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Eric Wayne
United Realty Group
12323 SW 55th Street,
Suite #1002
Cooper City, FL 33330

Cell: (954) 562-2019
Fax: (954) 775-3747

E-mail: EricWaynePA@Gmail.com

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Valuation

"Quick way" to get valuation

Question:
What is a quick way to get a general sales value for a residential maintenance landscape company? Is gross sales, number of clients, or margin the most important component?

Answer:
There is no "quick way" to value any business. Nor are there any bulletproof generic rules. Valuation is an art, not a science. But when all is said and done, the valuation must be based upon the total owner benefits number which includes: Pre-tax Profit + Owner Salary + Owner Perks + Interest + Depreciation less any foreseeable allocation of profit for capital expenditures.

In the lawn and landscape business, they usually trade at around 1.5 times this number. But, each business is different: are the financials provable? Are there more commercial or residential accounts? Commercial accounts can bring in big dollars but they can be lost quicker than residential maintenance accounts where you perform the old "Mow, Blow & Go" routine. Are all the employees paid on the books? If not, you need to adjust the profit downwards because you should always run your business legally.

Having said all of this, if you were already in the business, and were buying out a competitor, then you could pay them on a per-account basis. Industry averages on the ones that sell for a percentage of sales are usually around 40% - 60% of annual sales but I would recommend staying away from this formula. Profits, not sales, are what you take to the bank!

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Valuing a service business

Question:
How do I go about determining the value/selling price of a service business? I am a CPA who is interested in selling my practice and purchasing a practice in another state but I am confused about how to determine the price at which to sell and to buy.

Answer:
Great question. The good thing about service businesses and especially professional practices is that they are not complicated transactions. The bad news is that they do rank at the top of potentially risky acquisitions. Depending on the practice itself, if the owner is perceived as "the business" the possibility exists that as the owner goes out the door, so too can go the clients.

Generally speaking, the valuations should be around one time the annual Owner Benefit figure (Pre-tax Profit + Owner Salary + Owner Perks + Interest + Depreciation). Plus, you should also have an earnout formula based upon retention of certain key clients for a period of about 12 months. You need to be sure that the business you take over will be the same or better in a year as long as you are as effective in running it as the current owner.

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Valuing inventory

Question:
I am involved in a transaction and I'm having trouble valuing the inventory that is part of the deal. The seller says it's all good but is there really a way to measure this or should I take their word for it?

Answer:
Never take their word for it! Assuming that it's non-perishable product, you need to classify the inventory as either "Good and Resaleable" or "Obsolete". G & R is product that you can sell in the normal course of business over the next 12 months (this way it's still a "Current Asset").

The way to calculate this is by reviewing the prior year's sales and making sure that you do not have more on hand of any item than the company would normally sell in that period. As an example, if there are 24 widgets in stock and the company sold 18 in the last 12 months, then 18 are G & R and 6 are "obsolete". Therefore, you can pay full acquisition cost of the 18 but you need a drastic discount on the 6 "obsolete" ones.

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Add Backs and and Owner Benefits - Why? Which Ones? How to Prove?

Question:
I have a question about Owner Benefits when they "add back" certain expenses. Why does Interest and Depreciation become "cash flow to owner/Owner Benefit"? I understand why the owner's salary that's considered "excessive" and Net Income do but Depreciation and Interest are part of what makes up the Net Income. How is it that they get counted again (added back to get the Owner Benefits?)

Answer:
Depreciation is non-cash expense. It's included solely for accounting and tax purposes. Example: the business owns a truck and they paid $20,000 for it, and there is an estimated useful life of five years. Each year they can deduct (depreciate) $4,000 of it for tax purposes. While it reduces the tax burden, the fact is that it's not an actual outflow of cash. As such, it's added back to the Owner Benefits.

However, any Depreciation that you add back must be offset by any amounts you will need to annually set aside to replace these assets. If you're looking at a capital-intensive business, you cannot add back the entire Depreciation amount, and remember to allocate a certain amount regardless of the depreciation add back for your future capital expenditures.

Interest Expense is a function of the capitalization of a business and can vary widely from one owner to another. Example: you may run the business entirely off the cash flow and decide to not obtain any additional funding; therefore, there won't be any interest expense. On the other hand, if there are any loans to the company which you will assume after closing, then of course you have to factor the interest as an expense. Generally, these loans are paid off at closing by the seller from the proceeds of the sale. As such, any future interest will be dependent upon your business, not theirs.

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The Proper Definition of "Profit" for a business

Question:
I've just begun to look for a business and I'm a bit confused. My search has been focused with online business for sale listings. Each Website seems to have different terminology for the profit of the business.

Answer:
You're correct; there's no uniform terminology for the profit of a business between the various websites. Some may call it: EBITDA (earnings before interest, taxes, depreciation and amortization), Cash Flow, Seller's Discretionary Cash, Owner's Benefit, and a few others.

Regardless of the exact term, you'll always want to clarify and reconfirm the information with the seller/broker so that it's perfectly clear what numbers are included in the figure. EBITDA is not really applicable for a small business acquisition where you'll be replacing the owner, as this is simply a financial picture of a debt-free business.

Personally, I don't like the term Cash Flow. It's not the same thing as profit, and many people are confused by this. Cash Flow simply means the cash the business had at the beginning of a period, and what they had at the end, and what happened with the difference. The figure you'll want to determine is Seller's Discretionary Cash or Owner Benefits. This is the Pre-tax Profit of the business + Owner's Salary/Perks + Depreciation + Interest less future capital expenditure allocation. Pay special attention to Depreciation. For capital-intensive businesses, you'll have to reduce this figure by any amounts you may need to purchase additional or replacement assets in the future.

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Buying a Business that Includes Real Estate

Question:
I need some advice on a business I am evaluating and would like to move forward with an offer shortly. The company has good books and records, is profitable on the tax returns, and I believe will be approved for bank financing. The business is priced including real estate that is owned personally by the seller and the company pays rent to him. My questions are: how do I do value the business considering the real estate? Should I buy the property as well? What other options if any, do I have, and are there any issues to look for with this type of transaction? Thank you.

Answer:
These are great questions and I want to address of them individually. Let’s take one at a time:

Valuing a Business that Includes Real Estate:
This is actually far simpler than you think. First, you need to separate the business and property and value them independently. The good news is there are established market values for real estate even though we may be in a bit of an inflated period right now. You can inquire with the business broker (if one is involved) whether they have experience and can assist you with the property valuation. They may simply recommend a good commercial realtor if necessary to get industry comparables on “like” property. Although real estate valuations can vary, they are far less subjective than valuing a business. As such, keep the property valuation completely separate from the business valuation.

Ask the seller if they have a recent appraisal on the property which can assist you. If not, it may be something you want to consider. In any event, if you obtain a mortgage, it will be required by the lender.

Conduct the valuation on the business using a variety of methods. There are some excellent past articles on this subject in the other ‘Ask the Expert’ sections on this Website. You will learn that business valuation is an art, not a science; however, an accurate valuation can be obtained using these methods in large part because the company has good books and records.

Financing the Purchase:
With real estate being involved, coupled with good books and records and a historically profitable business, you will greatly increase your options to leverage third-party financing. Banks, and any other lenders, will almost always prefer to have bricks as an asset over any other business asset that may be required as security above your personal security. Plus, some lenders may in fact be willing to blend the real estate and business loans, which can result in a longer term to repay it. Here again, this plays heavily in your favor.

Should You Buy the Property?
I have very mixed feelings about doing so. I know that there are plenty of reasons why someone would want to acquire the real estate, and they’re all valid. My concern stems mainly from a cash flow perspective. One of the main objectives when buying a business is to be able to grow it beyond what the current owner has done. You will need capital to do so. Further, it is not uncommon for a business to decline slightly and temporarily after a new owner takes over; and the last thing you want is a cash crunch.

That being said, I always prefer to negotiate a 12- to 24-month option to acquire the property at a pre-determined price or formula. This way, you can retain your capital, and be certain that the property itself makes sense for the business operations. Then, you can always choose to exercise your option. At the very least, if you do not buy the real estate, include a “Right of First Refusal” clause in the business purchase contract to buy the real estate.

What to Look Out For:
One of the biggest issues that arise when a seller personally owns the property and collects rent from the business is the actual rent rate, and what is and isn’t included. This may necessitate an adjustment of the Owner’s Benefit. If, for example, the rent the seller has charged the business is less than what you will have to pay for a mortgage, taxes, insurance, maintenance, etc., you will have to adjust the Owner’s Benefit downwards to reflect these added costs.

Similarly, if you decide not to buy the property and lease it from the seller, these same costs that the seller paid himself need to be reconciled against what your rent will be after you take over. It may require an adjustment either way.

In Summary
Buying a business that includes real estate will generally provide the buyer with a number of viable options. You should be open-minded to any of the scenarios, and sometimes the direction may not be entirely up to you. As an example, a lender may insist that you acquire the property along with the business.

The key now is to speak with the seller/broker and see if they are open to the opportunities outlined herein. If so, you can table all of the possibilities and move the deal forward with the goal of successfully completing a transaction that is favorable to all of the parties.

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How are "Multiples" Determined for Specific Industries in Business Valuation?

Question:
I am familiar with the concept of multiples of sellers' cash flows or owners' benefits as a means to determine value. My question is: How is the multiple determined? With the scarcity of verifiable information on business sales, how does one determine an appropriate multiple for an industry, specifically, the property management industry?

Answer:
If you spend anytime looking at businesses for sale, you'll see multiples that can be "all over the place". However, when a seller has the right professional assistance (i.e. CPA, business broker) the valuations will subscribe to certain historical formulas. Unlike residential or commercial real estate where comparables rule, every business is different, and so it is difficult to have any standardization that can be used without margin of error.

Keep in mind that business valuation is an art, not a science.

That being said, there are some general parameters regarding the range of multiples. Many of these evolved from the concept of what a buyer can expect as a reasonable return on their investment and the level of risk to the new owner of each potential venture.

As an example, small businesses will generally sell for 1 - 3 times the Owner Benefit number. However, this is an enormous spread. My own rule is that for any business where "out the door goes the seller, so too go the customers" should be closer to 1 multiple. Examples can be professional practices, businesses with very high customer concentration issues, distribution companies where the seller has a long-standing personal relationship with suppliers/key customers, etc.

On the other hand, businesses with solid fundamentals, including good books/records, increasing revenues, a stable marketplace, no major customer concentration issues, ease of transition, growth opportunities, etc, will naturally all trade on the high side at, or even above, 3 times.

A typical Property Management business will likely have components of both of the examples noted above and will likely sell near the middle. However, you certainly want to look out for customer concentration issues, contract assignability, potential properties bringing the management function in-house, the bidding process to maintain/acquire accounts, etc.

Historically, Property Management businesses sell for a much higher multiple because they generally appeal to a very large buyer pool, they are considered "easier" businesses to operate, and they are pure service businesses with no inventory and can be operated with little overhead. I've seen them sell for 3 - 5 times the Owner Benefit figure, but in these cases an earnout and substantial seller financing is usually involved.

Since this is very much a relationship business, you have to consider an earnout deal structure (see prior articles) to be certain that revenue is sustained and key clients remain on board or, if there is a big drop, the purchase price may be adjusted accordingly after a review period.

Although the comments herein outline an extremely wide range of potential multiples, the core strength and possible future threats will dictate a realistic figure. If you want to give yourself a frame to operate in then the more creative the deal structure (earnout, seller financing, specific contingencies materializing) the higher the multiple.

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How to Evaluate Legitimate and Non-Legitimate Add-Backs

Question:
When reviewing a company's recast statement, what Add-Backs are considered legitimate when a buyer is evaluating the cash flow of a business? My understanding of this evaluation process is that Depreciation, Interest, Amortization, and Owner's Salary are the only items that are truly considered Add-Backs. Yet when I review a business for sale, Add-Backs such as travel, auto, health insurance, etc., typically show up. Are those items legitimate Add-Backs and, if so, to what extent? Please give an overview of the correct way to evaluate the Seller’s Discretionary Cash Flow. Thanks.

Answer:
You raise an excellent point and this is clearly something that comes up with many buyers. Let me first discuss the guiding rule for add backs and then touch upon the correct way (formula) to evaluate the Seller’s Discretionary Cash Flow. In addition to Interest, Depreciation, Amortization, and Owner’s Salary, any personal perks that are not regular or essential business expenses, or ones that you as the new owner must incur, can be added back, as long as they are provable. This can include non-business-related travel, auto, health insurance, and other expenses. However, if you as the new owner will require a vehicle to operate the business, then certainly it is not an add back. Insofar as health insurance, the choice will be up to you, but it is not imperative that the business covers this expense and it is not an essential operating expense, so the add back is legitimate. With regards to travel, if it is for personal trips, then again, the add back is legitimate.

Unfortunately, there is a wide interpretation of these add backs which at times can make for an interesting debate. Again, the golden rule is that if the add backs are for legitimate personal expenses not required to operate the business, they can stand; all others are disqualified.

The theory behind the Seller’s Discretionary Cash Flow or Owner Benefit number is to take the business’s profits plus the owner’s salary and benefits and then to add back the non-cash expenses. Then, a multiple, based upon a variety of factors, is applied to this number and a valuation is established. For the sake of all our readers, I will also outline below the rationale behind adding back Depreciation and Interest.

The Owner Benefit formula to use is:

Pre-Tax Profit + Owner’s Salary + Additional Owner Perks + Interest + Depreciation
LESS Allowance for Capital Expenditures

Why Add Back Depreciation?
Depreciation is an expense that allows a business to deduct a certain amount of money each year from an asset so that its purchase value is reduced by its overall useful life. As an example: if the business buys a $25,000 truck and its useful life is estimated at 5 years, then each year the company can deduct $5,000 off its income to lessen its tax burden. However, as you can see, it is not an actual cash transaction. No money is physically leaving the business or changing hands. As well, when you purchase a business, it will likely be an asset sale whereby the assets come to you free and clear. You may be able to “step up” the assets’ value and depreciate them again for tax purposes. Therefore, this amount is added back.

Why Add Back Interest?
Each business owner will have separate philosophies for borrowing for the business and how to best use borrowed funds, if necessary at all. Furthermore, in nearly all cases, the seller will pay off the business’s loans from their proceeds at selling; therefore, you will have use of these additional funds.

A Note About Add-Backs and Capital Expenditure Allowance
After completing any add backs, it is critical that you take into consideration the future capital requirements of the business as well as debt-service expenses. As such, in capital-intensive businesses where equipment needs replacing on a regular basis, you must deduct appropriate amounts from the Owner Benefit number in order to determine both the true value of the business as well as its ability to fund future expenditures. Under this formula, you will arrive at a "net" Owner Benefit number.

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Should FF&E be included in Asking Price?

Question:
I saw a listing for a granite fabrication company with an asking price that included a multiple of over 3.5, plus a significant additional amount for FF&E. I understand there is a lot of industrial equipment involved, but this seems like double dipping to me. Is this reasonable?

Answer:
You are correct - the sellers cannot have it both ways. There is a great misconception regarding assets and the role they play in business valuations. Assets are a means to drive revenue, but a business must be valued based upon the historical seller cash it has produced or, in some cases, what it is expected to generate.

With all due respect to the accounting industry, they typically place too much emphasis on assets when valuing a business. I am not suggesting that assets are unimportant. They do in fact have their role in analyzing a business but less so in determining the actual purchase price. For example, when calculating the Owner’s Benefit or Seller's Cash Flow, one must adjust this amount downward for future capital expenditures in asset-heavy businesses, and by this I mean ones with machinery and equipment (not inventory) which will need to be replaced over time.

Generally, you will find that sellers may over-value their assets altogether and present buyers with a replacement or fair market value and expect to get dollar for dollar in the sale. Unfortunately, most equipment is not worth anything near these values and all you need to do is try to sell these assets quickly and you’ll soon discover they’re worth a fraction of the amounts represented.

So to answer your double dipping question, yes it is, but on the other hand, the multiple itself may be low. One must consider numerous additional factors including:

  1. Total Owner’s Benefit
  2. Is business trending up or down?
  3. Are there customer concentration issues?
  4. Any threat of foreign production (lots of granite coming from overseas now)?
  5. Any large contracts in place for the new owner?
  6. Can you significantly build the business?

I would suggest that you perform your valuation based upon the Owner’s Benefit and attach a multiple in keeping with the points above plus the many others that one must consider. Then, make your capital expenditure allowance and attach a multiple that provides you with an acceptable return on your investment. If the business is generating under $500,000 in OB, then a 2-3 multiple is in line. Above that, and up to $1,000,000 should be around 2-4 and 3-5 beyond.

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