Financial Performance and Real Estate
Financial performance and real estate?!? How the heck are they related in a business sale??
Well, they aren’t, really – except that last week’s post got quite a few comments and they were mostly about two things: examining the financials and determining the best way to handle the real estate. Business sellers and business brokers need to understand the importance of both when considering bringing a business – small or not-so-small – to market.
If you’re a business broker – or aspiring to become one – the former is important from the standpoint of valuation. The later is important from the standpoint of understanding the myriad ways a deal might be structured.
Let’s take a brief look at both.
A company’s financial performance is arguably its most important indicator of value. Unless a buyer is looking for a hobby – or for some way of keeping one or more of his wayward offspring out of jail – he or she is going to be asking, among other questions, “how much money will this business put into my pocket every year?” This is the question that the broker’s Offering Memorandum should clearly answer. Much of the buyer’s due diligence work will be spent confirming this. (Make it easy for them!)
Financial performance of the company should be clearly illustrated and supported by all sorts of data including, but not limited to, tax returns, bank statements, financial statements, payroll records, tax filing receipts, etc. and for larger businesses, auditor’s notes and work papers.
Though the buyer of a Main Street business – AKA, a “mom and pop” business – may not have a team of advisors to consult with, most will have some counselor that will be asked to “look over the numbers”. Make sure they are clear and easy to understand. Your job is to make it easy for the buyer to get to “yes”.
Buyers of larger businesses will most likely have a team of third-party talent working on their behalf. Strategic buyers – companies that are growing through acquisition – will in many cases have in-house talent. In both situations, the analysts will tear your Offering Memorandum (and financial data) apart looking for gaps, errors or anything that doesn’t add up. In the case of the company’s financial performance, the less they find to question, the more they’ll trust what you tell them.
What’s the Number?
The financial performance analysis will examine all revenue sources and expense categories. It will consider recurring revenues. It will look closely at existing contracts to try to determine whether the existing numbers are likely to grow, remain the same or fall. But it has to start by determining one number: the seller’s Discretionary Earnings.
Discretionary earnings is the answer to the question, “how much money will this business put into my pocket every year?” Though there are many other aspects to consider when estimating the value of a small or mid-size company, determining what those earnings are is a major component of determining value, especially in a small business. We show you how to do this in our upcoming course, The “How-To” of Becoming a Business Broker”. If you’d like to learn more about that course, let me know where to send the information:
If the business owns the real estate, the seller’s options might be limited. Having the business lease the real estate it uses from an unrelated landlord takes the issue of real estate off the table and its value out of the financial analysis (though the existing lease – rental rate, remaining term, terms for renewal, etc. – must be considered). But if the real estate is held by an entity that is owned, in whole or in part, by the owner of the business, but separate from the business, you have the optimal situation.
Why? Because the sellers then have several options for a “liquidity event” and the choice they make will be dictated by their exit strategy. If they want cash now but the business is not quite worth what they need in retirement, they can sell the real estate and keep the business until its value increases to their target level.
If they are ready to sell the business, they can keep the real estate and receive monthly rent payments from the business and its new owner(s) for years to come.
If they are ready to cash out of everything and head to the islands to do epic clinical research on the life-altering characteristics of good rum, they can do that also. Importantly, in this case, they can sell to two different buyers!
I’ve held forth on this topic before and it is critical that the business broker or owner understand the range of options that are presented by the various methods of holding the real estate and, most importantly, how those methods will likely impact the total value of what the sellers own through or related to their business.
Our course, The “How-To” of Becoming a Business Broker”, devotes a lot of time to real estate and working with real estate brokers.
Learn how to sell businesses…
I have been advising the owners of a small, $3.7 million engineering business on the process of preparing their business for sale. They bought the business – which had been started in the 1950s – about 15 years ago and when they bought, they bought everything; business name, inventory, list of clients, etc.; everything to do with the business that the previous owners owned. That included the real estate that the business operated from.
Over the years as they grew their business, my clients acquired additional real estate, primarily by buying parcels adjacent to their original property. They added a couple of buildings. Unfortunately, they did all this through their existing company; their engineering company owned all the real estate
As technology advanced, they were able to do more work in less space so they began to lease some of the space they no longer needed to others. The business became a landlord and enjoyed a modest monthly income from the tenants.
Fast forward to today.
They are now ready to sell their business but there are two real estate issues that must be addressed.
- They like – and would like to retain – the monthly income that the tenants provide, and;
- Few business buyers are going to want to become landlords and will balk at buying a business that includes tenants.
The solution, of course, is for the sellers to set up another entity the sole purpose of which is to own all the real estate. A lease will be drawn up between the new entity and the engineering company, even though the owners own both entities, thus increasing their monthly rental income (although decreasing the business’ bottom line). The owners can then sell the engineering business without any real estate. And unless Amazon or Apple announce a new headquarters next door, the real estate will most likely be valued based on that rental income. If our clients manage their property properly, they should have this additional valuable asset to sell at any time in the future.
The Bottom Line
Schmaat cookies will argue that the business’ lower bottom line will negatively impact its value. True. But the value of the real estate will more than offset that reduction – particularly when tax issues are considered – and the business will be easier to sell if no real estate is involved.
I hope this post answers some of the questions that were raised by last week’s post. If you need any help on dealing with a business real estate issue, let me know. I have been dealing in commercial real estate in North America – as a private investor and an investment advisor since 1991 – and brokering businesses and advising business owners since 2001. I would be happy to offer some private coaching on either topic.
If you have any questions, comments or feedback on this topic – or any topic related to business – I want to hear from you. Put them in the Comments box below. Start the conversation and I’ll get back to you with answers or my own comments. If I get enough on one topic, I’ll address them in a future post or podcast.
I’ll be back with you again next Monday. In the meantime, I hope you have a profitable week!
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