“So, You Want to Buy a Business?”

 “Valuation Overview and Commentary”

 “Top Valuation Reasons to Sell Now”

 “The Value of Valuations”

 “How to Value a Home-Based Business”

 “Professional Practice Valuations: Part One and Two”

 “Business Valuation Rules of Thumb and Service Companies”

 “Use of Quantitative and Qualitative Tools for Business Evaluation”

 “Introduction to Business Plans”

 “Start-Up and New Company Issues”

Article One: “So, You Want to Buy a Business?”

You’ve made up your mind. It’s time to break away from old routines and work for yourself on your own terms. Congratulations! Having had the opportunity to watch literally hundreds of people work their way through this same thought process, weighing the costs and benefits of self-employment versus career employment, I can assure you that the challenges ahead will be both stimulating and rewarding. I would be deceitful indeed if I did not mention that self-employment does not work out for everyone - there are tremendous risks, trials and tribulations! I can further assure you, however, that your best overall chances for financial and emotional success lie in the purchase of an established business.

Time and again I meet with former employees, managers, and executives who explain their business search within the overall context of either starting a business from scratch or buying an on-going concern. Clearly, starting from scratch is the riskiest mode of entry. Consider the following grid:

Start-Up >>>> Turnaround >>>> Franchise >>>> Established >>>>

The only choice riskier than buying a “turnaround” business (a currently unprofitable business which is bleeding cash, either in or near bankruptcy, or about to close the doors), starting a business from scratch is uniquely risky, generally requiring the attainment of three goals:

1) product/service which fills a need on an economic (profitable) basis

2) an environment which allows entry by newcomers at less than exorbitant cost

3) finding the right location which minimizes working capital (cash) requirements while the company works toward positive cash flow and profits

Clearly, buying an existing business is less risky and normally allows immediate attainment of the three goals above. You are able to step into an ongoing stream of revenue and focus only on how to maintain and improve the cash flow. Basically, by purchasing an on-going concern, you are purchasing a proven customer base, steady suppliers and hopefully loyal employees. Not a bad start!

Another intermediate option is the franchise, which combines the start-up component with a time-proven (hopefully) product/service and operating system. As a franchisee, however, be prepared to give up a certain degree of autonomy (rules, regulations, restrictions, requirements, etc.) and cash (franchise fee, royalty expense and advertising fees). Many of the best opportunities in the market today are in fact established franchise operations, but be prepared to pay top dollar!

My “bottom line” advice is that most entrepreneurs (both experienced and first-time buyers) will benefit from the purchase of an established business versus a start-up endeavor. A primary reason why this is true is the emerging abundance of quality businesses to choose from. As more and more people choose to start businesses, obviously more and more will appear for sale through business brokers or by owner. If you are reasonably flexible in terms of business type and geographic location, there are literally hundreds (thousands) of possibilities to pick from in a given metropolitan area. Having made the decision to buy an established, time-proven business, the key is to find the “right company” at the “right price”. Along these lines, nobody can help you accomplish this as much as a qualified business broker can.

The glue that connects the right company to the right price is “due diligence”, a term which generally refers to the period of time during which the buyer is free to scrutinize the seller and his company. In reality, this term also refers to the efforts made by the seller to evaluate the buyer’s financial statement and resume, which is particularly important if the seller will be carrying a note from the buyer or if the seller is to remain “on the hook” of a long term lease assigned to the buyer. Due diligence technically begins the moment the buyer is introduced to a given business, formally evidenced by the signing of a non-disclosure (AKA confidentiality agreement) form. Be advised, however, that any thorough review of the books, records and operations, e.g. review of bank deposits and sales reports, will be delayed until such time as there is agreement on price and terms, i.e. a signed purchase agreement. Buyers should take great comfort in the fact that their accepted offer is normally contingent upon several events, including a satisfactory review of the subject company’s books and records. In other words, the earnest deposit from the buyer will not normally be at risk until the buyer is satisfied that the presented sales and cash flow by the seller are indeed accurate and otherwise acceptable.

Before delving too deeply into the technicalities of due diligence, allow me to stress the importance of finding the “right company” before worrying about the “right price”. In other words, my opinion is that it is foolish to base your search primarily on finding a “good deal” or a “steal”. The price must be considered secondarily to your personal preferences relating to how you want to spend your time and energy. Remember that you will be spending between 40 and 80 hours at your chosen business! How do you know what the “right company” is? The answer is complicated and may even change over time. A good place to start is by purchasing one of many personality oriented career guidance books, such as “Do What You Are”, by Paul D. Tieger and Barbara Barron-Tieger from Little, Brown and Company (second edition). The decision as to what type and size of business you purchase requires serious introspect, which can be aided by books like “Do What You Are” and people close to you like spouses, other family members and close friends. An excellent source of guidance in this realm, believe it or not, is a qualified business broker. Because they deal with so many people in similar situations, they are in a unique position to match customers with businesses and their associated lifestyles.

Please bear with me at this point as I introduce my book to you - “The Upstart Guide to Buying, Valuing and Selling Your Business”, published by Dearborn Financial Publishing and available by calling either 602-949-8825, extension 14 or 1-800-829-7934. This comprehensive guide combines intuitive, personality-related insights with the hard core financial and contractual components of buying and selling businesses. It features a complimentary computer disk which holds dozens of sample contracts, checklists, questionnaires and analytical forms supporting buyers and sellers. The guide also includes an exhaustive collection of contacts for additional reference materials (phone numbers and websites) and business brokerage related services (brokers, bankers, free consultants, etc.). This guide is intended to be one stop shopping for entrepreneurs interested in buying, valuing or selling a business.

After you have decided on the general type and size of business, e.g. retail computer supplies with $50,000 to $70,000 cash flow, you must evaluate specific opportunities with intense focus and completely open eyes (my guide includes a formal mechanism for matching your personal criteria with the business of your dreams). To properly evaluate a specific business, e.g. Smith’s Computer Supplies, Inc., you must combine the intuitive side with the analytical side. On an intuitive level, you should begin to “visualize” yourself running the business day in and day out. Does it feel right? Can you see yourself coming to this business every day for the next few years? At the same time, you should begin brainstorming with your significant others (spouse, friends, CPA, banker, attorney and your broker) and the seller about possible changes which would increase revenues, reduce expenses or otherwise improve the business. Ask the seller several times during due diligence what he or she would do to improve the business. If your visualizations of coming to work here and implementing changes are favorable, you might have found the “right business”!

So far, so good; but now the real work begins! After finding a business that feels right, you must make an offer and work your way towards the “right price”. In practice, evaluation of the business and the asking price will be occurring simultaneously. My point is to stress the relative importance of finding a business that feels right as opposed to simply finding a good deal on price and terms. Do not buy a business simply because it is a “steal”! A discussion of generally accepted procedures for making offers and negotiating price and terms now follows.

Your initial offer, which typically includes a down payment (comprised of an earnest check to be held by broker and subsequent certified funds brought to closing) and terms (often a seller carry-back note from buyer, paid over X years at X%), is based upon what you believe the business is worth. You may choose to “lowball” the seller, but this is done at great peril. If you offend the seller, he or she may conclude that you are wasting their time and avoid making a counteroffer. It is one thing to negotiate a fair price in good faith and quite another to try to “steal” a business before making a fair offer. Regardless of your strategy, note that your assessment at this point as to what the business is worth is based upon unaudited or unverified information presented by the seller. In other words, you must assume that the seller’s presentation of asset values, sales revenues, adjusted cash flow and other pertinent information (e.g. lease is assignable and/or extendible) is materially accurate and otherwise reliable. Precisely because this information is unaudited, your offer must be made contingent upon a satisfactory review of books, records and operations. You should never make an offer which does not include at least one contingency, normally satisfactory review of books and records.

Another common contingency is an acceptable assignment or transfer of the property lease (you want a favorable rent for an economically viable length of time). For many businesses (notably retail), the value of the operation is based to a great extent on the location - without the current location, you may not have a viable business. Normally, attempts to transfer the lease (undertake discussions with the landlord) will not occur until books and records have been reviewed and signed off on (contingency removed).

A third, increasingly common contingency concerns bank financing. With a strong economy, record profits and a structurally changing economy (more small businesses), hundreds of commercial banks and non-bank banks (e.g. AT&T Capital and The Money Store) are aggressively courting borrowers who seek to acquire an established business. Small Business Administration (SBA) loans, which are loans funded by financial institutions and guaranteed by the federal government, are being made at record levels. A key advantage to buyers is the ability to offer what amounts to an all cash offer, which generally will result in a purchase price as much as 25% less than a deal based upon seller financing. Banks like to see the seller “participate” by carrying back at least 10% of the total price in order to maximize their assistance to the new owner once closing has occurred. A seller who is paid all cash will have lowered motivations to help the buyer during the transition period and thereafter. If the seller will agree to this formula (cash down payment plus SBA loan plus seller carry-back), the buyer is also more confident that the transition period will proceed smoothly and productively. The challenge, however, is to convince the seller that the risk of their small carry-back note is worth the heavy cash down payment, given that the seller’s collateral protection is in second place behind the commercial bank (seller has a second lien against the business and its assets).

In practice, these three contingincies are satisfied in the order just presented. Books and records can be reviewed as quickly as one week (or as long as four to six weeks), with landlords acting upon a transfer in as little as two working days to two or three weeks (if the decision maker is on vacation or located in another state). A common scenario is the satisfaction of the first two contingencies within two to four weeks, while waiting for bank financing, which may take as long as six to eight weeks, depending upon the size and type of loan (real property may require appraisals) and the diligence of the buyer and seller in providing complete and accurate information to the lender. One practical solution here is to “open escrow” upon satisfaction of the first two contingincies and receipt of a formal/informal letter from the bank or lending officer that funding appears likely, subject to certain conditions being satisfied.

You must be cognizant of the fact that once escrow is opened and your earnest check “goes hard”, there are real risks as to the disposition of these funds. Work closely with your broker and attorney to be as comfortable as possible with these procedures.

Returning again to the concept of “right price”, you should realize that on occasion the sales, cash flow and operational data provided by the seller will be either insufficient, inaccurate or blatantly misleading. If your review establishes a verifiable cash flow equal to 75% of the presented amount, you must be prepared to withdraw or revise your offer. Depending upon the size and source of the discrepancy, you may choose to lower your price and down payment by an appropriate percent. If the seller has proven to be misleading or fraudulent, you may wisely withdraw your offer entirely.

All first-time buyers are faced with the daunting challenge of determining just what is a fair price for a given business. The fact is that business valuation is equally art and science - reasonable parties will disagree. Not only will larger businesses generally sell for higher multiples, the value of any business will change from month to month. For example, a retail business is worth significantly more in September than it is in February, given the concentration of sales during the holidays. My book will present all of the valuation approaches used by brokers, CPA’s and business appraisers along with insights into using rules of thumb and market comps. My strong advice is to use the tried and proven knowledge and expertise of the VR Business Broker’s network. Having brokered over 35,000 businesses since 1979, they have the most developed database of market comps for small businesses in the entire country. They can uniquely combine the particulars of a given business with the industry-specific rules of thumb and market comparables to help establish the fair market value (the “right price”) of the business of your dreams.

Most commonly, small businesses are valued at a multiple of “cash flow”, typically ranging from one times to four times cash flow. The important questions are:

1) What exactly is meant by “cash flow”?

2) What multiples apply to particular types and sizes of businesses?

As concerns the first question, there is broad-based agreement among practitionaers that the cash flow of a business is equal to:

Net Income (per the books or tax returns)

+ Owner’s Salary/Payroll Taxes (if deducted to arrive at net income)

+ Owner’s “Perks” (e.g. auto payments, travel and entertainment,

personal insurance [health, life and auto], other

personal or discretionary expenditures)

+ Depreciation, Amortization (these are non-cash expenses which did not

require current period cash outlays)

+/- One-Time Expenses/Revenues (non-recurring, unusual expenses or revenues

which are extremely unlikely to occur again

next year or thereafter)

+ Interest Expenditures (interest is an “add-back” because we seek a

bottom-line figure representing cash flow

available to the prospective owner)

Cash Flow

Different brokers will refer th this amount using different terms such as “cash flow”, “net”, “adjusted cash flow” or “seller’s discretionary cash”. Importantly note that the concept does not refer to gross sales or revenues. In my book, I refer to this amount as adjusted cash flow (ACF), whereas VR Business Brokers network utilizes the term seller’s discretionary cash (SDC). Whatever it is called, it represents the amount of cash flow available to a new owner (after all expenses but before income taxes) to accomplish three things:

1) Pay the owner-operator a reasonable salary

2) Service the debt associated with the acquisition

3) Earn a return on the cash down investment

Reasonable people will also disagree as to what precisely constitutes SDC, but the general thrust is indisputable. We are seeking a figure which consistently represents the cash flow available to a new owner who will be working the business full-time (forty to sixty hours).

Examples of disputes include whether or not to include “excessive” payments to accountants or lawyers. Although these fees may be deemed essential to the operation of a business, the amount of fees could be reduced or possibly even eliminated (if the new owner was capable of preparing financial statements using user-friendly software). If legal expenses were of a personal nature, e.g. changing your will, they should be added into cash flow in their entirety (as should all strictly personal expenses).

Another common area of disputes concerns family members. For example, some family members contribute a great deal of work without being paid a single penny at the same time that other family members may be doing little or no work while receiving large sums of money or services. The first situation calls for reductions in SDC whereas the second calls for an increase, both of which entail somewhat arbitrary assessments. It is these types of adjustments that make it essential that buyer and seller be honest and forthright with each other from the very beginning. If there is trust and mutual respect, these issues are easily addressed. If not, each new issue which calls for judgement and/or concessions may become increasingly troublesome. There is no substitute for mutual trust and respect when it comes to concluding the purchase/sale of a business, which requires literally hundreds of separate agreements within the agreement!

Consider this: if the current owner works full-time and the new owner will be an absentee owner, the cash flow available to the new owner must be reduced by the amount of a reasonable manager’s salary. Conversely, if the current owner is absentee, the SDC will include the amount paid to the manager to arrive at the cash flow which would be available to an owner who is willing to work the business full-time. The major advantage of calculating cash flow to a full-time owner-operator is that most purchases are made by people who will be exclusively devoted to the business, allowing useful comparisons of cash flow performance from one business to the next.

The final question to answer is what multiple of cash flow should a given business sell for. Whether it is one or four times depends upon a host of factors, including but not limited to:

1) The type and amount of work performed by the owner combined with the general appeal of the subject business

2) The history of the firm’s sales and SDC; have they been falling, steady or rising?

3) Are there substantial “hard assets” included in the purchase, providing operational and collateral value (any other material barriers to entry, such as licenses or proprietary products, equipment or processes)

4) Is the lease favorable, e.g. below market rent with several short term renewal options?

5) Is there excess capacity, i.e. can sales and SDC be expanded in the near future with existing facilities?

My guide addresses all of these factors and many more in great depth as they relate to business valuation and purchase offers/agreements. According to VR statistics, the average multiple for all businesses (all types and sizes) has been a remarkably consistent 2.2 times SDC. Do not forget, however, that this is simply an average. Roughly speaking, for every business selling for 2.2 times SDC, there are businesses selling for 1.2 and 3.2 times SDC (in other words, averages must be used with great caution). When looking at statistics for particular types and sizes, e.g. retail gift and party stores, keep in mind that a few of these sales were probably distressed sales, which will skew the averages (VR’s database actually addresses this problem by removing extreme outliers).

In closing, a useful framework for buyers is to begin their valuation efforts at a 2.2 multiple and then assess the relevant particulars of your chosen business. Some factors will push the multiple up, some will push it down. Your local VR business broker is uniquely qualified to assist you with a fine-tuned evaluation, providing expert insights and suggestions on your way to self-employment!!

Article Two: “Valuation Overview and Commentary”

This seminar will introduce the participants to the basics of business valuation and appraisals. The differences between valuations and appraisals and the major valuation approaches and methods will be discussed, allowing the participants to understand the key concepts dealing with establishing a company’s fair market value. Feel free to ask questions during the presentation.

Seminar Outline

I) Introduction

A) Presenter’s background and experience (see Bio)

B) Why obtain business valuation/appraisal?

1) contemplated sale or purchase

2) estate settlement

3) buy-sell agreement between partners

4) aid in obtaining bank loan or investment money

5) establish insurable value

6) ESOP purposes

7) divorce

C) How much do they cost? (valuations as little as $700; appraisals up to several thousand dollars)

II) Overview of Business Valuations and Appraisals

A) Valuations by anyone; Appraisals by certified parties only

(appraisals require understanding of appraisal theory/practice, general business principles, relevant industry insights, detailed factual knowledge of company and the business environment)

B) Typical components of valuations/appraisals (formal appraisal versus letter appraisal)

1) summary conclusions

2) function and purpose (e.g. to assist seller in establishing asking price and to

determine fair market value)

3) definition of value (FMV defined as willing buyer and seller, arm’s length, full information, reasonable time period, no duress, etc.; as opposed to book value, liquidation value, investment value, replacement value, loan value, etc.)

4) definition of property ( stock versus assets, personal versus real property)

5) description of business

6) valuation approaches (income, cost and market)

7) synthesis of valuation approaches ( typically not a weighted average)

8) assumptions and limiting conditions (appraiser has not audited information, effective as of certain date only, valuation effective for stated function and purpose only, calculated cash flow includes adjustment for family members/imputed rent)

9) highest and best use (legally permissible, reasonably feasible usage generating highest economic benefit to the owner)

C) Differences between small versus large companies

1) privately held versus publicly traded

2) compiled statements versus audited statements

3) active owner versus passive owners

4) higher discount rates versus lower discount rates

5) lower multiples of cash flow versus higher multiples of cash flow

D) Valuation results based upon all cash price

E) Terms will impact final purchase price

1) higher down payment, shorter payback period, lower interest rate, more collateral, personal guarantees will reduce the required purchase price

2) purchase of stock will allow seller to accept lower price (tax advantages)

III) Common Valuation Approaches

A) Income Approach (multiple of cash flow or discounted cash flow; these are inverse of each other)

B) Cost Approach (typically asset oriented, e.g. sum of the assets minus sum of the liabilities)

C) Market Approach (find similar companies recently sold)

IV) Common Valuation Techniques/Methods

A) Multiple of cash flow or earnings

1) small businesses: multiple of adjusted cash flow (ACF)

a) adjusted cash flow (ACF) is:

net income plus owner’s salary/payroll taxes plus owner’s perks (auto, life and health insurance, personal travel/entertainment, personal use of products/services, other discretionary expenses) plus depreciation/amortization plus interest expense plus or minus one-time, non-recurring expenses/revenues

2) larger businesses: multiples of net income, EBIT or EBITDA

3) the greater the cash flow, the higher the multiples:

a) ACF up to $250K, multiples of 1 to 3

b) ACF between $250K and $500K, multiples of 3 to 5

c) ACF between $500K and $1m, multiples of 5 to 7

d) ACF over $1m, multiples over 7

Note: these are generalizations only (all other things equal), unique industries and firms possess unique features and multiples (consult a professional)

B) Rules of thumb

1) are industry specific

2) are rough estimates of value only

3) should be used in conjunction with other methods

4) examples are:

a) accounting/tax firms: one times anticipated gross revenues (requires earnout)

b) travel agency: 3% to 7% of annual gross commissions

c) ISP’s: $150 to $350 per customer

d) lawn maintenance: 30% to 50% of annual revenues

e) small retail: 1 to 2 times ACF plus inventory

C) Discounted cash flow analysis

1) the “purest” valuation method

2) based upon “present value” and the “time value of money”

3) used primarily for middle-market and M&A transactions

D) Excess Earnings method

1) first promulgated by IRS, which now shuns its usage

2) value of business is equal to FMV of tangible assets plus capitalized value of company’s “excess” earnings (earnings above average return on similar assets)

E) Use of Market Comps

1) private versus publicly held comparables

2) comparability issues (equally desireable substitute, similar circumstances and terms, reliable and complete information)

3) data sources

a) VR Business Brokers (949-8825, ext.14), BIZCOMPS, Institute of Business Appraisers

b) Value Line, S&P, Hoovers, D&B, etc.

V) Summary Reminders

A) Cash flow is king

1) Purchasers are first and foremost buying cash flow or earnings

2) Accrual accounting can mystify true cash flows

B) ***Most small businesses sell for 1 to 3 times adjusted cash flow***

1) VR average year in and year out at about 2.2 times ACF

2) Various factors push multiple up or down

a) trend in revenues and cash flows

b) how important is owner to future sales and profits?

c) What is FMV of included tangible assets?

d) Does lease have LT options or below market rates?

C) Always use market comparables if possible

*** This applies to businesses with adjusted cash flow up to approximately $250K

Article Three:“Top Valuation Reasons to Sell Now”

This is the time of year for most entrepreneurs that calls for a hard look at their company’s state of affairs. Year-end financial statements/tax returns, inventory counts and the barrage of reflective analyses found in the media create this introspective dynamic. New year’s resolutions take many forms, including those related to the future of entrepreneurial dreams.

As it turns out, there are three current developments that support the decision to sell a business in the year 2000. As each of these developments have a direct bearing on the value of most businesses, understanding their ramifications is essential. The decision to sell a company is one of the most important choices any entrepreneur faces, warranting an exhaustive review of the associated pluses/minuses. These three current developments are:

1) Record high equity values, transferred generally to all businesses

2) Impending tax change concerning tax liability upon sale of business

3) Probable accounting change that diminishes the attractiveness of acquisitions

Each of these impact business value, although different companies will be impacted differently. First, the high-flying equity markets translate into generally higher valuations for all businesses through the impact of “market comparables” utilized to estimate small business value. If the publicly traded “internet service provider” sells for high multiples, the smaller yet similar companies enjoy a spillover valuation benefit. This process applies to most types of businesses. Generally, the best time to sell a company is immediately before a recession and/or a major “stock market correction”. Although it is possible that equity markets will continue to rise, it is also possible that they will decline, bringing down the value of all businesses.

The second development is as difficult to understand as it is damaging to the business sales process and valuation. According to a recent Wall Street Journal report, there is a provision in the tax bill headed for President Clinton’s desk that will eliminate a “carve-out” used by small business owners allowing them to defer capital gains for tax purposes until they actually receive the money owed for the sale of the business. Present owners selling their company with “terms” (loan from the seller to the buyer) pay the associated tax only as the money is received , i.e. the resulting tax is deferred over the life of the seller’s promissory note. If the bill is signed, the seller must pay the entire tax obligation at the time of sale, even if the seller receives only a portion of the purchase price at closing. Needless to say, this will damper the “demand” for small businesses as sellers will be forced to ask for more cash up front. Buyers will need to put more cash down to buy a business. Business brokers understand that there is a “pyramid” structure for buyers and their amount of cash, with many buyers having small amounts of cash and fewer buyers having alot of cash. For a change that will bring only about $2 billion to the Treasury, it’s impact on valuation and marketability will be tremendous. It is not too late to call your congressman and senator!

The third development is still a work in progress, but will most likely take formal effect by the end of the year 2000. The Financial Accounting Standards Board (FASB) has proposed elimination of the “pooling of interests” accounting method, which allows buyers of companies to both “purchase” earnings and avoid recognizing goodwill on their balance sheets, which will reduce future earnings through the related amortization expense. The relevance is greatest for larger, publicly traded companies, but because they routinely purchase smaller, privately-held companies , they too will be impacted. If the buyer is forced to use “purchase accounting” instead, their future earnings will be reduced by the amount of goodwill acquired in the deal, generally amounting to the difference between the purchase price and the current FMV of the tangible assets. For companies such as internet service providers, a tremendous proportion of value lies in goodwill, making such acquisitions less attractive, i.e. less valuable.

When you add the impact of these three developments together, a compelling case can be made that this is the time to sell your company. If your company is attractive to larger, publicly traded entities or if you plan on selling your business with seller financing, there may be a sense of urgency about this decision.

Article Four: “The Value of Valuations”

Having worked over a 15 year period has given me the opportunity to participate in a wide variety of situations that involve the valuation of companies. As a corporate professional privy to merger and acquisition rumors and details, the often mystical elements of the stock market played a major role in assessing “value” of proposed acquisitions. As a business broker guiding buyers and sellers through the acquisition/sale processes, rules of thumb passed on from friends and relatives were critical determinants of perceived value. As a business appraiser in divorce or other adversarial environments, the biased, typically one-sided view of a company was emphasized by the hiring party, creating a special challenge to ultimately arrive at a fair estimate of market value. As a M&A specialist, the unique vantage point of the buyers in search of synergies and economies of scale would often drive the valuation process. Irregardless of the situation, there was tremendous “value” associated with properly and credibly evaluating and estimating business value.

There are few events more important to business owners than the times when they are required to estimate firm value for one reason or another. An improperly valued business can cost owners thousands and even millions of dollars in money either “left on the table” upon sale or lost due to overpaying for an acquisition. Inaccurate assessments can be problematic as well when trying to pass a business from one generation to the next in the interest of minimizing estate taxation. Parties to a divorce that rely on “gut feelings” or try to avoid the hassle of a valuation may also needlessly suffer. Small business owners that try to sell their businesses via SBA/conventional bank financing will improve their chances of receiving the most cash at closing if they obtain a credible, accurate business valuation as part of the loan application.

The “value” of valuations or appraisals can be measured in many ways. For example, if a credible business valuation helps a seller obtain a higher sales price, the extra cash will undoubtedly far exceed the cost of the valuation. Even if the valuation result is lower than anticipated or desired, a seller at least has the ability to make a rational decision as to whether or not a sale at the present time is desirable (avoiding the cost and time associated with listing a business for sale and spending valuable time with the broker and prospects).

The more experienced the valuator or appraiser is, the more “value” there will be to the business owner. Make sure that they have at least five years experience in valuing businesses (the more, the better) and that they have valued businesses similar to yours within the past two years. Different businesses/industries naturally possess unique and dynamic characteristics that only experience can recognize and appreciate. Inquiring about their “certification” is also important, e.g. Certified Business Appraiser, as any certification is preferable to none at all.

After the experience requirement has been satisfied, evaluate the costs. There is a wide range in costs and services provided by valuators and appraisers. Depending upon your needs, a lower end or higher end report may be preferable. If you are seeking to understand the value of your company as a general tool for long range planning, you may not need all of the “bells and whistles” that lead to inflated costs. If you are battling the IRS or a spouse, the added cost may be justifiable. Working off of recommendations from colleagues or friends is preferable. Valuation reports can be obtained for as little as $1,000 or as much as $30,000.

Many brokers (non-certified) will perform “valuations” for as little as $1,000 or even “free” if the seller simultaneously enters into a listing contract to sell the company. Note the distinction between “valuation” and “appraisal”. Only certified professionals can perform appraisals, which require standard procedures/disclosures after passing an exam and comprehensive review process. Because of the extra training, verification of skills and minimum mandated reporting requirements, appraisals will cost more than valuations. A valuation costing $1,000 may cost between $2,500 and $5,000 for a formal, written appraisal. The more complicated the assignment, e.g. multi-locations and entities, rapidly changing technologies, presence of real estate, etc., the higher the cost. Regardless of the cost, obtaining reliable, credible estimates of value can be one of the best investments any business owner can make.

Article Five: “How to Value a Home-Based Business”

Overview of Valuation Techniques

It is no secret that the process of valuing businesses is one of the most mysterious aspects of entrepreneurship. Given the unique features of a home-based business, the mystery is even greater! The fact that home-based businesses are a relatively new phenomenon at their current large and growing numbers means that there is not a well defined and generally accepted “rule of thumb” for valuation as there is for many types of businesses. Having said that, it is important to recognize that there is a logical and credible format to be used when valuing these increasingly important businesses of the 21st century.

Although business owners of all types will have opinions as to the value of their business, they will inevitably seek the input of one or more professionals (business appraiser, business broker, CPA) to ensure optimal valuation, whatever their purpose might be.

To understand why business valuation efforts can lead to such diverse results, consider the following ideas. To begin with, the purpose of the valuation will impact the range of results, e.g. obtaining a bank loan (seek highest value) or IRS estate tax audit (seek lowest value). Next, the timing of the valuation can have a material effect, particularly for businesses of a highly seasonal or cyclical nature, e.g. retail businesses before the holidays versus after the holidays.

Assuming that the purpose of your valuation efforts is to evaluate the purchase or sale of a business, the following points are relevant. First, sellers and their agents inevitably believe their business is worth more than it is while buyers and their agents believe it is worth less than it is. Another consideration is the wide variety of possible terms that make up a purchase agreement. Most small business valuation results are based upon an assumption of about 33% down with the balance carried over several years at going market rates (currently between 8% and 12%). Note the effect of various terms on the “price” at which your business might sell:

1) Higher Down Payment >>> Lower Price

2) Shorter Repayment Term >>> Lower Price

3) Higher Interest Rate >>> Lower Price

4) More Collateral >>> Lower Price

Note that none of the factors listed above are related to the unique features of a given business, such as the amount and stability of cash flow, the composition and fair market value of the assets, or the general reputation of the firm. Before turning to the specifics of valuing home-based operations, we should review valuation techniques in general, which fall into the major categories listed below. Each category has its proper place, depending on the specific type and size of business.

1) cash-flow based

2) asset based

3) revenue based

4) market based

5) rules of thumb

Category 1 is by far the most relevant for business valuation in general, with the “average” business selling for approximately 2 times adjusted cash flow (ACF). Valuing a business based upon asset value alone (Category 2) is a rare occurrence, unless the business being sold is characterized as an “asset sale”, which implies that the business is not profitable and lacking in “goodwill”. Valuing businesses at a multiple of adjusted cash flow (ACF) plus the market value of all assets is quite common. For example, pool cleaning operations may sell for 1 to 1.5 times ACF plus the fair market value of all equipment and inventory. Category 3 applies to accounting practices (often home based), which consistently sell for approximately 1 times annual gross revenues earned by the new owner. Landscaping businesses are known to sell for between 33% and 50% of gross revenues. Category 4 blends with all other categories, particularly category 5. Rules of thumb have been derived chiefly from evolving market values. The importance of category 4 is evidenced by the fact that no business valuation is accurate or complete without evaluating recent “market comps”. Category 5 is comprised of hundreds of diverse formulas. Home-based examples include bed and breakfast inns, which may be valued at $40,000 to $100,000 per guest room, coin operated car washes, which may sell for between $8,000 and $12,000 per stall, and insurance agencies, which may sell for one times annual renewal commissions.

For comparison purposes, note that larger (privately-held or publicly traded) companies will often sell for higher multiples of earnings before interest and taxes (EBIT) or some other derivation of cash flow besides ACF. Without a doubt, the favored formulas for valuing small businesses is a multiple of ACF or at a multiple of ACF plus the market value of assets.

Key Aspects of Valuing Home-Based Businesses

Being cognizant of the wide variety of non business-specific factors (e.g. down payment, collateral, term and interest rate, etc.) and the several distinct valuation approaches (e.g. cash flow based, revenue based, rules of thumb, etc.), we must address those factors which are unique to a particular business (more specifically, unique to home-based businesses). Consider the following home-based business characteristics:

1) generally relocatable (not location dependent)

2) no property lease

3) typically service-oriented (as opposed to manufacturing or retail)

4) material impact from local, state and federal regulations

5) special tax considerations, e.g. changes in Section 179 deductions

Having perused the above list of characteristics, it is important to return to the central foundation of most business valuation approaches, namely what is the amount, trend, and stability of the future cash flows (ACF). As used by business brokers/appraisers, the term cash flow (whether called ACF, net or take-home) refers to a specific concept, as defined below:

Net Income (per tax return or credible income statement)

+ Owner’s salary and payroll taxes

+ Owner’s perks, e.g. auto, health insurance, vacations

+ Non-cash expenses, e.g. depreciation, amortization

+ Interest expense

+ One-time, non-recurring expenses

- One-time, non-recurring revenues

-/+ Adjustments related to family members

ACF

Understanding the calculation above is critical. Consult your local business broker for additional clarification or consider purchasing “The Upstart Guide to Buying, Valuing and Selling Businesses”, published by Dearborn Financial Publishing (800-829-7934). The relevance of cash flow for home based businesses is equally valid. What is different, of course, is the choice among various multiples to apply to the appropriate cash flow. If you are buying such a business, you are primarily buying a hoped for future stream of cash flow (in addition to a few pieces of equipment and inventory) which can be used to service the debt, pay the owner a reasonable salary and generate a return on the cash down payment.

The bottom line when it comes to accurately assessing the market value of a home based business is a function of the strength and transferability of the ACF over the near and longer term. For example, the fact that there is no lease involved is a plus in terms of overhead expenses and ease of relocating the business. The negative side is based on the idea that there is no protection from a given location, as there is for a successful gift shop located in the same spot for over ten years. The absence of a lease, however, is not a problem if the customers are willing to accept the products/services of the new owner. Is the cash flow solid and growing strongly, and if so, can it be transferred to a new owner with a different skill base and no relationship with customers, employees and suppliers? If so, this will lead to higher multiples of value. The obvious question is what is the correct multiple? Is it one or four, or somewhere in between? Why? The answer to this question is not ever crystal clear, making valuation as much art as it is science.

Given that the great majority of home based businesses are service based, their multiples will tend to be lower than overall averages, owing to the lower inventory and equipment values. Service businesses also receive lower valuations as a result of the higher degree of competition and generally “easy” entry into the industry. Consideration of material changes in regulations and taxation that impact home-based businesses is necessary to properly estimate future ACF and business value. For example, the Home-Based Business Fairness Act of 1997 would increase the deductibility of health insurance costs of self-employed individuals and clarify the precise nature of tax deductible use of a business owner’s home. Both of these changes would increase the value of home-based businesses by stabilizing and even increasing the cash flow being generated by home based entrepreneurs. On the other hand, if neighbors and local governments grow weary of the proliferation of home based operations, the resulting regulation could be devastating.

In summary, to properly estimate the market value of a given home-based business, you must utilize the generally accepted valuation techniques/rules of thumb and adapt them to the uniqueness of your business. Finally, being able to locate and compare recently sold similar businesses (market comps) is mandatory for optimal results. Contact your local broker for help in this regard, or call 1-800-377-8722 for the nearest VR Business Brokers office (VR maintains a database with over 35,000 market comps, including recent sales of home based operations). You may also obtain valuation tips by visiting their website at www.vrbusinessbrokers.com or Shannon Pratt’s homepage at www.transport.com/~shannonp/ (contains valuable insights and links to other pertinent websites).

Article Six: “Professional Practice Valuations”

Professional Practice Valuation Issues: Part I

It is a sad but true facet of modern day life that divorce is a common occurrence. A common valuation/appraisal assignment concerns the unique considerations associated with this tragic event. If a business is involved in divorce proceedings, it may represent the most valuable asset of the couple’s holdings and thus often becomes a major source of conflict. The situation is complicated when both spouses have been working in the business and when the business has been the sole or primary source of income. The typical resolution involves both parties obtaining business valuations and then either settling out of court or allowing a judge to make the final decision.

There are many important factors to consider when handling a marital dissolution, including the notion that distribution of the marital estate is driven by state-specific laws. In Arizona, the basis for the distribution is found in community property statutes and their related court findings. The community property standard implies that all assets acquired during the marriage are assumed to be acquired by and jointly owned by the marital community. Judicial precedent is often utilized by the court, so the hiring of an experienced attorney is a critical step towards protecting each side’s interests. Typically, the valuation or appraisal is conducted by the valuation professional in conjunction with an experienced divorce attorney. Reviewing Maricopa County Superior Court cases and Division I and II Court of Appeals findings will improve the valuator’s understanding of various legal interpretations of all related issues.

Selection of the valuation date is another important issue. Once again, the legal professional must guide the appraiser in establishing the “as of “ date, choosing among:

1) Date of marriage

2) Date of actual or legal separation

3) Date of legal filing for divorce

4) Date of the trial

If not formally addressed by the court prior to trial, the valuator must be prepared to offer results based upon each of these dates. According to Lee Richard, attorney with Mariscal, Weeks, McIntyre and Friedlander, using a valuation date as close as possible to the trial date is the preferred approach, barring specific directions from the court.

During the “discovery” process, if one of the spouses is not actively involved with the business, it is necessary to provide a written request for copies of all relevant documents, including the articles of incorporation, by-laws, minutes, financial statements, tax returns, existing contracts and any other document that might impact business valuation. Since a second request for information is not always possible, the initial request should be as thorough as possible.

Concerning the appropriate valuation approaches and methods, once again it is important to determine the “judicial precedents” that exist. Once you know which judge will be hearing your case, it is worthwhile to review his or her prior findings to properly understand what is important from their point of view. As is true for all valuation assignments, the pertinent valuation techniques will fall under one of three major approaches: Income, Market and Asset-Based.

Income based techniques include using multiples of adjusted cash flow (ACF), e.g. three times ACF and discounted cash flow analysis (DCF); market based methods rely on using statistics related to the sale of “similar” companies; asset-based techniques rely on adjusted balance sheets and include the “excess earnings method”, which holds that the value of a business is equal to the sum of the FMV of the tangible assets plus a capitalized value of the firm’s goodwill (reflecting the firm’s excess earnings beyond a normal return). Although each of these approaches can play an important role in a given valuation assignment, it is noteworthy that the courts in general have grown in their sophistication to a point where the most widely accepted techniques are discounted cash flow analysis and the use of market comps. The IRS, for example, which created the excess earnings approach in the 1920’s, now holds that this method be used only if no other technique can be properly applied.

Other important issues include:

1) Value of and distinction between professional and practice goodwill

2) Adequate compensation

3) Minority interest and marketability discounts and control premiums

4) Covenants not to compete

5) f18 Proper role of the valuation analyst

My next article will address the above issues in detail to conclude our coverage of marital dissolution disputes.

Scott Gabehart is a M&A Specialist and valuation expert with VR M&A (Roth & Associates) in Scottsdale, Arizona. In addition to authoring “The Upstart Guide to Buying, Valuing and Selling Your Business”, offered by Dearborn Financial Publishing and available at the Arizona School of Real Estate and Business, he is a faculty member at The American Graduate School of International Management (Thunderbird), where he teaches a course on business valuation.

Professional Practice Valuation Issues: Part II

This article continues an analysis of issues surrounding the valuation of professional practices as they relate to divorce settlements. The most substantial asset in a marital community is frequently a business started by one or both spouses during a marriage. Each state has its own marital dissolution statutes and case law, creating the need for experienced legal counsel. In community property states such as Arizona, all assets acquired during the marriage are typically considered to be jointly owned by the marital community (the exceptions to this rule should be explained by your attorney).

Since most state statutes addressing marital dissolution are silent as to the applicable “standard of value”, e.g. fair market value, fair value, intrinsic value, investment value, etc., the valuator must rely on legal counsel. Review of local judicial precedent is mandatory. Most courts will utilize fair market value (FMV), but some judges prefer investment value (IV). IV refers to the value of a given asset (company) to a specific buyer, i.e. the current owner, whereas FMV refers to a hypothetical buyer acting with complete information and under no duress, etc. This distinction becomes clear when dealing with professional practices such as accounting practices, medical offices or legal firms. A medical specialist may possess unique skills that are not easily replicable and relationships with patients that are not transferable. Generally, IV will be greater than FMV.

A unique aspect of professional practices is the importance of goodwill. Unfortunately, goodwill is a term that has numerous interpretations under varying circumstances. In terms of professional practice valuation, it refers generally to the value of a practice beyond the value of the tangible assets such as furniture, fixtutes, equipment and real estate. The importance of this concept for medical practices is evidenced by a publication known as “The Goodwill Registry”. It reports the total value of a firm’s intangible assets under the term goodwill, representing such assets as favorable contracts, the doctor’s reputation, below market rents, non-compete agreements, patient list, etc. Medical practices from over 250 specialty areas were tracked between 1988 and 1997, generating an average goodwill value of 35% of the firm’s total revenues.

To complicate matters, courts may differ in their assessment of “practice goodwill” versus “personal goodwill”, also referred to as institutional and professional goodwill respectively. Some states consider only practice goodwill as a distributable asset. Practice goodwill refers to the intangible value that would continue to exist without the presence of the current owner whereas personal goodwill is reflection of the unique attributes of the primary service provider (owner). Once again, consulting experienced legal counsel is mandatory.

Covenants not to compete executed as part of the purchase contract can also be problematic. If the professional practice is sold during the divorce proceedings, the portion of the purchase price allocated to the covenant may or may not be considered part of the marital estate. In general, since this covenant would restrict the earnings capacity of the selling spouse, it would not be considered part of the marital community. The compelling question may become whether or not the amount assigned to the covenant was proper. When one spouse attempts to buy out the other, this issue grows in importance.

Finally, there may be valuation discounts/premiums involved in the final estimate of value. I recently applied a substantial discount for lack of marketability to to the value of a practice due to the nature of the company’s ownership structure, which involved outside majority share owners entangled in a series of trusts (domestic and offshore). Another common valuation discount arises when there is a minority interest involved. Basically, the value of 10% of the shares is not equal to a prorata interest of the firm’s overall fair market value. For example, a 10% interest in a firm valued at $1 million would be less than $100K by a factor commonly ranging between 15% and 25%. Note that when both minority interest and marketability discounts are applicable, they are multiplicative in nature, e.g. after applying the minority interest discount, the marketability discount is applied on this reduced figure.

In conclusion, valuation of firms involved in divorce proceedings is uniquely ambiguous and dependent upon state statutes and case law. Consulting experienced legal counsel is mandatory for valuation purposes alone. The attorney and the valuator must work together closely to provide a user-friendly, coherent, credible and well documented valuation report that will stand up under the close scrutiny of opposing counsel and the court.

Scott Gabehart is an M&A specialist and business valuator for VR M&A located in Scottsdale, Arizona (Roth and Associates). He teaches a course on business valuation at The American Graduate School of International Management (Thunderbird) and has authored the book called “The Upstart Guide to Buying, Valuing and Selling Your Business”, published by Dearborn Financial Publishing (available at the Arizona School of Real Estate and major bookstores throughout the country). Scott may be reached at 602-692-0887 or 888-347-2811.

Article Seven: “Business Valuation Rules of Thumb and Service Companies”

A commonly abused yet potentially useful tool of business valuation is the use of “rules of thumb”, which are rough, industry driven value approximations. An incredible array of rules are applied to almost every type/size of company in existence. As new industries are created, new rules of thumb follow. Internet service providers are a recent phenomenon, but rules quickly emerged for use by interested parties. Today we focus on rules of thumb for service companies

The great majority are based upon multiples of earnings or adjusted cash flow (ACF) or multiples of annual revenues (AR). Some rules are seemingly irrelevant and others may exclusively determine business value. Accounting/tax practices are valued almost exclusively by multiplying the anticipated AR by between .9 and 1.2. Science turns to art when an attempt is made to choose between a lower multiple and a higher multiple. In practice, accounting/tax firm multiples are influenced by the following:

1) FMV of tangible assets

2) Degree of monthly write-up versus seasonal tax work

3) Average billings/hour

4) Growth in accounts and revenues

5) Profits/ACF relative to AR

A practice with ample, state of the art technology and a preponderance of high paying monthly accounts billed at above average rates in a rapidly growing practice with substantial cash flow will generate higher multiples. A shoddy office with only tax work billed at low rates generating declining revenues and minimal cash flow will attract low multiples. However, the majority of practices will sell for about one times gross earnings. Every business type possesses its own unique characteristics that drive the multiples.

The typical accounting/tax deal is financed through a down payment of 30%-50% with the balance paid over 1-3 years subject to an “earnout”. If the actual sales for the new accountant are less than the agreed upon anticipated AR, the final selling price will be adjusted downward through the seller’s note. In effect, the seller guarantees a certain sales level. It is rare for profitable businesses of any other type to be sold with a guarantee regarding sales, profits or cash flow. Typically only marginal, unprofitable companies will be sold with a revenue guarantee in order to attract buyer interest (or rapidly growing companies requiring compensation reflecting the future growth).

Realizing that other factors like down payment, payback terms (interest rate, number of years, collateral, personal guarantee), stock versus asset purchase, training period, FMV of included assets, covenant not to compete and the size of the company’s cash flow can impact the final price for a business, application of rules of thumb requires years of skill and experience.

An empirical relationship exists between the amount of ACF and the relevant multiples. For example, a business with $50K in ACF may sell for 1-3 times cash flow and a business with $500K in ACF will sell for between 3-6 times cash flow and a business with $5 million in cash flow may sell for between 6-10 times cash flow (all other things equal). The rules presented here apply to the smaller end of company size with AR up to $1 million and ACF of up to $200K.

Service Businesses

1) tabAdvertising Agency 75% of AR, may require earnout

2) tabCollection Agency 3-5 times MR

3) tabConstruction 4-6 times EBIT

4) tabDay Care/Child Care 1 to 3 times ACF or $1K-$2K per enrolled child

5) tabDental Practice 60%-90% of AR

6) tabDry Cleaners 2-3 times ACF or 70%-100% of AR

7) tabEmployment Agency 1-2 times ACF or 2-5 times EBIT or 50% of AR

8) tabEngineering/Architectural 40% of AR plus FF&E

9) tabFuneral Homes 2 times AR plus FF&E

10) abGolf Course 3 times AR or 4 times golf revenue only (no food/alcohol)

11) abInternet Service Provider $200-$400 per account (premium for business accounts)

12) abLandscaping 30%-50% of AR or 1-2 times ACF

13) abLaw Practice 40%-100% or AR, may require earnout; or 2-4 times after tax “excess earnings”

14) abMedical Practice 20%-60% of AR (larger practice, higher multiple)

15) abPest Control 70%-120% of AR

16) abProperty Management 5-8 times MR

17) abPublisher 3-6 times EBIT or 70% of AR

18) abReal Estate Brokerage 25%-50% of gross commissions or $10K per agent

19) abRestaurant/Café/Coffee Shop 30%-55% of AR

20) abTravel Agency 3%-8% of gross commissions

It is critical to stress that a company’s cash flow is ultimately the most important factor impacting business value. Firm specific characteristics also can materially impact valuation results, typically requiring an industry expert to assess their ramifications.

Article Eight: “Use of Quantitative and Qualitative Tools for Business Evaluation”

The use of quantitative and qualitative methods in evaluating and planning business related functions is paramount to business success. Good ideas and hard work are often irreplacable, but proper application of pertinent analytical techniques can help assure that your company is successful by any measure. Both quantitative and qualitative tools are available to even the smallest of businesses, ranging from straightforward techniques such as break-even analysis (quantitative) and SWOT analysis (qualitative) to seemingly obscure tools such as the Altman-Z (quantitative) and the General Electric Matrix (qualitative). An excellent source of both quantitative and qualitative tools is the “Vest Pocket CEO”, authored by Alexander Hiam and published by Prentice-Hall. This incredible book features over 100 useful, diverse evaluative techniques grouped into the following categories:

1) Financial Decisions

2) Leadership Skills and Methods

3) Manufacturing and Operations

4) Marketing Decisions

5) Organization and Human Resources

6) Product Development and Innovation

7) Sales Management Decisions

8) Strategic Planning Decisions

9) General Decision-Making Tools

After perusing this book, it is easy to see how one could “go overboard” in applying these tools, but selective application of pertinent techniques is a must for successful business operations. Obviously, depending upon the area being analyzed, the relevant tools and techniques will differ. Ten of the most common and useful techniques are presented below, with brief descriptions of their application following the list. Your instructor will guide you in terms of which tools to focus on in this final session, but exposure to each of these ten tools will prove beneficial to your future operations.

Quantitative

1. Financial statement analysis ( trend, common-size, ratio analysis)

2. Break-even analysis

3. EOQ inventory model

4. Altman-Z bankruptcy predictor

5. Discounted cash flow analysis and business valuation

Qualitative

6. SWOT analysis (strengths, weaknesses, opportunities, threats)

7. General Electric Matrix (matrix based strategic planning)

8. Drucker’s seven sources of innovation

9. Management by objective (MBO) rating of employees

10. Ernst and Whinney customer service principles

1. Financial statement analysis ( trend, common-size, ratio analysis)

This technique is covered in detail in the financing module, so only a brief overview will be presented here. Financial statement analysis (FSA) is perhaps the most important tool available to the small business owner due to its wide ranging scope and practical use. FSA can be grouped into trend, common-size and ratio applications, with some overlaps between these areas.

Trend analysis looks at account balances over time, searching for material or unusual changes from period to period. For example, if cost of goods sold is rising over time, a careful look at purchasing techniques might be warranted. One can also analyze ratios over time, for example comparing the firm’s accounts receivables collection period over time to spot problems with credit and collection procedures.

Common-size analysis expresses each account balance as a percentage of a common denominator, for example what percent of total assets is represented by cash or inventory. On the income statement, what percent of total sales is represented by advertising expense or rent expense. A critical technique is the comparison of your company’s common-size accounts to industry standards, looking for substantial differences and the cause of the diversion. For example, if the industry average for your firm’s inventory turnover is four times and your ratio is two times, a careful investigation of the type and pricing of your stock is warranted (or advertising or any other possible factor impacting inventory turnover). You should compare both your common-size account balances and your financial statement ratios against industry averages. Caution must be exercised in order to select the proper industry, as the uniqueness of your firm could mean that you are involved in two distinct industries, for example.

Ratio analysis is comprised of measures of liquidity, solvency, activity and profitability. The current ratio, times interest earned ratio, inventory turnover ratio and return on assets ratio are examples from each category. Once again, reviewing these ratios over time and against industry standards will shed light on the relative performance of your company in many different areas.

2. Break-even analysis

One of the most useful tools available to the entrepreneur, break-even analysis can be used to calculate what dollar level or unit level of sales are needed to “break even”, or cover both fixed and variable costs. With a bit of creativity, “sensitivity analysis” can be utilized to ask such questions as what level of sales are needed to generate $X in profits or what is the impact on break-even sales or profits if either fixed costs or variable costs rise? Let your imagination fit your specific needs when utilizing this tool. Another common concept related to break-even analysis is the so-called “contribution margin”. The contribution margin refers to the difference between a product’s selling price and the variable cost of production. In other words, if a product sells for $10 and its variable cost is $7, each unit sold “contributes” $3 to cover fixed costs and hopefully generate profits.

This tool is especially important for start-up operations based on the need to understand how long it will take to make a profit or more importantly how long will additional cash need to be injected into the business. Break-even analysis will aid in estimating cash requirements specifically and budgeting generally. It will also help the start-up firm realize what type of pricing is needed to reach break-even by a certain point in time. Although pricing must reflect other factors as well such as the competition, if you cannot obtain a price that covers all variable costs and at least some fixed costs, you will never succeed.

Let’s begin with a very simple example. If a mailing costs $100 and each sale generates $10 in revenue, ten units sold will create a break-even point. A formula that captures the break-even level is:

Q = TFC where: Q = quantity sold, P = price per unit sold

P – AVC AVC = average variable cost

Noting that P – AVC is the contribution margin (CM), the formula can be restated as:

Q = TFC

CM

To incorporate a desired profit, simply add the profit amount to the TFC in the numerator.

Your instructor will present sample problems to the class as a whole for further insights into this method.

3. EOQ inventory model

This tool will help retail businesses in particular understand the optimal ordering quantities for inventory given the costs of ordering, receiving and carrying the stock. The use of this tool, in effect, will generate the optimal order quantity that minimizes costs for a given level of demand. It attempts to balance the costs of overstocking (lack of space for other items, higher rent and insurance costs, etc.) versus understocking (lost customers, rush orders). The formula utilized calculates the economic order quantity (EOQ) as:

EOQ = the square root of : 2RA

CI

Where: R = demand per period, A = acquisition cost per order, C = cost per item and

I = inventory cost

This formula is derived based upon the premise that the total costs of inventory include the acquisition cost (personnel, phone, stationary, delivery, etc.) and carrying cost (insurance, rent, maintenance, etc.). A related formula addresses the costs of not carrying sufficient inventory, so-called “outage” costs as well as “lead time” per order and “usage rate”, which is a measure of how quickly the inventory is sold and removed from stock.

At the instructor’s discretion, the related formulas will be presented and applied. For additional insights into EOQ applications, consider purchasing Barron’s “Quantitative Methods” by Douglas Downing and Jeffrey Clark in their Business Review Series, available at most major bookstores. This book is full of dozens of business related quantitative techniques and their applications, including useful self-study exercises.

4. Altman-Z bankruptcy predictor

This tool is a multi-faceted financial statement ratio, encompassing ratios that address working capital, retained earnings, earnings before interest and taxes (EBIT), sales and market value of shares versus total debt. An obvious problem, therefore, is how to apply this to companies without market values, i.e. companies that are privately held and not publicly traded. The solution is to either drop it from the equation or estimate a market value for the shares based upon similar companies. Although this is not a perfect solution, this part of the formula is relatively minor. Also, the trend of this measure is often as significant as the number itself.

In general, this tool is used by analysts as a predictor of bankruptcy and insolvency based upon a so-called “Z-score”, which is calculated as follows:

Z = 1.2 (X1) + 1.4 (X2) + 3.3 (X3) + .6 (X4) + X5

Where: X1 = working capital divided by total assets

X2 = retained earnings divided by total assets

X3 = EBIT divided by total assets

X4 = MV of equity divided by total debt

X5 = sales divided by total assets

The higher the score, the less likely bankruptcy or insolvency is to occur. Note that working capital is defined as current assets less current liabilities, such that the greater the relative liquidity, the greater the score and the less likely bankruptcy or insolvency is to follow. Note also that retained earnings are likely to be lower for newer firms and higher for established firms, meaning that lower retained earnings will generate a lower score. As is the case for almost all financial statement ratios, the results can be misleading. For example, a low retained earnings may simply mean the owners have paid out dividends which have depleted the retained earnings. On the other hand, the more money that the owners leave in a business, the more stable it will be, all other things equal. Higher EBIT and higher sales for a given level of assets will generate higher scores while a high MV of equity relative to debt will do the same. Simply put, the greater the working capital, retained earnings, EBIT, MV of stock and sales are, the less likely a firm is to become involved in bankruptcy proceedings. Once again, looking at this ratio over time and compared to industry averages will shed additional light on possible trouble spots.

5. Discounted cash flow analysis and business valuation

Both of these topics are wide-ranging and often complex such that an exhaustive discussion of either would be well beyond the scope of this handout. Note that the “Upstart Guide to Buying, Valuing and Selling Your Business” contains several chapters devoted exclusively to business valuation. Within these chapters there is a solid introduction to the concepts related to discounted cash flow analysis such as the time value of money, present value and net present value. Before turning to business valuation concepts here, let’s take a brief look at discounted cash flow analysis.

Discounted cash flow analysis (DCF analysis) refers to a common financial tool used to evaluate the present value of a series of future cash flows. In modern financial theory, the value of any asset, whether it be a piece of equipment or an entire company, is equal to the present value of all future net cash inflows accruing to the owner of the asset. In other words, the cash inflows and outflows associated with buying, owning, operating and then selling any asset are calculated on typically an annual basis, with these future period figures then being discounted back into present value to account for inflation, opportunity cost and risk. Specifically, these future cash flows are discounted into present value via usage of a “discount rate”, which is determined based upon the unique nature of the relevant cash flows. In general, the riskier the cash flows, the higher the discount rate and the less their value is in present dollars.

There are numerous ways to calculate a discount rate, once again depending upon the circumstances at hand. For example, to estimate the proper discount rate for the purchase of a piece of new equipment, the firm may utilize their predetermined hurdle rate (their required rate of return on capital investments) or they may utilize the company’s weighted average cost of capital (WACC). When estimating discount rates to calculate the value of a business using discounted cash flow analysis, a “build-up” method may be utilized. There are several build-up approaches to choose from, including a technique which adds a series of risk premiums to a risk-free rate of return. For example, US government securities offer a proxy for a risk-free return and depending upon the time horizon of the relevant cash flows either a T-Note or T-Bond will be used to choose the risk-free rate. From here, risk premiums are added to reflect different types of risk such as company risk, macroeconomic risk, regulatory risk, market risk, etc. The key to proper application of this technique is to try to be consistent in your development of discount rates such that you can truly compare “apples with apples”. One method used frequently by business brokers in search of a quick estimate calls for using the “Schilt Risk Premiums”, which are empirically derived, rough estimates of discount rates under five different scenarios ranging from low risk to high risk situations. The Upstart book lists these premiums as well as other build-up techniques.

To better appreciate the concept of time value of money and present value consider the following simple scenario. Suppose that you win the lottery and will receive $10,000 for the next five years. What is the present value of these future cash flows? There is a temptation to say it is $50,000 or the sum of the five nominal amounts. In financial terms this is incorrect. Because of inflation, risk and opportunity cost, the true present value is something less than this figure. If nothing else, we know that there will be inflation over these five years equaling at least two or three percent per year. Using a three percent inflation rate, the value of the $10,000 received in year five will be worth roughly 15% less than the $10,000 is worth today. There is also a risk factor. Perhaps the state you live in will discontinue the lottery or become bankrupt. Granted this is a low risk, but it is a risk nonetheless. Finally, there is an opportunity cost involved. In other words, $10,000 today is worth more than $10,000 five years from now because if you have the money now, you can invest or use the money to work for you. $10,000 today can be invested to earn 5% per year quite easily such that $10,000 today invested for five years will generate approximately $2,500 (actually more because of compounding).

When using DCF analysis for business valuation, the “devil is in the detail”. To the extent that DCF analysis is based upon the future, pro-forma projections are required for sales, cost of goods, operating expenses, tax rates, working capital infusions, capital expenditures and ultimately a “terminal” value, which is the dollars received upon sale of the company in the future net of commissions and taxes. The phrase “business valuation is a prophesy to the future” applies especially well to DCF analysis. Even fairly modest changes in sales, expenses or any of the many assumptions will deliver a different valuation result. In addition to the pro-forma projections, the discount rate selection is also critical to the value estimation.

When attempting to value most small businesses (big ones too, for that matter), a multiple of cash flow will be the likely valuation method. In fact, approximately 75% of all small businesses will sell for between one and three times cash flow, with cash flow being comprised of net income plus a series of addbacks. As the form on Handout Number Nine illustrates, these primary addbacks are:

1) owner’s salary and payroll taxes

2) owner’s perks and benefits (auto, travel, insurance, etc.)

3) depreciation and amortization

4) 8 interest expense

Bear in mind that different parties will refer to cash flow with different terms, including “net”, “adjusted cash flow” and “seller’s discretionary cash”. No matter what it is called, it represents the amount of cash flow available to a new owner to service debt, pay themselves a salary and hopefully earn a return on their cash investment. Another way to look at cash flow is that it represents the amount of pre-tax, cash equivalent benefits accruing to an owner who works the business full-time. If other family members are involved, this figure must be adjusted. Remember again that the Upstart book has four chapters devoted exclusively to business valuation.

Qualitative

6. SWOT analysis (strengths, weaknesses, opportunities, threats)

This tool is an excellent way to attempt to understand fully the unique attributes of your company. In addition to your own assessment, asking employees to anonymously present their perceptions of the business will be enlightening. This technique is basically self-describing, whereby the goal is to credibly and truthfully assess the strengths, weaknesses, opportunities and threats of the business.

7. General Electric Matrix (matrix based strategic planning)

General Electric is one of the most successful companies in the world, having penetrated industries of diverse nature around the world. To coordinate the activities of such a large organization, effective strategic planning is mandatory. To assist their planning and evaluation, a matrix was created based upon flexible definitions of industry attractiveness and business strength.

The matrix is created by identifying, listing and weighting internal and external factors to generate measures of “business strength” (internal) and “industry attractiveness” (external). Examples of pertinent factors are:

Internal External

Advertising Seasonality/Cyclicality of sales

Depth and breadth of product lines Customer demographics

Quality of customer service Barriers to entry

Number of distribution channels Environmental exposure

Financial wherewithal Pace of technological change

Image to public Profitability

Technological strength Regulatory risks

Manufacturing skills Market concentration

Market shares International opportunities

Quality and quantity of sales staff Sales growth

New product innovations Input availability

Each of the chosen factors are then rated on a scale of 1 to 5 or 1 to 10, with a higher score representing a more attractive situation, e.g. 10 is extremely attractive. It is important to utilize a diverse group of employees/managers to develop the proper list. In rating the internal factors, it is suggested that the point of comparison be the strongest competitor in the industry.

After the list is created, reviewed and assigned scores, an overall assessment is required for the particular company being evaluated. Both business strength and industry attractiveness should be ranked as low, medium or high, with the end result being a spot on a matrix with business strength on the vertical axis and industry attractiveness on the horizontal axis.

Depending upon the final assessment, e.g. business strength high and industry attractiveness low, a particular strategy is recommended. Here are a few examples:

Business Strength Industry Attractiveness Recommended Strategy

High High Grow, seek dominance and maximize

Investment of time and money

High Low Specialize, seek niches and consider

Acquisitions

Low High Maintain overall position, seek cash flow

and invest only to maintain investment

Low Low Trust leader’s salesmanship, focus on

competitor’s cash generators and plan exit or divestiture

Medium Medium Identify growth segment, specialize, invest

selectively

7. Drucker’s seven sources of innovation

No program on entrepreneurship would be complete without some reference to the world’s management guru Peter Drucker. His seven sources of innovation allows an organization to systematically search for innovative ideas and prioritize innovation efforts. Mr. Drucker has long argued that firms must “practice” systematic innovation. Innovations typically exploit change, so he identified the areas in which a firm should investigate changes to allow pertinent innovations. His seven sources of innovation are:

1) Unexpected events or results

2) Incongruities

3) Process needs

4) Unexpected changes in industry or market structure

5) Population changes

6) Perception changes

7) New information or knowledge

Note that these items are listed in order of significance, with unexpected events or results being the most important. Each of the above areas should be assigned to company personnel with periodic reports expected to ensure exploitation of material changes. Consider the following example. Your firm enjoys an unexpected increase in sales and profits for a particular product. Because most firms focus on problems, unexpected success is often overlooked. A better response is understand why the successful event occurred and devote additional resources to this area. A full discussion of these innovation sources is beyond the scope of this handout, but once again the “Vest Pocket CEO” includes an informative overview and application of this technique in addition to about one hundred more tools (available through the internet at .

Before moving on, let’s look at one more source of innovation that may need additional clarification. Structural change in an industry or market requires participants to innovate in order to adapt to the new paradigm. To predict change, look for rapid growth, inappropriate segmentation strategies by leaders, a convergence of technologies or rapid change in the way firms conduct business. Industries that are dominated by one or two leaders are attractive targets for innovators. The established firms are not used to challenges and may be slow to recognize changes in their industry.

9. Management by objective (MBO) rating of employees

This human resource tool was a hot item in the 1980’s and still offers a credible mechanism for rating the performance of employees in conjunction with the desire to meet the goals and objectives of the firm as a whole. Periodic performance appraisals are utilized in order to focus employees on new organizational objectives and to adapt employee behavior to better achieve organizational success.

The procedures here include identification of specific objectives and development of performance measurements on a collaborative basis between managers and employees for employees. At the end of a given period, employee performance is compared against employee objectives in order to evaluate the employee’s work, identify training needs and assess the success of organizational strategies in light of developing future period goals and objectives.

The theory behind this performance evaluation tool is that it reduces the personal and subjective elements of employee reviews by establishing quantitative goals and objectives where possible. If integrated into the company’s strategic planning and employee training programs, this tool can be of substantial value to the organization. The objective setting process provides an opportunity for brainstorming how to do a given job “better” with favorable results for the employee and the company. In effect, it connects the employee with the overall strategies and objectives of the firm, allowing all parties to move in the same direction. An excellent article addressing MBO is “Setting Goals in Management by Objectives”, by H. Tossi, J.R. Rizzo and S. Carroll, found in the California Management Review (12-4, 1970, pages 70-78).

10. Ernst and Whinney customer service principles

Most businesses require quality customer service in order to prosper and generate profits. These principles are designed to make customer service more effective and customer-oriented by diagnosing problems with customer service programs.

These principles are presented in a checklist which is utilized to evaluate or audit the customer service function of any company or to establish strategies and guidelines for customer service. This checklist was developed by Ernst and Whinney (major CPA firm) in response to problems their clients were experiencing in the customer service area. According to this approach, customer service policies and activities should have the following characteristics:

1) Linked to business strategy

2) Tailored to customer needs

3) Uses customer-oriented measures of customer service

4) Predictable and consistent

5) Applied selectively

6) Designed to balance cost and benefit

7) Constantly revised and renewed

An article written by Gene Tyndall, partner for Ernst and Whinney, called “Seven Principles Help Achieve Successful Customer Service” outlines these principles in detail (Marketing News, September 26, 1988, publication of the American Marketing Association). Although most of these characteristics are self-explanatory, consider number five above. Some customers are more important than others, as evidenced by the familiar 80-20 rule which holds that 80% of a company’s revenue comes from 20% of its customers. Obviously this does not always hold true, but it is true that certain customers are more valuable to any given firm. Multiple customer service standards gives the firm the ability to focus its resources on the most valuable customers. Also, it may be that there are different categories of customers that require different types and levels of customer service.

In general, investments in customer service should be directed toward areas offering the greatest return while balancing the hoped for increase in sales and profits against the increased costs of improved service. Importantly, customer service programs should be periodically reviewed and updated to meet the demands of changing markets. Watching how the competition alters its customer service can shed light on important changes that may keep existing customers or attract new ones.

Article Nine: “Introduction to Business Plans”

Most business experts agree that every firm should create a business plan and update it periodically for optimal planning and execution of business strategies and tactics. Start-up firms in particular are dependent upon business plans not only for effective business operations but in order to receive financing of any type from practically any source. Most business acquisition loans are also premised upon a satisfactory business plan, in particular on the projected cash flows accruing to the new owner under new management.

Business plans vary in length from a simple plan of 4 to 6 pages to a detailed, complicated plan of up to 40 pages. Regardless of size, there are a few key items that are addressed in most every business plan, as follows:

1) Clear and concise company mission and description of management team

2) Powerful executive summary

3) Knowledge and insights into relevant markets

4) Credible financial forecasts and detailed cash flow analysis

What follows next is the outline from a medium-sized business plan which offers a satisfactory outline for your future efforts:

I. Executive Summary

II. Introduction

History

Description of Business

Goals/Objectives/Strategies (near term and long term)

III. Management

Managerial Skills/Requirements/Track Record/Depth

Organizational Chart

Concise Statement of Corporate Policies and Procedures

IV. Marketing

Industry Overview

Marketing Strategy

Product Classifications and Descriptions/Market Niches

Market Demand/Competitive Analysis/Customer Profiles

Anticipated Market Share

Price Determination/Compared to Competition

Advertising/Promotion

Distribution

V. Production

Anticipated Production Quantities By Category

Capacity By Category/Required Facilities

Efficiency/Productivity

Make/Buy Decisions

Purchasing Strategy/Sourcing

Quality Statement

Inventory Control and Shipping/Receiving

Plant and Equipment Maintenance/Safety

VI. Financial

Sources and Uses of Funds

Balance Sheets and Income Statements (Initial and Projected for 3 Years)

Cash Flow Analysis By Month (Until Profitable)

Breakeven and Ratio Analysis (Including Industry Comparisons)

Implementation Schedule (Pert Chart)

VII. Conclusion

VIII. Appendix

IX. Exhibits

One of the most successful books addressing business plans is the “Business Planning Guide” by David Bangs (Dearborn Publishing), which is available at most major bookstores. See the information sources on Handout Number Four for additional business plan reference materials and professional assistance. Remember that SCORE offers free assistance with business plan formation, as does many Small Business Development Centers across the nation. As mentioned earlier, paying a consultant to assist with the development of a business plan is worthwhile if you need help with writing or cash flow forecasting/financial statement preparation. If you choose a consultant that has recently helped similar companies obtain financing, then you are probably spending your money wisely.

Writing a business plan is in some ways similar to conducting due diligence reviews, so check the handout presenting due diligence and business review procedures for additional insights into areas for coverage in your plan. If you have already written your plan, review these materials with an eye toward improving or supplementing your existing plan.

Remember that business planning does not end with completion of the written document. Business plans should be updated regularly or at least annually to keep up with changes in your industry and your firm. Since writing a good business plan takes substantial time and effort, considering the benefits of such an endeavor is worthwhile:

1) Writing your plan will help you spot trouble before it occurs or diminish its impact when it occurs.

2) Writing your plan will generate new and useful insights into your own skills and the skills of the people working for and with you.

3) Writing your plan will present you with the obstacles ahead of you and help you generate creative solutions and identify strengths and weaknesses, bringing order to what is actually a chaotic process.

4) Writing your plan will help you focus on clear, quantifiable goals related to sales, profits and cash flow. In particular, it can help you avoid the most common reason for business failure: lack of working capital, i.e. lack of cash.

Article Ten: “Start-Up and New Company Issues”

“Start-Up and New Company Issues/Checklists”

Although starting a new business from scratch entails a set of unique considerations, whether you begin from scratch or purchase an established business you must take certain steps to become a legal, operational entity in compliance with local, state and federal laws and regulations. Consider the following checklist:

1) Have you completed your strategic and business planning?

2) Have you determined the type of business structure your organization will assume?

3) If so, have you followed the appropriate registration procedures for the organization structure?

4) If applicable, have you registered your trade name and trademarks?

5) Have you determined whether your business is subject to any special licensing requirements?

6) Have you obtained a federal employer identification number (Form SS-4)

7) Will your business be required to obtain a state sales tax license and submit monthly reports?

8) Will you be required to withhold state and federal income taxes from the compensation paid to your workers?

9) Will you be required to pay state taxes and submit quarterly reports for unemployment purposes?

10) Will your business be required to pay federal unemployment taxes and submit quarterly reports?

11) Will you be required to provide insurance coverage to protect against industrial injuries?

12) Have you made a thorough review of your insurance needs?

13) Have you reviewed federal and state labor laws and determined personnel-related policies?

14) Have you checked the environmental regulations regarding air, water and solid waste?

15) Have you consulted your accountant regarding tax planning, management controls and accounting systems?

16) Have you obtained state, county and city operating permits and licenses associated with your business?

17) Have you made sure your operations are consistent with correct zoning?

18) Have your checked with utility companies to ensure delivery and to obtain the cost of service extensions and deposits?

19) Have you opened the necessary banking accounts and arranged for credit card processing?

20) Does your lease have satisfactory provisions for assigments, extensions and leasehold improvements?

Whether seeking a business start-up or acquisition loan or applying with a landlord to lease space, you will be required to provide these decision makers with a snapshot of your financial condition. All lenders and most landlords will require a personal financial statement filled out by the borrower or lessee similar to the one that follows here. Having this information already prepared can save time and effort when such events occur.

Personal Financial Statement

Date _________

Name ___________________________

Address _________________________

City ____________________________

State _________ Zip _________

Phone (Res.) ____________ (Bus.) ____________ (Email) _______________

Assets Amount Liabilities Amount

Cash on hand in banks> Notes payable to banks>

U.S. govt. securities Secured>

Listed securities Unsecured>

Unlisted securities Notes payable to relatives>

Accounts and notes Notes payable to others>

receivable due from

relatives and friends >

Accounts and notes Accounts and bills due>

receivable due from

others--good >

Accounts and notes Accrued taxes and interest>

receivable--doubtful >

Real estate owned Other unpaid taxes>

--see schedule >

Real estate Mortgages payable on real

mortgage owned> estate--see schedule>

Automobiles> Chattel mortgages and

other liens payable>

Personal property> Other debts--itemize>

Other assets--itemize>

Total Liabilities>

Net Worth>

Total Assets Total Liabilities & Net Worth>

Source of Income Personal Information

Salary $> Business or occupation>

Age>

Bonus and commissions $>

Dividends $> Partner or officer in any other venture>

Real estate income $ >

Other income--itemize $> Married> Children>

Single> Dependents>

Total $>

Contingent Liabilities General Information

As endorser or comaker> Are any assets pledged?>

On leases or contracts> Are you defendant in any suits or legal

actions?>

Legal claims> Personal bank accounts carried at>

Provision for federal Have you ever taken bankruptcy?>

Income Taxes>

Other special debt> Explain:>

When evaluating a company for purchase, one of the most important areas for review is the adjusted cash flow being generated by the subject operation. Here is a worksheet for calculating this important figure, which ultimately represents the amount of cash flow available to a new owner-operator to finance debt, pay the owner a salary and hopefully earn a favorable return on the down payment.

Adjusted Cash Flow Worksheet

Seller

Date~

Business Name: > Period: >

From Income Statement:

1. Owner(s) salary (including payroll taxes) if on P&L + >

2. Discretionary expenses, if on P&L

Auto expense + >

Travel and entertainment + >

Insurance: auto, health, life + >

Interest + >

Other > + >

3. Nonrecurring (one-time) expenses (explain) > + >

>

4. Noncash expenses

Depreciation/Amortization + >

5. Expenses not included on income statement (explain) > - >

>

6. Total adjustments $ >

7. Net profit (loss) from income statement $ >

8. Adjusted Cash Flow (ACF) $ >

The parties signing below warrant that they are the owners of this business and that the

above numbers are true and accurate to the best of their knowledge.

> >

Owner Date Owner Date~

Once the purchase price is established and the adjusted cash flow determined, the implications of various payback terms and working capital requirements can be evaluated within the following framework:

Analysis of Price and Terms

Line 1: Total Sales Price $>

Line 2: Down Payment $>

Line 3: Additional Working Capital Infusion $>

Line 4: First Year's Total Cash Investment (2+3) $>

Line 5: Balance Requiring Financing (1-2) $>

Line 6: Length of Note > years

Line 7: Interest Rate > %

Line 8: Monthly Payment Amount $>

Line 9: Total Annual Note Payments (Line 8x12) $>

Analysis of Adjusted Cash Flow (ACF)

Line 10: Adjusted Cash Flow (ACF) $>

Line 11: Total Annual Note Payments (from Line 9) $>

Line 12: ACF After Note Payments $>

Line 13: Return on First Year's Investment (12 divided by 14 ) > %

Analysis of Stabilized ACF

Line 14: Desired Owner's Wages $>

Line 15: "Stabilized" ACF (ACF after owner's/manager's salary) $>

Line 16: Total Annual Note Payments (from Line 9) $>

Line 17: Stabilized ACF After Note Payments $>

Line 18: Return on First Year's Investment ( 17 divided by 4 ) > %~

Finally, when starting a business from scratch, it is essential that a credible and realistic assessment of initial and short term cash requirements be undertaken. The following worksheet will help determine the amount of cash needed to start your business and maintain it during the start-up phase. It may take several months if not a year or two before profits are turned, so planning for cash requirements is critical. As noted earlier, one of the most common reasons that businesses fail is a lack of working capital resulting from either poor planning, poor operating results or an inability to raise cash when needed.

Start-Up Worksheet

Start-Up Costs Estimated Costs

Leasehold Improvements

1. Redecorating $ >

2. Furniture, fixtures, and equipment (FF&E) >

(e.g., computers, fax, security systems, modem, copiers,

pagers, scanners, mobile phones, software)

3. Signs and displays >

4. Associated labor costs >

5. Vehicles (lease or own) >

Deposits, Prepayments, etc.

1. Rent deposit >

2. Utility deposit >

3. Business permits and licenses >

5. Equipment lease deposits >

6. Service contracts >

Inventory

1. Merchandise >

2. Office supplies >

Operating Expenses for Six Months

1. Working capital >

(cash, accounts receivable, debt service)

2. Labor >

(employees and self, including payroll taxes, training, recruiting)

3. Utilities >

4. Other payments >

(tradename and trademark search, research fees, bank fees,

accounting and legal fees, trade association fees, chamber of commerce fees)

5. Health care and worker's compensation >

6. Marketing fees >

(yellow pages, mailers, brochures, newsletters, business gifts)

7. Travel and entertainment >

(e.g., gas, tolls, parking, trade shows, vendor meetings)

8. Loan payments (bank and credit cards) >

Living Expenses for Six Months

1. Home and auto >

2. Utilities and insurance (home, auto, life, health) >

3. Other payments >

Total Cash Investment Required $ >~

Now we turn to our coverage of frequently asked questions.

Frequently Asked Questions

Q: Can I sell my business alone or should I hire the services of a business broker?

A: It is possible to sell your business without the aid of a business broker, but this increases the need for attorney assistance and other support. My Guide contains dozens of forms and sample contracts which will make it easier to sell on your own, but experienced brokers can offer unparalleled insights and contacts which can maximize the price you receive upon sale of your business.

Q: What are the typical fees charged by a business broker?

A: Most brokers work on a straight commission basis without being paid any monies up front. Commission rates begin at 12% and/or a required minimum commission such as $10,000 with lower percentages possible for larger businesses. Everything is negotiable, including the commission rate and the length and exclusivity of the listing contract. As described earlier, I offer both the standard fixed rate commission and a fee structure based upon an upfront fee combined with a lesser percentage rate at the time of closing. Fees associated with business appraisals or valuations are discussed elsewhere in this site, noting however that most brokers will value a subject business free of charge in exchange for receiving a sole and exclusive listing contract for at least six months.

Q: How do I know what my business is worth?

A: With the proper training and guidance (as found in my Guide, Available by calling 1-888-347-2811), most business owners can perform the appropriate business valuation procedures, which will generate useful results if the owner has access to reliable and recent market comps (as maintained by VR Business Brokers, a national network of brokerage offices having sold over 35,000 businesses of all types since 1979). There is no substitute for the day to day experience that qualified brokers have accumulated when it comes to pricing a business. Call 1-800-377-8722 to find the VR office nearest you or click here to go to their webpage at www.vrbusinessbrokers.com. For larger businesses (priced over $1 million), call me at 1-888-347-2811 or 1-602-692-0887 to discuss our services offered through VR M&A. Click here to go to coverage of business valuation services on this site.

Q: What is meant by the term “adjusted cash flow”?

A: This term relates to the cash flow generating capacity of a company and plays a major role in the business valuation process. Whether it is referred to as adjusted cash flow or something else (net, seller’s discretionary cash, annualized cash flow, etc.), it is calculated as the sum of the following items:

Pretax Income

Owner’s Salary and Benefits

Depreciation/Amortization Expense

Interest Expense

One-Time, Non-Recurring Expenses

Note that the benefits component refers to any personal and/or discretionary expenses incurred on behalf of the owner, e.g. personal automotive expeneses such as lease payments, gas and repairs, insurance, etc.; personal insurance expenses for life, health and auto; personal travel and entertainment; personal phone expenses and other personal, discretionary expenditures that did not directly aid in the production of revenues and profits.

The proper interpretation of this figure is that it represents the pre-tax, cash equivalent benefits accruing to a single owner working the business full-time, providing an estimate of the amount of cash flow that is available for a new owner to service their unique debt responsibilities, pay themselves an appropriate salary, replace worn out FF&E and hopefully to earn a positive return on the cash investment made by the buyer.

Q: Who can I turn to for professional assistance if I decide to buy/sell a business?

A: For most small businesses, the expertise of a reputable business broker is without comparison. For example, VR Business Brokers has over 70 offices across the nation and around the world and has participated in the sale of thousands of businesses of all types and sizes. In addition to receiving the most comprehensive training in the business brokerage arena, their brokers have access to the most extensive and current database of market comps in the country. Their collective knowledge and contacts make the process of buying and selling as productive and beneficial as possible. Experienced brokers have the skills to write clear, valid, enforceable and otherwise desirable contracts for the purchase of going concerns. In addition to using a qualified broker, attorneys are helpful in perfecting the language of purchase agreements and tightening any potential ambiguities or weaknesses that might be present. Accountants can assist with due diligence, in particular with the verification/audit of reported sales, expenses and cash flow. Finally, consultants can help entrepreneurs write business plans to aid in securing SBA or other bank financing.

Q: How long does it take to sell a business?

A: Of course there is no single answer to this question as it depends upon many factors, including:

1) the relationship between asking price and verifiable cash flow and the fair market value of assets included in the sale

2) the amount of seller financing offered

3) the general attractiveness of the business

4)the degree of motivation of the buyer and seller

5) the skill and aggressiveness of the broker

In other words, a business offered at a low multiple of cash flow with high dollar hard assets and a low down payment will sell more quickly ( all other factors equal). Similarly, if the seller and buyer are not overly concerned with each and every issue involved in the sale, the closing will come quickly. Finally, a skillful and aggressive broker can shave months off of the normal time frame. You should expect to wait at least six months or one full year before giving up on your broker, assuming he is adequately marketing your business. Advertising on the internet is becoming increasingly important in fully exposing a business for sale.

Q: What other costs are there besides the broker's commission?

A: Beyond the broker's commission, the seller should be prepared to pay an attorney for his or her review work and legal guidance (ditto for a CPA advising on tax matters). The buyer will face similar costs plus the fee paid to a CPA to review the books and records of of the target company. In most cases, closing costs ( escrow services) are split equally between buyer and seller, ranging from $600 to over $2,000 per deal, depending upon business size and requested services. Financing fees when borrowing from a bank can also add thousands of dollars to the “other costs” category. Finally, it may be necessary to reimburse the seller for certain “prorations” involving pre-paid rent, property taxes, etc.

Q: How do I locate and select a qualified business broker?

A: It is the opinion of the author that there is no substitute for experience. Make sure that your chosen broker specializes in the sale of privately held companies (not the sale of residential real estate or commercial real estate) and has at least 2 or 3 years of verifiable experience (hopefully more than this). You should also at least ask for references, even if you do not ultimately receive them. If the broker hesitates, this could be a “red flag”. In addition to general experience, it is wise to ensure that the broker has sold businesses similar to yours in the not too distant past. Understanding the “particulars” about a given type of company can make or break a deal as it is unfolding. Industry peculiarities, licensing, required employee skill levels and many more areas such as these will vary dramatically from one type of business to another. A very good question to ask them to “test” their knowledge about selling businesses is “Explain to me the differences between a stock sale and an asset sale.” If they cannot answer this quickly and effectively, they may not have the necessary skills to optimize the transaction. When answering this question, they should mention topics such as goodwill, allocation of the purchase price, capital gain taxation, assumption of known and unknown liabilities and/or other related areas. A final important area to review is the quality of the company that the broker works for and the experience of the other brokers working in the same office. Ask for the company brochure to evaluate this element.

Q: What are the options involved in entering into a listing contract with a broker?

A: Similar to real estate contracts, the seller and broker have a range of possible contractual arrangements ranging from a “sole and exclusive” contract (broker’s preference) to a “one-party listing” (most flexible for seller). There are distinct advantages and disadvantages to any option, with the most common arrangement being a sole and exclusive listing contract for a period of six to twelve months. A one-party listing is a limited agency contract which allows the broker to earn a commission only through a sale of the company to the “one party” listed on the contract. A fairly common middle ground is found through what is known as an “exclusive agency”, whereby the broker involved is the only broker able to earn a commission on the sale of the business, but the seller retains the right to sell his or her company to a buyer that they locate independent of the broker. An “agency listing” also allows the seller to locate a buyer on their own, but there may be two or more brokers with such a contract. Finally, the seller may give one or more brokers what is referred to as a “open listing”, giving each broker the right to locate a buyer and earn a commission. Problems may arise here if the same buyer is working with two different brokers on the sale of the same company, leaving the seller open to potentially paying two commissions at the close of escrow!

Most contracts are for 12 months, but I will gladly list a business for six months with the understanding that if I live up to my obligations in marketing the business and working with buyers, then the listing will be extended. Furthermore, to offer the seller peace of mind, I will normally offer the seller the right to exit the contract with 30 days notice (to my knowledge, I am the only broker in town that routinely makes this offer to sellers). I do this because I am confident that I will do the best job possible and will not lose any listings because of this clause.

Q: What are the common types of financing available to help buyers purchase more substantial companies?

A: The basic advantage of obtaining financing is found in the concept of leverage. By paying only a certain percentage of the purchase price in cash, the buyer is able to obtain a more substantial business with greater assets and higher cash flow and profits. Typical seller financing involves a cash down payment of between 20% and 50%, with the balance financed by the seller at between 8% and 10% over 3 to 7 years. The buyer/borrower must be willing to offer all acquired assets (tangible and intangible) as collateral as well as a personal guarantee signed by both spouses (community property requirement in the state of Arizona). The loan is secured by the business assets and personal guarantee, evidenced by a UCC-1 Financing Statement filed with the proper government agency.

The optimal advantage of financing comes via bank financing, typically SBA related financing. Note that the SBA no longer makes direct loans, but acts as a guarantor of principal amounts up to 85% or so of the loan amount (thus encouraging banks to make these loans). It is advisable to utilize what is referred to as a “Preferred Lender”, which basically means that if the bank approves the loan, it will be guaranteed by the SBA without any time delays. The true power of SBA financing is found in the leverage. In many cases it is possible to acquire a company with only 10% cash down payment (if the seller will participate and take back a promissory note from the buyer/borrower in an amount equalling the 10% cash down payment). In other words, the deal is made through 10% cash down, 10% seller carry-back note and 80% bank financing. Assuming a buyer has $100K to invest, a business worth approximately $1 million could now be purchased as opposed to one worth $300K (through traditional seller financing and a 30% cash down payment). The basic requirements for obtaining an SBA loan are as follows:

1) Adequate cash flow to service debt (at least 1.5 times debt service)

2) Relevant management experience on the part of the buyer/borrower

3) Strong credit record (not necessarily perfect)

Please be aware that the SBA loan process can be frustrating, trying and confusing, but patience will typically help ensure a happy ending (and they truly are happy!). Also, each bank will have their own requirements, making it prudent to apply to 2 or 3 lenders at the same time.

Q: What is the difference between the sale/purchase of assets as opposed to stock?

A: There are many substantial differences between the two, requiring the assistance of qualified brokers, attorneys and accountants to ensure the optimal outcome. The Upstart Guide covers this issue in great detail, but for now consider the following insights.

Most small businesses are sold as “asset sales” for two primary reasons. First, buyers are able to “re-depreciate” the fixed assets only under the asset purchase scenario. If stock is purchased, there is no “allocation of the purchase price” as required by the IRS under an asset purchase. If stock is purchased, the existing depreciation schedules are inherited “as is”, thus disallowing the possibility of large, future depreciation deductions against income. Second, most buyers are not comfortable agreeing to inheriting all liabilities, known and unknown, as required by a stock purchase. Although it is possible to execute various seller disclosure statements and include strong representations and warranties in the purchase contract, the potential for dealing with unknown liabilities is enough to make most buyers choose the asset purchase option.

Besides the fixed asset depreciation and liability assumption issues, there are also major tax implications for the seller when choosing between the sale of stock or assets. For example, if certain requirements are met, e.g. form a C-corporation and hold the stock for at least five years, it is possible for the seller of a company’s stock to eliminate a large portion of the capital gains tax due based upon the sale (consult your CPA or tax attorney for detailed requirements). In general, the seller will benefit from the sale of stock versus assets due to the incurrence of capital gains taxes exclusively rather than a combination of capital gains and ordinary income taxation related to the sale of assets. Accordingly, most sellers will accept a lesser price if the buyer will purchase stock rather than assets (reflecting the reduced tax burden). Finally, there are a series of “tax-free reorganizations” available through the Internal Revenue Code that are based primarily upon the sale of stock rather than assets. Although termed “tax-free”, they are really “tax-deferred”. They are often referred to as “Type A, B, C, D, etc. Reorganizations, each with different requirements and ramifications. A Type A Reorganization, for example, is premised upon a “stock for stock” transaction. Consult your CPA or tax attorney for current interpretations and insights.

Q: What is meant by “allocation of the purchase price”?

A: When a business is sold as an asset sale, both the buyer and seller must allocate the purchase price among five classes as defined by the IRS. Although it is not mandatory that both buyer and seller utilize the same allocation, any difference between the two may generate a “red flag” warning for the IRS, thus precipitating an audit of sorts. It is preferable that both parties agree to the same allocation and that the allocation is included in the body of the purchase contract.

The general idea is that to the extent that the purchase price exceeds the fair market value of the identifiable tangible assets, the balance must be allocated to intangible assets such as goodwill. Whether it is allocated to goodwill or a covenant not to compete, the implication for tax purposes is the same. Under current IRS rules, all intangible assets are “amortizable” over a 15 (fifteen) year period. Whether the allocation is general in nature to goodwill or specific in nature to a customer list, tradename and covenant not to compete, the tax implications are identical. For book purposes (accounting purposes), the allocation will impact future reported income to the extent that each intangible asset has a different useful life (amortization expense will differ each year, but ultimately add up to the same amount).

The immediate impact is on the seller’s tax due to the IRS based upon the sale of the company’s assets. Different allocations to different classes (among the five classes) will generate different amounts of capital gain income versus ordinary income, thus impacting the total tax owed. The future impact is on the buyer’s reported taxable income, i.e. fixed assets can typcially be written off over 3 to 5 years whereas intangible assets like goodwill can be written off over fifteen years (remember that accounting for book purposes is based upon Generally Accepted Accounting Principles, not the IRS code).

Q: What is goodwill and how do you place a value on it?

A: Goodwill has many meanings that differ according to circumstances. The common “street” interpretation is that it reflects the benefits of quality products and service, i.e. a company earns the “goodwill” of its customers. Other meanings attach to the term in an accounting context and a business valuation context.

In regards to accounting, goodwill is an intangible asset that occurs on a company’s balance sheet only after an acquisition has been made as a purchase of assets (as opposed to stock). The allocation of purchase price called for under an asset purchase requires that the excess of the purchase price over the value of the identifiable tangible assets be allocated to intangible assets, collectively referred to as goodwill. Goodwill must be amortized against future earnings (for both tax purposes and book purposes), thus reducing reported taxable income and net income (despite its non-cash characteristic).

Regarding business valuation, the “goodwill” value of a company in its most basic interpretation reflects the value of the company over and above the value of the tangible assets. Goodwill can be calculated indirectly as just described or directly through a valuation technique known as the “excess earnings” method (initially created by the IRS during the prohibition of the 1920’s to help value the losses due to shutting down breweries and related businesses). This method holds that the value of a company is the sum of the fair market value of the identifiable tangible assets plus the capitalized value of the company’s “excess earnings” (reflecting the above average return generated by a company when compared to typical, average investments in assets of similar risk). Thus, the value of a company is the sum of its assets and goodwill. Note that the IRS today recommends that this valuation technique be utilized only if no other better method exists. Despite this IRS position, this technique is commonly used to aid in the valuation of professional practices.