This article was originally written for the Tax Tips column of The Business Bulletin.
I had an Allergy Specialist tell me the other day: “They say a General Practitioner knows a little about a lot, and a Specialist knows a lot about a little. Nobody seems to know a lot about a lot!” So we can use this column to talk a little about a lot, or a lot about a little.
Hopefully every month it’s a little useful to a lot of readers, or a lot useful to a few readers! If so, I’m satisfied.
With the spreading out into new congregations that we as a conference have been seeing during the last while, I have noticed that I get quite a few calls from brethren inquiring about buying and selling businesses. I get more inquiries about selling than buying, so we’ll work this article that way.
For purposes of simplicity I’ll not go in to selling farms and like kind exchanges, or even the tax implications of selling and buying businesses. I usually begin by telling my client this basic fact, “Ultimately it comes down to what the seller is willing to take and what the buyer is willing to pay.” That being said, negotiations need to start somewhere, don’t they? We usually think of breaking the business price down into about two or three categories (we’ll also ignore real estate – land and buildings). Those categories are equipment, goodwill and inventory. Usually the easy part is putting a value on the equipment and inventory. Basically that amounts to fair market value for the equipment and cost for the inventory. To charge retail price for the inventory would usually not be reasonable because the buyer could simply refuse to buy the inventory and restock for cost. Sometimes inventory may even be sold at a discount, particularly if there is a question about whether some of it is “stale.” Goodwill, also known as “going concern” or “blue sky,” is more challenging to price. The following factors may influence how a seller or buyer would look at the value of goodwill, not necessarily in order of importance: Repeat customer sales – A new home builder would not have the same customer calling him often, maybe never. A lube shop may have the same customer come back every two months. Loyalty or retention of the customers – Does the customer patronize the business because of the proprietor, or the business itself? For instance, in the case of a single barber selling his business, the customers may be leery of the new barber. More about how to prepare for that later. Opportunity for expansion – Does the capacity to expand exist, or is the market pretty much saturated? For instance if there is a town of 1,500 population, could an extra car wash be added to the other side of town, or would it just take cars away from the old one? Can something be added to the product/service mix that’s a natural? Personnel – If there are employees involved, will they stay with the business? Will the owner stay to help make the transition seamless, if there is such a thing? Will he train the new owner? Location – Does the location lend itself to enhanced value? Maybe a truck wash right next to a truck stop? Health of the business – If the business is healthy, goodwill is a bigger factor. If the business has already been shut down, or if it has a bad reputation, goodwill could actually be called “badwill” and the buyer would be better off starting over from scratch. Competition – Does this business face high competition (which can be good or bad)? Is there a monopoly in place? Barriers to entry for newcomers – Some industries are relatively easy for the average Joe to get into. So when one business shuts down or sells, another person is ready to step up to the plate. Why pay for the business when you can start up easily on your own from scratch? A case in point is a lawn care business: If the business is mostly based on working for individuals and has not been in place for many years, the good will would not be very high, because another person can quickly enter and replace the customers without a huge investment. However, if the lawn care business is long standing, it has probably weeded out the bargain hunters and moved to higher profile customers. Possibly the work has tended toward more commercial jobs that pay on contract and are secure for years at a time, and that pay year round. In that case the goodwill is worth substantially more. In all of the above scenarios, we’re assuming the name would go along with the business, the seller would agree not to operate in the same locality for a set amount of time, and the customer and supplier lists would be shared. The bottom line is that the seller and buyer have to come together and agree on a workable deal. Let’s suggest that the owner of the business is thinking of retiring and has time to prepare the business for sale: If he has a landscaping business, for example, he may inquire of a capable employee if he’s interested in buying the business at a future date. If so, the seller can begin the process of “I must decrease but he must increase.” (One of Dad’s favorite sayings when he wanted us boys to take more responsibility). If the buyer is introduced to the customers and that connection of trust is made, the customers are much more apt to stay with the business making it worth more to both seller and buyer. If no employee is interested, a buyer may be sought and asked to come on board first as an employee. Use your imagination and creativity if you have time to anticipate the sale of your business. If you are the seller, put yourself in the buyer’s shoes, and consider what would be valuable to you if you were buying. You know too well the pains of growing the business, but maybe the buyer takes that for granted and doesn’t appreciate it. In the case of father/son changeovers we see this often. Maybe there needs to be a heart to heart talk of what it took to get this going. Employees often have the impression that it’s the boss who’s “in the big money.” They don’t always realize what kind of time and planning and mental energy goes into the managing of the jobs and dealing with collecting and bidding, etc… Sometimes the buyer is concerned about whether or not the repeat business is as strong as the seller feels it is. In that case there can be a limitation worked into the contract. The total price can be a bit fluid, depending on how the repeat business turns out. Of course this leaves things open to a little messiness. Repeat business could be down due to poor management or performance of the buyer, or the economy could slow down. In a poor economy, especially with high unemployment rates, more people are apt to mow their own lawn, change their own oil and wash their own cars. All of this can influence the future of the business, but who, after all, knows the future completely? How do we get starting setting an asking price? Usually we look at the value of the equipment and inventory and add goodwill to the mix. Depending on the questions we looked at above, goodwill may bring the total price up to a certain multiple of gross income or net income, depending on the business. Usually the most we would see would be a multiple of net income for three years. Remember the buyer will probably need to repay his loan in five to seven years and interest is a factor. But it’s important how we determine “net income.” For this purpose, net income would usually be taken from tax returns, as people don’t usually overstate their income on their tax returns. Here’s one way to calculate it: 1. Start with the bottom line on the business schedule, be it profit or loss. 2. Add depreciation back in. 3. Add interest paid back in. 4. Add any owner compensation or perks back in (health insurance, etc). Remember that the buyer will need to either make his living with that, or pay a manager to run the business. He will need to make bank payments on the purchase of the business. For example, if the recalculated net income is $50,000 annually and the business price was set at $150,000, and the buyer had 20% down, he would need to borrow $120,000. At 7.5% interest he would have payments of $1,840 monthly or roughly $22,000 annually. That leaves him with $28,000 a year to take home to live on. Maybe we’re too high here, unless it’s a part time business. Let’s change the figures a bit. Say the net income was $75,000 with the other circumstances the same. For a multiplier of three years, the buyer would make payments of $2,760/month or $33,120/year leaving him with roughly $42,000 to live on. Now we have something more workable. Like we’ve heard before “figures don’t lie, but liars can figure.” I still say it pays to push the pencil around a little. Maybe the buyer and seller can both get educated a bit and become more realistic. It’s not rocket science, either. This should give you something more solid to start with. In my short lifetime, I’ve encountered many approaches to buying a business. Some people are very careful mixed with fear. They will look at all the “what ifs” and analyze the customers and the history and the future and will drag their feet until the seller sells the business to somebody else in exasperation. Other people look at a business and go entirely on “gut feeling.” They say if John can drive the kind of vehicles he drives it must be a money making business and I’m sure I can manage better than he can. In fact, I think I can do it as a sideline! So they buy the business and hope for the best, only to get some terrible surprises. You need to be somewhere in between those two scenarios. Be a “middle-of-the-roadist.” No business is without risk. No business is without work. Possibly all businesses have some potential. There are ways to reduce the risk, though, and to facilitate the transfer of the business to the ultimate satisfaction of the buyer and the seller. Many times business owners look at the business as their “baby” and are offended at a “low ball offer.” Sometimes sellers are willing to sell for less than what they had originally asked for if they feel like their business is going to be in good hands. Many of us are just that way. And remember, it’s best to be able to be somewhat objective when we come to the bargain table. We don’t HAVE to sell and we don’t HAVE to buy! I wish you the best; that’s all for this month…
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