Before meeting a seller to negotiate the price of a business, do your homework and be prepared. Don't try to get rich quick. Don't be overconfident nor too optimistic.
Exercise to negotiate the price of a business
Imagine you found an interesting business. How do you prepare for the first meeting with the seller?
Finding out about the numbers might be the obvious thing, such as:
- Which years are the numbers from?
- What are the French benefits?
- Why did you prefer to pay taxes for this year instead of french benefits?
- Who is doing the work in the business?
- Which duties is he doing on his own?
- How old is the equipment?
- How much of your sales are online?
- How many bids do you have for a sale?
Those are all good questions, BUT in fact, you want to build up a trustful relation. So they are NOT good for the first meeting. To build trust, you'd better ask:
- Can you tell me about the business?
- Let me learn about this business?
- How did you build it up?
- What is your background?
- How is it developing? (is it improving against the competition?)
- How works your supply chain?
- Why do you want to sell? (the reason they tell you and the true reason are most likely different.)
- What are you planning to do after the sale is done?
- What keeps you up at night about the business?
Before you actually start to negotiate the price of a business, ask in a curious way: Help me understand ... e. g.:
- Kieth, please help me understand: In the abbreviation EBITDA, what stands the A for?
- The A stands for: Amortization
Earnings before Interest, Taxes, Depreciation Amortisation
How much can the business grow
Why isn't it already that big?
What is the perfect buyer for your business?
Research the websites about the industry
Every industry has a trade association, check for the business which went public. Read the S1 document, it contains a description of the industry.
On ww.edgar.gov publishes all shareholder relevant information including S1.
Research about the seller on LinkedIn, Facebook, ...
"You must be very proud, I am very impressed, what a great business you built."
If I am unhappy with the content, I need to change the context. The context always is a
- believe
- point of view
- or assumptions.
If you are in the picture, you cant see the frame! So, step out. Can I have a tour through the business?
The only outcome of the first meeting is: Do I want to follow on with this? Yes/No. In the case of Yes, you want to impress the seller like you, build up the trust, that you are seriously interested.
If the broker denies arranging a meeting with the seller:
Call the seller directly and tell him:
I am breaking protocol because I am interested in buying your business. Your broker doesn't want to arrange it. But I have to talk to you, are you interested?
The duty of the owner is: To make the team and the company successful. That for it is my job to coach the employees to make them effective.
Seller financing is a legal note, it is unsecured or by a second lean. The buyer needs to commit personally. But, the only option the seller has, to take you to court or take his business back. That's what they don't want to do. So you can usually extend the time period for the payment.
If the business is location sensitive, there is a need to own the property.
To sell for a premium price, agree on an earn-out, for a risk, e. g. keeping a key customer.
Become brilliant in asking questions. Listen to the answer and follow up on the answers with follow-on questions. Train to dig deeper.
While you negotiate the price of a business, keep in mind, that the seller has the following problems:
- psychology, because they have been the identity of their business for years, which they want to detach from
- build rapport, to get them over that, help them to make a smooth exit
- integrity issues, there are some things they know about, and they don't want you to know about. They want freedom and to get rid of it. You are their key to freedom. If they are selling, and give you a credit, you want and need to keep them attached for a while.
After the meeting, review the notes. Research the answers, to verify the answers. If taking notes, you can always ask for thinking time, because you need to write down. Ask the broker for similar offers or search for similar listings. Check the rules, sort out what doesn't fit.
4 research projects
1. the industry
2. the competition
3. the business
4. similar listings
Get the letters from the bank, accountant to facilitate deal flow.
How to buy your competition?
- Call the owner
- Have lunch
- Well about how we are doing (set the frame, and make him building rapport)
- What information would I feel comfortable to disclose? And give it to them.
- There is probably some overlap in our markets.
- What would happen, if we would join forces, instead of competing?
- What would it turn out like?
- How can we combine 1 + 1 = 11, or at least significantly more than two?
Anytime if there is a disagreement, the problem is too small!
Instead of: How do we share? Search for a bigger problem, both can agree on, and so they will be willing to join the forces. Do not mention, that you want to buy his business.
Strategy and Questions for the second meeting with the seller
About the numbers:
- Marketing and Business plan
- What product makes the most and least profit
- Evaluate key employees
- Salary for employees
- How much longer are you willing you stay in the business?
- Do you think, that I can learn everything you knew, and I need to know, to run it as successful as you, within this time?
- Are we in an exclusive conversation?
At the end of the second meeting request the full set of financial statements.
Send them a letter of interest or toss. Usually, you don't hear from a potential buyer anymore. That is annoying. Do better than this. If the outcome of the second meeting is that you seriously want to buy it, set up a "letter of intent" (LOI). This should be its content:
The LOI should describe the main points of the deal. You should do the short form, and have it verified by the lawyer, to draft this. It is hard to unwind the LOI. So it should be well thought.
An accountant who has been through several transfers before, on both sides of the deal!
Lawyers and Accountants are ignorant about business, value, operations.
How much to offer if you want to negotiate the price of a business?
10-20% below valuation. (Justifiable vs. bottom fishing which happens in real estate) Chances to buy a business half price hardly ever happens. Justification needs to be done for a reason, e. g. Industry average. 40-50% of the sales price usually get financed by the seller.
500k EBITDA * 3 = 1,500 k
750k cash down payment, financed on a bank loan
750k finances the seller over 5 (-7 years) years with 5-6% interest.
The seller is usually interest rate sensitive and forgets about the risk if you offer 1-2 % more.
If the seller is in debt 600 k
He gets in the first year
750 + 150 - 600 = 200k
Be aware, that he probably doesn't want to let it go for that. Because our of that he has to pay:
- 150k for the broker
- 150k taxes (got to be paid as the money come in)
so he would end up with -100k!
The business produces 500 to keep it running. Still, some might do it anyway, because they are so fed up with it! Understand their situation, when negotiating the deal. And never put more than 20% of your net value in one deal.
Merging companies can reduce taxes, but it is a question for a tax consultant.
Key Elements of an LOI (Letter of Intend)
Stock deal: sending the money to the owner, buying the balance sheet with all of its assets.
Asset deal: sending the money into the sellers business, buying only some assets
Usually, the asset deal gets done, due to liabilities e.g. unpaid taxes or legal issues from the past. Which is better for the buyer. Due to that an asset deal usually has a higher price than stock deal.
In a few cases the stock deal is good: If there is a contract which is very favorable for the business. Usually, you want to buy only assets, because you can avoid some risks.
There are a lot of moving parts, that is why the lawyer and tax consultant is essential, who understand the details. Learning about that makes you smarter, but not richer. In general, it is an asset deal, that avoids the remaining risks from the past. The lawyer helps you to figure out the assets that need to be in and to be avoided.
Contents of an LOI
- Price and form of payment
- assets vs, stocks
- financing contingencies
- conditions to close
- due to diligence
- assignments of contracts
- purchase price adjustments, e.g. bills for that past, that will come up.
- training and consulting, how much the seller is available, and what it costs to have him longer available
- non-compete/non-interference and its compensation
An LOI is non-binding. It is a basic outline and general deal. And it reserves a lock-up exclusivity period. You find an example in exhibit B.
Tips to negotiate the price of a business
- directly with the seller
- have an out (usually financing or due-diligence)
- have a walk away number
Hot Topics
- personal guarantees
- seller note subordination
- real estate
- which assets
- due diligence clause
- buyer drafts the final agreement, even if is more expensive, I want to get to draft it, to be in control. Otherwise, you will get to see some ugly stuff in it.
60 days due diligence (evaluation) if you don't come to a relationship
30 day close
Deposit
It is not very common. Only offer or accept it if you think the seller is still shopping and show him your urgent interest. Make it refundable if possible on certain conditions.
Franchise
It is not a horrible idea if you can live with the colors of the logo and the rules that come with it. But it need to have a real brand, so it does not make sense with a new franchise system.
- buy an existing franchise shop, not only the manual and the brand name
- startup with a plan that has worked
- follow directions
- brand vs. systems
- protected territory
- multiple locations
Due diligence:
- the viability of franchisor and location
- restrictions
The problem, you don't get a protected territory!
EBITDA
- Comparison Tool between similar business
- Not Cash
It ignores
- capital expenditures for sustain or grow
- depreciation is not really for real estate it goes down, but the value goes up
- Working Capital and its relation to
- taxes
- debt repayment
- free cash flow = operating cash flow - capital expenditures
It is only good as a tool for comparison and valuation. The sales price gets estimated based on EBITA but the financing needs to be on free cash flow.
Normalized earnings
EBITDA + Add-Backs
- add backs = sellers' compensation expenses or
- one time revenue or expense event
Taking all the yaya (private benefits to the owner) out
If they take out their salary (replacement management) put in a realistic compensation for someone else.
Look for one time large revenue events, e.g. redoing the webpage.
Is the development continuous?
weighted last 3 years EBITDA
(1*y-³) + (2*y-²) + (3*y) / 6
Scrubbing the numbers
- common size and trends, calculating everything in percentages of sales/units/people to get the effectivity of the invested assets
- $ / unit / people & trend
- tas returns are NOT EQUAL financials
- industry ratios
In the US the tax office pays 25% if you report someone who did not declare his income. So if someone who got a cash business, is running around with a lot of status symbols, it is like that you found one.
Financial statement stitchery
- income statement
Collecting revenue in advance, and the revenue is calculated for the month the money came in. It is unearned revenue! It looks good but for the buyer, it's very dangerous. In the balance sheet, it should be reported as:
120 in revenue
110 in debt
10 in earnings
Because that represents the work that is done vs. the work that has been paid.
- interest income
- capitalized expenses
- cash / barter / unreported sales
Valuation
- assets FMV (fair market value balance sheet)
- income multiplier adapted to the risk an grow
- Market Value: an appraisal (oh no!) usually on discounted cash flow, so not look at it, because it works like that:
- discounted cash flow: $1 today < 1$ in 10 years,
- based on a future stream of cash earnings
- discount factor (risk/growth/ return)
- expertise / insight
The earnings in the future are the fruits of the work from the buyer, so it not even worthy of thinking or talking about it!
Excess earnings = IRS method
- two sources:
How can I verify if the business is worth the asking price?
Calculate the cash flow after paying all of the costs including taxes, rates for debt and the interest.
To sell, get more than one offer from interested buyers.
An investment banker can help to make contacts to those people.
Valuation summary
formulas are estimates
art and science: Deal flow is your best friend. You need to see several deals to see which one is a good one.
I need to understand the risk, to understand the multiplier.
The multiplier represents the estimated stay-ability in the industry.
For big business, there is a premium for it,
for small ones, a discount!
Attract a partner for financing before taking the deal. If I cannot find a partner for the deal I don't do it. This is a technique to verify the deal being good.