start cleaning up their books 3-5 years before they want to sell their business. A good accountant can help you straighten out your financial house while still getting reasonable tax benefits from your business. Good books give buyers confidence that you are honest and fair dealing, which makes invensting in your business a better risk.
Expansions need to be carefully considered with respect to your intentions to sell. There are a number of perfectly legitimate investments that you can make in your business that need TIME to allow your profitability to catch up. Adding a facility is a great example. When you add a second location your cashflow will (at least for a short period) go DOWN. So your business operating at capacity from a single location could easily be more valuable than a business with two locations one of which is being supported financially by the other.
How do you give yourself the best chance to successfully sell your business? Get professional advice early. You should be regularly speaking with your advisory team including your financial planner, your accountant and a qualified business broker. Find out the value of your business, even if the numbers aren’t what you hoped it is better to have realistic expectations so that you can take proactive steps (which may change depending on your timeline to sale) The sooner you need to sell, the less you will be able to do to maximize your business value.