Sale of company requires professional evaluation

July 1, 2003
LONGTIME owners of successful companies understand their bottom lines. But they may not be prepared when the time arrives to sell their businesses for

LONGTIME owners of successful companies understand their bottom lines. But they may not be prepared when the time arrives to sell their businesses for top dollar in a competitive and critical market place.

Providing buyers with a description of company operations and some glossy brochures will not substantiate the true value of a business. Buyers want to see a quantitative evaluation of a company that is prepared by a professional third party, including the preparation of adjusted historical income statements, pro forma income statements for future years, an adjusted balance sheet, and an analysis of costs and expenses.

“Selling a company on your own will not quantify the intangible value of your business,” said Allen Oppenheimer, founder and president of A M Oppenheimer Inc. “Every company has off balance-sheet assets, which may be worth millions of dollars, such as a customer database, research and development, in-house computer software, patents, and brand names.

“You must quantify the value of these off balance-sheet assets. Business owners who decide to do nothing will wake up one morning and realize their companies aren't worth anywhere near what they wanted for a selling price at retirement.”

Oppenheimer spoke at the 39th annual National Truck Equipment Association Convention in Atlanta, Georgia. Oppenheimer is a Certified Public Accountant, licensed business broker, and registered securities principal. Prior to founding his company in 1983, he worked for Peat, Marwick, Mitchell & Co and Ernst & Ernst in New York City (now Ernst & Young).

“Privately held businesses tend to reduce profits in order to save taxes,” he said. “Income statements must be adjusted for owner-related costs and expenses, non-recurring costs, and other items that distort the value of a company. When we evaluate a business, we ask for at least three years of historical income statements, and we recast or adjust them to reflect its true profitability.”

As one example, he cited a business owner who received $875,000 in salaries and bonuses from his company that earned $8 million in annual revenues. If the business was sold, a professional manager would be paid a much smaller salary. The difference between the two salaries is profit to a buyer, and income statements would have to be adjusted to reflect that difference.

On the other hand, a trucking company in New York with $12 million in annual revenues paid the owner a $50,000 salary. Hiring a professional manager to replace the ownerwould require a larger salary, he said, and that would reduce the profitability of the business.

Any textbook on business valuation will include a formula. Oppenheimer said the value of a business is its market value of equity at the time of sale plus future earnings capacity. Adjusted equity, balance sheet value, and net asset value refer to market value of equity at time of sale.

Typical balance sheet items requiring adjustment include cash, cash surrender of the owner's life insurance, loan due from or due to the owner, and long-term debt. A personal automobile used by the business owner is one example of a discretionary expense. Some business owners lease their personal real estate, such as a building, back to the company, and buyers want to see the true market value of the rent. If the company paid for a roof repair to the building, that is a non-recurring expense and also must be adjusted out for the buyer.

Another component of value is goodwill, which is quantified by five years of future net earnings in present value terms, he said. Depending on the economy and the industry, five years is used as the average time for pro forma income statements, cash flow analysis, and discounting of present values. Companies that have been consistently losing money for several years can be worth millions of dollars because of their goodwill.

Future potential

“The goodwill of a business is a function of future potential,” Oppenheimer said. “If a business has significant future potential, goodwill can be worth millions of dollars. This concept is not theoretical. It is substantiated by market research. Thousands of privately held businesses with revenues in excess of $1 million are sold every day in the United States based on this valuation process. Future potential is a key issue in terms of what you will get in your pocket from the sale of a business.

“Valuation of a business doesn't mean anything unless it is quantified and substantiated in the marketplace,” he said. “Accountants can perform the necessary calculations, but they are not in the business of selling companies. Value must be adjusted up or down.”

The most important section of the evaluation is market research, Oppenheimer said, because it substantiates the future potential of the business. In almost all cases, executives of a prospective buying company first will turn to the marketing research section of the evaluation package.

“They want to determine whether there is a strategic fit,” he said. “If there is no compatibility, then it doesn't make sense to buy the business.”

Computer databases are key tools that Oppenheimer uses to facilitate market research and acquisition analysis. Buyers need information on historical growth, industry trends, future growth analysis, and how a company that is for sale fits into the industry.

Many business owners aren't ready to sell their companies. Oppenheimer said his services include helping owners create an exit plan so that their businesses have retained the highest possible value at the time of sale five or 10 years later. His company also handles other needs of privately held businesses, such as Employee Stock Ownership Plans (ESOP). His presentation at the NTEA convention, however, focused on the valuation of a business to an external buyer.

Saleable company

The first step in the evaluation process is to determine if the company is saleable. Buyers look for continuity. A business that cannot continue without the owner is not a desirable investment. If a replacement for the owner can't be found, then the owner only has a job, not a growing business. In some cases, a buyer may want the owner or a professional manager to remain under an employment agreement so that other people can be trained to manage the business.

“One of my clients with an arts and crafts business had $5 million in annual revenues,” Oppenheimer said. “He said he was burnt out, wanted to sell his business, and travel around the world. But he was the artist as well as the owner, and without him there was no business.”

Buyers also want to see structure within a business. Names of owners and their percentage of stock holdings, nature of the business, and history of the company should be thoroughly explained. In a closely held business, one person may handle many functions. Titles, such as president, vice-president, and descriptions of their responsibilities, should be defined in detail.

Proper presentation of a company's sales forecast to buyers is extremely important, Oppenheimer said, because they want to see an increasing sales trend into the future. By using market research, a company can present a forecast of continuously increasing sales rather than a trend of increasing, decreasing, and increasing sales.

Asset valuation

In preparing an adjusted balance sheet, asset valuation can be divided into three areas: inventory, machinery and equipment, and real estate. The question to ask during the process is what items will the buyer want to buy.

Companies want to show the replacement value of inventory higher than its book value because of tax considerations. Cost of sales is beginning inventory plus purchases minus ending inventory. If ending inventory is understated, then the cost of sales goes up. If the cost of sales goes up, gross profit goes down. Less profit equals less taxes. So replacement value of inventory must be estimated for the buyers because companies understate their ending inventory.

Machinery and equipment usually are shown as depreciated fixed assets on company books, but their replacement value could be significantly higher. “Determine the replacement value of your fixed assets based on their existing condition and age — that is the cost of a buyer to replace equipment of the same age and condition,” Oppenheimer said. “The replacement value of equipment can make a big difference in the negotiation of the sales price.

“However, adding equipment to a business doesn't necessarily mean you are adding value to the business for a buyer,” he said. “In many cases, I have seen business owners spend millions of dollars for more equipment that never added a penny to the value of their businesses. They only succeeded in giving away millions of dollars to the buyers.”

As part of the valuation process, real estate and the business are separated because they both have independent value. A buyer can move the business to another location or may decide to purchase the business and the real estate if it has a specialized facility.

“You could get additional dollars in your pocket if you have a specialized facility needed by the buyer,” he said. “Or you might decide to keep the real estate because you have a great tenant in the building.”

After the evaluation is prepared, the business owner examines qualitative and quantitative reasons to sell. A family owned company that pays $400,000 in salaries and bonuses might be valued at $3 million after taxes. From a quantitative view, it wouldn't make sense to sell the business because investment income from the sale of the company could not compare with salaries. From a qualitative aspect, selling the business might be the best choice if the father is in poor health and didn't believe his children could operate the business profitably.

If the business owner chooses to sell the company, computer databases can be used to find prospective buyers — the type of buyers that have bought similar types of companies during the past three years. In addition, a compatibility analysis will find additional prospective buyers who have not made recent company purchases.

A letter of introduction that includes a description of the business, market niche, future potential, off balance-sheet assets, and profitability is sent to prospective buyers. It is mailed to a prospective buyer after the business owner provides written authorization, and a letter of confidentiality is signed by the buyer.

Balance sheet items requiring adjustment

  • Cash
  • Cash surrender value of owner's life insurance
  • Organization costs
  • Loan due from owner
  • Loan due to owner
  • Loan due on personal assets
  • Long term debt

AM Oppenheimer Inc

Financial areas that require emphasis

  • Preparation of adjusted historical income statements
  • Analysis of costs and expenses
  • Preparation of pro forma income statements for future years
  • Preparation of adjusted balance sheet

AM Oppenheimer Inc