A recent Pepperdine University Private Capital Markets Project survey revealed that almost two-thirds of nearly 1,000 business owners surveyed expect to transfer ownership in the next 10 years. Most of these companies are privately owned. If personal experience and other surveys apply, many, if not most, owners expect sale value to finance the bulk of their retirement plans. Is that realistic?
The business intermediaries, investment bankers and business brokers surveyed reported that about one-third of their selling engagements terminated without a sale. In effect, those owners withdrew from the selling process for one reason or another. The primary reason was failure to agree on price. The owners thought their businesses were worth more than buyers were willing to pay. That value gap was the reason for 1 in 5 of those withdrawals.
The Pepperdine survey presents the bones of a dilemma facing every exiting business owner. Let’s put some flesh on those bones.
Value is almost always tied to cash flow or profits. The value gap arises either because buyer and seller disagree about future cash-flow expectations or on the multiple to attach to those cash flows. The word used to describe that disagreement is “risk.” Price is always tied to risk. It almost goes without saying that buyers often perceive a higher degree of risk than do sellers. For a transaction to occur, the risk-perception gap must be closed.
Sellers often present a future that is rosier than past experience. Sellers call that opportunity. Buyers generally refuse to pay for opportunity because they incur the risk the opportunity will fail to materialize. Buyers will pay for a growth pattern that is well-established and reasonably expected to continue. If sellers want to maximize selling value, they must improve earnings and cash flow. If a business has not been operated to maximize value, it may take three years or more to put improvements in place. Don’t wait until you are ready to retire to begin revitalization.
Once buyers and sellers agree on future prospects, they must still agree on the value multiple – how many times the earnings or cash flow is the business worth? Smaller businesses often sell based on a multiple of cash flow available to the owner. That multiple generally ranges from 1.5 to 2.25. In other words, a business with owner’s cash flow of $100,000 will usually sell for $150,000 to $225,000. It is unusual for such a business to sell for more than that.
Medium-sized businesses will often sell based on a multiple of Earnings Before Interest, Taxes, Depreciation & Amortization, or EBITDA. That multiple often ranges between three and six. A business with EBITDA of $500,000 may sell between $1.5 and $3 million. Larger businesses can expect to sell for higher multiples.
There are exceptions to some multiples reflecting unusual conditions or expectations.
When you are ready to retire is not the time to begin to think about sale value. For maximum cash-out potential, the process should start three to five years before the desired exit date.
Bowser@BusinessValueInsights.com. Dan Bowser is president of Value Insights Inc. of Durango, Chandler, Ariz., and Summerville, Pa.
