Author Archives: Rick Krebs, CPA - Business Valuations, Mergers & Acquisitions

4 Common Sales Structure Types

4 Common Business Sales Structures

4 Common Business Sales Structures

As a M&A professional representing Sellers and Buyers I see a lot of sales structures and deal types. I wanted to share 4 of the most common structures that I see for the sale of a business. These are based on a $1.5 Million Sales Price.

A. All Cash. This is usually paid in full at close, but at a discount from the full Asking Price, usually 10-20%. You could expect to see $1,350,000 – $1,200,000 at Close for a $1.5 Million Sales Price.

Advantages: Quick and you don’t have to rely on a bank for funding. Disadvantages: Buyers generally aren’t willing to pay full price for an all cash structure.

B. Cash with Seller Carry. I usually see 10% Seller Carry so you would get $1,350,000 at Close (for $1.5 M sale) and be paid over time, generally 3-5 years for the remaining $150,000. If the interest rate is 6% the Seller would get paid $190,000 total so they make more money with this, but have to wait 3-5 years for the remaining money.

Advantages: Sellers get more money for their business in the form of interest and can save money on taxes. Disadvantages: Purchasers sometimes don’t pay and Sellers run the risk of non-payment.

C. Earnout.  This includes an up-front down payment, usually at least 50% of the Sales Price and then the rest of the Sales Price is earned over time and variable. Using a 50% down scenario, the Seller would get $750,000 up front and be paid based on the profitability of the company over 3-10 years for the rest of the money and potentially “earn” more money for the business.

Advantages: The advantages to this are: Sellers could be paid much more for the business if it does well. This usually works well when the owners are staying to work in the business and not retiring from it at Close. If the business does better than expected, the Sellers get more money for their business over time. Disadvantages: Sellers have to wait to get paid and if the business does poorly under new management. Sellers can get less money than the other options.

D. Seller financing of 100% of the purchase price. This is used most often for a partner buy-out or buy-in. The Purchaser gains ownership from the beginning and his/her share of the profits are used to buy his/her share of the business.

Advantages: A Purchaser can own a business with little or zero down payment. The sales prices is established based on some set criteria negotiated and can be higher than the market price. Disadvantages: Sellers get paid over time versus up front.

Just listed – Wholesale Distribution Company

Business Sales Group – M&A division is pleased to announce the offering for sale of a Wholesale Distribution Company in the Inter Mountain West.  They sell name-brand products to distributors in the US and internationally.  Sales for 2018 (projected) are $15 Million. EBITDA is just under $1 Million.  For details go to: https://www.bsalesgroup.com/our-listings.

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Another Successful Purchase

heroBusiness Sales Group (small business division) is pleased to announce the successful completion of the acquisition of an Event and Promotional Production Company In Arizona.  The Buyer was from the mid-west and hired BSG as his buy-side advisor to advise him through the whole transaction. BSG successfully completed the Business Valuation, Due Diligence, Negotiation, LOI, Accounting and Advising functions for the buyer. Lori from Midwest Bank was big help in making this transaction happen as well. Congratulations to J.H. and his family who will surely help this business excel.

Purchase of Jibij

 

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Business Sales Group, Small Business Division, is pleased to announce the successful purchase of Jibij by James Sawyer. With the help of his father, James acquired this excellent business. Rick Krebs was the Advisor for the Buyer (Buy-side Advisory) helping him navigate all aspects of the sale from start to finish including valuation, negotiation, due diligence, licensing transfer, closing, etc.

 Jibij is an online retailer of ski, outdoor, and rafting products including well-known brands such as Patagonia, Oakley, Under Armour, Scott, and Volkl. James will certainly do well with this excellent business.   Christon and Liz Horstman were excellent sellers to work with and extremely helpful in making this purchase possible.

 Congratulations James!

GAAP versus Cash Basis for Selling a Business

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When considering a sale, it makes sense to do an annual compiled financial statement that is presented on a GAAP basis versus Cash Basis, which is commonly used to report Income on a your tax return.  This GAAP financial can then be used for valuing and selling your business compared to using Tax Returns.

The reason for this is you do everything you can to minimize your tax burden.  This includes prepaying for expenses, buying inventory at year-end, buying equipment at year-end, etc. to employ tax saving strategies as advised by your tax professional or financial planner.

When preparing to sell, it makes sense to hire a CPA to do a Compiled Financial Statement on a GAAP basis. Why? GAAP tend to normalize income and increase Net Income which increases EBITDA. For example, companies on the NYSE that are publicly traded report on a GAAP basis because it tends to show more Net Income. As a business owner, you learn this the year you are forced to go from a Cash Basis Tax Return to an Accrual Tax Basis Return because you generally pay more taxes in the year you switch over because your taxable income increases. For this reason, taxpayers like to stay report on a Cash Basis for taxes as long as they can or until they are forced to do an Accrual Method by the IRS when they have $5 Million a year in average Gross Revenue.

When you are ready to sell, if you will have a GAAP basis Financials prepared, chances are, you will get more for your business and put more money in your pocket.

Valuing an Orthodontics Practice

Dentist

When valuing an Orthodontics Practice, two important considerations need to be made:

  1. Accounts Receivable.
  2. Accrual versus Cash Basis Accounting.

When valuing an Orthodontics practice, especially if it is a startup and less than 2 years old it is important to consider Accounts Receivable in the valuation equation.  For instance, when valuing an orthodontics practice, they typically have AR that can stretch out 24-30 months.  If you are using cash basis financials, it is important to subtract out beginning AR and add in ending AR to gain a true reflection of actual revenue

Calculation from Cash Basis Accounting to Accrual Accounting is as follows:

Revenue                                                                              $1,500,000

Cash Basis Cash Flow                      $400,000                  $400,000

Add: Ending AR                                 $375,000                  $375,000

Less: Beginning AR                          ($179,000)             ($179,000)

Equals Accrual Basis Cash Flow   $596,000              $2,096,000

Adding back the change in Accounts Receivable to Cash Flow and Revenue reflects a more correct picture of Cash Flow and Revenue.  Orthodontics practices are unique due to the fact that their AR may stretch out for 2-3 years, so it is an important consideration to make when valuing an Orthodontics practice.

Beware: A Self-input Business Valuation is not a good idea

There is a type of business valuation software and service available that allows a business owner to input their own financial information.  Although this may seem like a good idea, it is a very bad practice.  Valuations, like tax returns are complicated and require a seasoned professional to analyze and input the data to get an accurate number for value.  One of the main reasons that a business owner would not want to do the valuation themselves is there are key expenses that can be added back into the EBITDA and Cash Flow calculation. If these expenses are missed, the valuation number is inaccurate.

Key add backs and charges tend to be buried in the tax returns or financials and are easily missed. These include:

  1. Amortization Expense, which is usually shown on the Schedules and buried in the tax return.
  2. Section 179 Depreciation Expense, which is usually shown on Schedule K-1 of the Tax Return and erroneously added back with the rest of the depreciation.
  3. Partner Wages and cost to replace the owners for a situation where there is multiple partners who own a business.
  4. Cost of a working spouse who is not paid.
  5. Adjusting the lease to the market rate.
  6. Correct calculation of SDE, EBITDA.
  7. Repair and Maintenance Expenses that need to be capitalized.
  8. An S-corp tax return will show more Taxable Income (Net Income) than the P&L due to the expenses and pass through items on the Schedule K-1’s. If the business owner doesn’t understand income and pass-through entity taxation, he will undervalue the business.
  9. Schedule M-1 on the Tax Return contains important information and business owners tend to not understand how Schedule M-1 works.

pexels-photo-374074.jpegBusiness Valuations are exponentially more accurate if a Valuations Expert or CPA gathers, assimilates, and inputs the critical information pertinent to the engagement to get an accurate value for the business.

The second consideration applies to financial advisors who refer clients to a third-party valuation service and allow their clients to input sensitive financial information themselves.  One main reason for a Financial Advisor to not want to refer a client to a self-valuation service like BizEquity is the client’s data is captured by the provider and that data is sold to competitors. Financial advisors often pay for the service, send clients to the service provider, and their clients’ personal financial information is resold by the business valuation service provider to anyone who wants to purchase it.  It doesn’t make sense to give competitors sensitive client information, especially when an advisor is paying for the service.

 

I recommend that a business owner contact a knowledgeable valuation expert who is an independent third party to get an accurate estimate of value for their business. If a client inputs the financial information themselves it is highly likely to produce an inaccurate value for the business.

How to register a new business and get an EIN

I get a lot of requests from Buyers who need to register and start a new business in Utah. This includes getting an EIN, picking a name, etc.

Here is what you will need to start, register and license a business in UT.

1. Pick a name and register it. https://secure.utah.gov/bes/

2. Get an EIN.  Go to: https://www.irs.gov/businesses/small-businesses-self-employed/apply-for-an-employer-identification-number-ein-online

3. Register your entity with the State of UT. This site will walk you through the process.  https://secure.utah.gov/osbr-user/user/preoption1.html?beginRegistation=Begin+Registration&_csrf=a8761e29-dfec-4241-911c-e61e35d5f5e0

The State has a boiler plate set of Articles of Incorporation/Organization, but I would suggest finding a good attorney to help you with that and a good Operating Agreement, particularly when there are partners who are involved. If you need one, I can suggest one that I have used in the past.

Adjusted EBITDA or EBITDA? – Part 3 of 3

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Now that you can calculate EBITDA correctly it is time to drill down into the difference between Adjusted EBITDA and EBITDA.  Before we review this important distinction, I think it is important to explain the reason for using another benchmark for valuation.

If you classify businesses as small, medium or large, breaking them up into categories based on sales, it would be safe to categorize lower-midmarket businesses in the following ways:

  • Small sized businesses have less than less than $1 Million in Annual Revenue or Sales.
  • Medium sized Businesses have between $1 Million to $20 Million in Annual Revenue or Sales.
  • Large sized businesses have >$20 Million in Annual Revenue or Sales.

These categories of businesses are each represented by different types of advisors.  Business Brokers do a great job selling the small businesses. Investment Bankers do a great job selling large sized businesses.  Medium sized businesses are often represented by Brokers or Investment Bankers. The problem lies in the fact that there is a big difference between selling a mom-and-pop sandwich shop and a $15 Million Manufacturing business.  Brokers who aren’t experienced in Mergers & Acquisitions have a hard time selling medium sized businesses due to these differences.  There is also a big difference between selling a $40 Million-dollar Internet business and a $3 Million distribution business.  For the same reasons, Investment Bankers have a hard time selling medium sized businesses.  It doesn’t quite fit into their model.  For these reasons, I believe, we have differing opinions about what EBITDA is and the need for ADJUSTED EBITDA to be calculated.

For example, let’s use a simplified example to explain the problem.  A small business usually has an owner-operator who runs the business. For these businesses SDE (Seller’s Discretionary Earnings) is the most important number to use to assess as an income multiplier of value. The reason SDE is used is the buyer of the business is most likely to run the business himself and replace the owner and his function.

With a medium sized business, the new owner may or may not replace the current owner. The current owner may have a manager in place to run the day-to-day operation and not need to be replaced. If this is the case, then EBITDA or ADJUSTED EBITDA would be more a more relevant income multiplier of value.

Larger sized businesses rarely have an owner operator who will be replaced so EBITDA is the best revenue multiplier to use for valuing the company.  It is the medium sized businesses that have the most problem with what multiplier to use for four reasons:

  1. SDE and EBITDA both may need to be applied as an income multiplier for a fair valuation.
  2. EBITDA doesn’t always paint a true picture of cash flow if the current owner of a business needs to be replaced after the business is sold.
  3. Discretionary expenses (perks) are not accounted for in the EBITDA Calculation. In many medium sized businesses there are discretionary expenses that should be added back to income since they will no longer be an expense for the new owner of the business.
  4. One-time losses and Revenue are not accounted for in a simple EBITDA calculation.
  5. Lease expense over or under market isn’t accounted properly when the current owner of the business owns the real estate that the business is leasing.

For this reason, the new market practice is to use ADJUSTED EBITDA.  Adjusted EBITDA is calculated as follows.

Annualized
2015 2016 2017
 Income  Revenue $2,000,000 $2,200,000 $2,500,000
 Pretax Income (loss)           225,000           425,000           625,000
Expenses  Depreciation              26,000              25,000              25,500
 Amortization                 4,000                 4,000                 4,000
 Interest              16,000              16,000              16,000
    Unadjusted EBITDA $271,000 $470,000 $670,500
 Owner Compensation
 Wages of Owner           175,000           175,000           175,000
 Payroll Taxes – Owner              10,718              10,718              10,718
 Health Ins – owner              10,000              10,000              10,000
 Life Insurance                 4,000                 4,000                 4,000
 Automobile                 6,000                 6,000                 6,000
 Cell Phone                 1,000                 1,000                 1,000
 Travel                 4,000                 4,000                 4,000
 One-time Expenses
 Loss on Sale of Assets              10,000                           –                           –
 One-time Bad Debt                 5,000                           –                           –
 Lease over charged              15,000              15,000              15,000
 One-time (Revenue)                           –
 Gain on sale of Assets                           –                 6,000                           –
  Seller’s Discretionary Earnings $511,718 $701,718 $896,218
 Less: Cost to replace owner         (125,000)         (125,000)         (125,000)
 Adjusted EBITDA $386,718 $576,718 $771,218

MyBiz_Logo_value

This is the correct calculation of Adjusted EBITDA as shown in a Valuation Report by My Biz Value.

The bottom line is for the 5 reasons listed above, ADJUSTED EBITDA is a more important and relevant metric to use as an income multiplier when calculating true cash flow and the value of a medium sized business.

Adjusted EBITDA or EBITDA? Part 2 of 3

confused guy

Now that we have a good baseline Earnings number we need to look at Interest, Taxes, Depreciation, and Amortization.

Interest Expense. The interest you can add back is all interest from debts and credit cards and consumer debts. It also can include finance charges. What interest does not include is bank fees, charges, or merchant fees. The interest you can add back is all interest that the new business owner would not have if he were paying cash for the business and had zero debt.

Taxes Expense. The taxes you can add back are income the taxes for the company. This add-back only applies to C-corps that you use a baseline number of Earnings After Taxes and not before taxes.  If you use Earnings before taxes as a baseline number, then you don’t have to add back taxes for a C-corp. since the tax expense hasn’t been added to the Income Statement.

It doesn’t apply to S-corps or LLC’s or Partnerships. This includes all state and federal income taxes. It does not include payroll taxes, sales taxes, or local taxes. This is the tax your business pays. When you have an S-corp or Partnership the taxes flow through to the owners as individuals.

Depreciation and Amortization Expense. These can be found at the following locations on the tax returns and financials.

  • Compiled, Reviewed or Audited Financials – look on the Statement of Cash Flow for the Depreciation and Amortization Expense if it is not shown on the Income Statement, Statement of Revenue and Expenses or Statement of Operations.
  • Schedule C – sole proprietor – Line 13 and 27a for Amortization Expense
  • Form 1120 – Line 20 or the Statement for Line 26 for Amortization Expense
  • Form 1120S – Line 14 or the Statement for Line 20 for Amortization Expense
  • Form 1065 – Line 16c or the Statement for Line 20 for Amortization
  • Internally Generated P&L – Depreciation and Amortization are usually shown as line items expenses.

One item to note is Section 179 depreciation is not an item you add back.

These are the expenses you add back for a simple calculation of EBITDA. This is place where you start to calculate “Adjusted EBITDA”. In Part 3 of 3 this post I will cover Adjusted EBITDA, how it is defined, and how it is calculated and used.

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