What’s Your Business REALLY Worth? The Risk Factors
The effort required to prepare a business for sale can be daunting – and if more business owners understood this preparation process, fewer would be trying to sell their business themselves.
Over the past eight weeks or so, I’ve written a series of posts on business valuations – a significant part of that preparation process.
The first three were entitled, “What’s My Business Worth?” parts 1, 2 and 3, and can be read here, here and here. The final discussion in that series was written in answer to some questions raised by the first three and was entitled, “What Constitutes Value?”
As my previous posts detail, there are a lot of individual aspects of a business that impact its value.
Not surprisingly, most business owners – and many buyers – point directly to net income as the basis of a business’ value; essentially, the answer to the question, “How much money will this business put in may pocket?” And while net income is one of the more important drivers of value, it cannot be looked at in a vacuum.
Risk – a category as broad as can be imagined – is arguably at least as important as the net income if for no other reason than that the net income is dependent, to a greater or lesser degree, on the level of risk inherent in the business. And that’s because the MAIN thing risk impacts is, of course, that all-important net income.
Evaluating the risk to the business in certain scenarios is a major factor when selling a business.
Business owners considering selling – and their advisors – must turn an unbiased eye on many aspects of the business to identify risk factors that most diligent buyers will uncover during due diligence. The only way to keep a deal from imploding from a risk hand grenade is to identify and, to the extent possible, mitigate the risk to the business’ earnings potential.
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Risk to a business’ health and safety lurks somewhere in every business’ daily operations.
From financial and strategic risks to compliance and security risks, critical risk factors must be identified and considered before bringing a business to market. Depending on the seller’s needs and abilities, some of these risk factors may not be able to be eliminated; but identifying them will enable the business’ owners and their intermediary to prepare for the objections buyers are likely to put forth as value is debated.
Trying to cram a comprehensive list of risks into a 1750-word post is impossible so let’s look at a few examples.
Risk Factor: Taxes
Depending on how the transaction will be structured – as an asset sale or a stock sale – a big risk factor could be taxes.
Has the seller filed all necessary forms and submitted all withheld (payroll) taxes? If not, the liability for those taxes may transfer to the buyer. In smaller businesses – the Main Street and Lower Middle Market areas in which we play – this is constantly an issue the status of which MUST be confirmed. Sales and VAT taxes fall into the same category.
Is the seller current on all these obligations? If not, any deal is likely to blow up during due diligence – or, at the very least, the buyer will require the a portion of the proceeds be directed to eliminate this liability resulting in a significant reduction in what the seller was anticipating walking away with.
Examining and clarifying tax liabilities is a particularly important issue if the business operates in multiple jurisdictions with different tax systems.
Risk Factor: Customer or client concentration
Customer concentration is another risk. If the business gets a sizable percentage of its revenue from one or two customers, the risk to the business is significant.
For example, a couple of years ago we represented a U.S. business that got 27% of its revenue from its relationship with Walmart.
Walmart’s purchase agreements with small and mid-size businesses are generally terminable at will. This raised serious concerns with potential buyers because if Walmart was in a bad mood, 27% of the business’ revenue could disappear overnight.
The solution to this dilemma was to structure the sale with a multi-year payout – essentially an earn-out – whereby the seller got paid succeeding portions of the purchase price the longer the Walmart deal remained intact.
Risk Factor: Environmental risk
Environmental issues pop up all the time and these can be more or less serious depending on the environmental standards and regulations in the jurisdiction in which the business is located.
Over the years, we’ve had quite a few clients whose business was impacted by environmental issues. One was a U.S.-based auto service center.
Automotive service centers have been around since automobiles and trucks first appeared on the roads of the world – long before anybody gave any thought to any environmental impact they might have.
Businesses that were started in the 1970s and 1980s are now governed by significantly more stringent environmental laws and regulations than existed at the time those businesses were formed and the costs of complying with those laws and regs is significant. Business owners may not know that an environmental issue exists but an informed buyer will likely make an environmental survey a condition of the purchase of the business.
This issue applies to many businesses of many sizes in many industries – from car washes and laundomats to vehicle dealers, chemical and solvent distributors and small manufacturers – and dozens of other business categories.
Finding out that there’s a problem during due diligence is going to raise a bright red flag in the mind of the buyer. Identify this risk ahead of time.
Patent or Other Proprietary Asset Expiration
If the business being sold benefits from one or more patents or other proprietary intellectual property, how well is the proprietary nature of that property protected?
Patents expire. If the business being sold includes some proprietary property that will lose its protection over the next couple of years, the risk to the ongoing revenue is high.
Balance of Competition
Similarly, if the business owner – or the intermediary – is aware that some market imbalance resulting from new competition is on the horizon, the impact of this new competition on the business’ revenue and ongoing viability must be considered.
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For example, one of our clients was a 40 year-old family-owned hardware store with about $2 million in revenue. We knew that a large national hardware chain was sniffing around our client’s market looking for an opportunity.
Our client’s business was quite strong and benefited from significant goodwill and, as a result, it attracted potential buyers from up to 400 miles away who would relocate to operate the business. But this competitive threat to the business scared off all of them – and understandably so.
This competitive risk was extremely important to know about early in the process so that we could educate the seller on the proverbial “facts of life” in this situation – and to see if we could come up with a way to offset this threat to our client’s business.
In this case, the solution we devised was to approach the national chain to see if they might be interested in acquiring our client’s business. They were and we were able to salvage what could have been a disastrous closing act for this 40 year-old business.
Government is, of course, the elephant in the room.
Government – and its tendency and legendary predisposition to hobble business – is always a wild card.
As I write this, one of the two major political parties in the United States – the party that just happens to have total control of the government for the next two years – is trying to finagle a way to get around a procedural restraint in an effort to raise the federal minimum wage to $15/hr. No matter where you stand on this issue, you can be certain that, should they succeed in getting this policy enacted into law, millions of small businesses will be impacted negatively. Many will fail and most of those that survive will decline in value.
One of our U.S. clients owns a 25 year-old, multi-state check-cashing and payday loan business. Whatever you think of this type of business, it provides small loans to hundreds of people who have no other borrowing options.
For years, various efforts to shut down this industry have flared up from assorted factions of the “we know better then you” demographic. The argument is that such loans are made at too high an interest rate and are too costly thereby trapping the borrowers for years. This argument supposes that the borrowers would be better off having NO source from which to borrow funds when they need some emergency cash – for a car repair, for instance, or a new furnace – than to have a high-interest source.
Wherever you fall on this issue, one of the states our client operates in just made such loans illegal – thereby outlawing his business in that state. You might imagine what that did to the value of his business – to say NOTHING of what it did to the people who relied on it.
The Bottom Line
Every business has some risk. Some of these risks are specific to the business, while others – generally those emanating from the halls of government – effect all businesses in a certain category.
Unless these risks are identified and considered in terms of likelihood to occur and costs to mitigate, the chances of the sellers and their advisors being prepared for the impact on the business’ value and the likely challenge to selling are slim.
If you have any questions or comments on this topic – or any topic related to business – I’d like 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 safe and profitable week.