Pricing a Business to Sell Part 3: Pricing for Risk

Yes, another post on pricing a business to sell – and determining whether or not the business is sell-able.

Two weeks ago, in Part 1, I wrote about some of the questions a broker should be asking when considering taking a listing engagement. Last week, in Part 2, I wrote about calculating ROI, which most serious buyers will do but many brokers don’t.

This week’s post – Part 3 – is about risk; the risks – some obscure, some quite obvious – that many businesses have but few sellers seem to recognize.

When pricing a business to sell, especially in the Middle Market, a broker must analyze the business to identify potential risks and then consider how those risks will impact the sell-ability of the business. And there are all sorts of potential risks, many of them not readily apparent.

For the purposes of this conversation, we’ll define “risk” as a condition relating to the subject business that could change in the near term and have serious deleterious consequences for the business.

What To Look For

A professional business broker analyzing a business to establish a valuation – a Broker’s Opinion of Value – must perform a level of due diligence that is nearly on par with what a buyer will do in order to uncover hidden risks. The idea is to determine whether the business being evaluated is even worth taking on.

Here are some examples:

• Customer concentration: one or two customers accounting for a large share of revenue.
• Accuracy and clarity of financial statements
• Finance-ability: Will a government program be available?
• Owner-Dependent: Is the business dependent on the current owner?
• Location: Is the business located in a desirable area?
• Seller financing: Will the seller consider assisting in financing?

It’s pretty easy to look at financials and, using the Direct Market Data Method, doing the customary calculations, arrive at a valuation. Such an exercise will produce a Broker’s Opinion of Value (sometimes referred to as the Most Probable Selling Price) based on those obvious numbers. But what if there’s a high likelihood that those numbers will change in the next year or two?

This is an issue we go over in our course, The Basic “How-To” of Becoming a Business Broker and it is important that any broker that works or intends to work in the Middle Market – or even in the Main Street market – have a grasp of this concept. It is another tool that will make your job easier.

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Our course, The Basic “How-To” of Becoming a Business Broker”, teaches how to become a professional business broker.

Become a Professional Business Broker…

Case Study #1: Change is a-Comin’

You, the business broker, are approached by John Smith, the owner of a commercial lawn care business. After 12 years of hard work, he wants to sell. He goes on to tell you that he signs three-year contracts with his clients, which portends stability in the near-term that you know will be of significant interest to a buyer.

He provides his financials and you can see that last year’s sales were $775,000 and that his sales have been increasing by between 5% and 10% over the previous three years. You perform your customary analysis and determine that his recast earnings for last year were $225,000.

Without going any deeper, you might head on over to one of the trusty databases that we use and determine that the Most Probable Selling Price is around $427,000.

But you would be wrong because without further digging, you wouldn’t know the risks. In this case, there were three big ones:

• Even though sales have been increasing slightly, profitability has been decreasing (suggesting that his expenses have been rising faster than he has been able to increase his prices).
• More than 35% of his current contracts are scheduled to expire within the next 12 months.
• His largest client, accounting for 18% of revenue, has notified him that they won’t be renewing.

NOW what do you think his business is worth??

An even moderately savvy buyer will discover these issues during due diligence. If you took this listing at the price you originally estimated it to be worth, you would spend an enormous amount of time and no small amount of money only to get a year or more down the road with no sale and no compensation for all your work. You would also be sporting a reputational Scarlet Letter for bringing the business to market at a price point that, in hindsight, was significantly higher than it should have been had the risks been factored in.

Case Study #2: Multiple Risk Factors

One of our offices was contacted by the owners of a wholesale/distribution business. They wanted to sell.

The business’ most recent revenues were about $2.7 million and it had been showing reasonable growth. Its discretionary earnings were roughly $550,000 – a little more than 20% of revenue – and, as a percentage of sales, those earnings were fairly consistent over the last few years.

But as we dug deeper, we discovered the following risks:

• The business’ biggest customer accounted for 28% of sales and there was no contract with that customer.
• The business was weather-dependent which became obvious as we analyzed past years’ financials and asked about sudden dips and spikes in revenue.
• The owners were going through a bitter divorce and the chances of them working together with us to get a sale done was questionable.
• The business’ location was lightly populated suggesting that few people were interested in moving there.

Before factoring in these risks, we arrived at a likely selling price range of something slightly north of $1.25 million but, given the risks, we felt that it would be nearly impossible to sell this business for a price that was anywhere near that level.

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Our course, The Basic “How-To” of Becoming a Business Broker”, teaches how to become a professional business broker.

Become a Professional Business Broker…

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