Quick Consultant: Sellers Place Too Much Value on “Future Potential”

It's no big surprise, considering the state of the economy, that many printers are giving serious thought to selling their businesses. Fortunately, at least for some of these sellers, there are indeed buyers (mostly other printers) who are looking toward acquisitions as a method for surviving and growing their own businesses. That's the good news.

The bad news is that too many sellers are being unrealistic in their expectations. A few months ago during a discussion about business valuations, one printer angrily said that before he would sell his business for what "some expert was spouting," he would close his doors. I just smiled and shook my head. It can be very frustrating to get owners to examine their businesses from the eye of the buyer.

The fact is that, while most buyers are willing to pay sellers a fair price for the business, they are not willing to pay a seller—nor should they be—for the "future potential" of the business.
As a general rule, sellers should not expect to be rewarded for the talents and expertise that may be brought to the business by a new owner. If the business has potential for future growth and profits, then that potential should already be apparent in an examination of current and historical financial statements. If the business has grown steadily over the past eight years, has produced a net owner's compensation of 16-20%, has little debt and a good team of employees, then it can be argued that the business has good potential for the future.

On the other hand, you can't operate a business for eight years, demonstrate an erratic pattern of growth with lower than average industry profits, take out only a modest owner's salary, show significant debt on the balance sheet, and have a highly paid, under-performing team of employees, and still claim to a buyer that a significant portion of your asking price is based upon the potential of the business.

The more untapped the potential of a business, the lower its value. It is one thing for a business to have a bad year or two; it is a far different thing to expect a buyer to pay you top dollar based upon a history of lackluster performance. In some cases, your business may have far more value if you continue to run it than it will if you try to sell it on the open market.

Another option is to forget about selling the business as an ongoing entity and try to sell you customer list or "book of business." How much is that worth? Just as much or as little as an owner and buyer are willing to agree to—and not a dollar more.

A Very Discouraged Seller

I was recently hired by a national franchise to assist them in valuing one of their operations. The owner of the franchise, Frank McDonald, sent me three years worth of financial data plus a fairly detailed history of the business. Sales grew during the first four years of the business, but in the last five years sales have dropped off dramatically. Yes, the economy can be blamed for some of the decline in sales, but certainly not the entire decline.

About three years ago Frank decided, against the strong advice of the franchise, on three major changes he wanted to make in his business—changes that seemed to doom his operation and cause its value to drop considerably.

First, despite the fact that the business achieved only $505,000 in sales in 2008, Frank decided to hire a highly paid production manager, at a salary of more than $50,000. Why Frank wasn't performing this task himself was beyond me. I know of very few firms of this size that can afford the luxury of a production manager. That's the primary role of the owner, isn't it?

Second, Frank also hired an outside sales representative at a salary of $40,000 plus a generous commission. Once again, Frank or his spouse should have been performing this function. It is a rare company of that size that can afford the luxury of a highly paid outside sales rep.

Third, frustrated with finding a dependable offset press operator, Frank decided it would be more efficient to simply eliminate offset printing as an in-house service. Instead, he decided to broker all his offset printing to a fellow franchisee in a city 25 miles away. While that step did eliminate some operational headaches, it caused a serious drop in gross profit as a result of increased cost of goods.

Unfortunately, and totally out of Frank's control, was the fact that his wife was seriously ill for the better part of 2009. Her absence had a great impact on sales. It also took an emotional toll on Frank as he was forced to deal with both his wife's illness and the day-to-day operations of the business. The business continues to flounder while Frank decides what he is going to do.
Dominating my discussions with Frank were his constant references to the great "potential" of the business under a new owner. I reminded him that a buyer is likely to ask, "If the business has so much potential, why has it not shown up on the financial statements or on the balance sheet?"

The more Frank and I corresponded, the more discouraged he became. When I sent him my tentative valuation, it was prefaced with the statement that I was sure he would be angry or disappointed with me for arriving at a valuation far below what I assumed he was expecting. Here are just a few of the key ratios or factors that impacted my valuation of Frank's firm:

  • 6% drop in sales from 2008 to 2009 (actually, not too bad, compared to the industry at large)
  • 47% of total sales are brokered or sublet, including all offset printing
  • Digital color copying services rely on a Xerox DocuColor 12
  • Cost of sales: 35%; Gross profit: 65%
  • Payroll: 41%
  • One of the spouses does not take out any salary whatsoever
  • Overhead expenses: 37%, including a record-setting high rent of 15%
  • Net profit: -12.3%
  • Total equity (balance sheet): -$432,000
  • Balance sheet includes almost $500,000 in notes payable, a large portion of which is owed to a local bank, and a smaller amount ($60,000) due to the owner
  • Valuation assumes owner will sell fixed assets, retain cash and AR, assume current AP and other current notes, and will retain personal responsibility for all the long term notes payable

Final Valuation of this firm:

  • Valuation, relying upon owner's estimate of the net value of furniture and equipment: $203,000
  • My valuation, using a revised, yet still generous estimation of same: $110,000
  • Projected possible selling price averages all this information and arrives at $156,000

Are You Crazy?

Some readers no doubt think I must be crazy, valuing a business with almost $500,000 in sales between $110,000-$156,000. Believe me when I tell you a valuation such as this, based upon the facts, is actually quite generous. It is quite possible for a business such as this to actually close its doors before it finds a buyer willing to pay what the seller believes is a reasonable price.

Can Frank sell his business for more than the $110,000-$156,000? Sure, he might find a buyer who recently obtained a golden parachute, thus allowing that buyer to take risks he or she might not ordinarily take—the risk being paying more for the business than the raw numbers would indicate. What Frank constantly refers to "great potential," a buyer might consider highly risky.

Even if a buyer willing to pay that price is found, he better have some experience in the printing industry, because he will have to clean house and almost start over with a new team of employees. He will have to find a new press operator, and we all recognize the kind of challenge that represents.

The new owner will also have to upgrade his equipment package; certainly in the digital printing area. The DocuColor 12 was a good machine in its day, but you cannot be competitive or productive with such an archaic copier in today's marketplace. That means a new buyer is probably going to have to spend at least $30,000-$35,000 on a new digital color copier. By the way, Frank values his Doc 12 at $15,000. I valued it generously at $4,000-$5,000.

My candid advice to Frank is to seriously consider taking the business off the market completely, and dedicate himself for the next 12-18 months to turning his operation around. If he does that, there is a real possibility he can add $100,000-$150,000 to its current value. Yes, that means jumping back into the business with a new level of dedication that Frank may or may not have. Of course, even if he does jump back in there are no guarantees. And there still won't be enough time or money to repair all the damage to his balance sheet or relieve himself of that huge note payable to the bank, but at least it would be a step in the right direction.

A Special Tip for Potential Sellers: Have you loaned money to your business so there exists a note payable to officers on your balance sheet? Next payday, instead of taking out money in the form of a salary and, consequently, paying payroll taxes on same, take out the same gross amount in the form of a repayment of loan to officers. This will accomplish two things: 1) You'll improve your balance sheet by reducing a liability, and 2) You will take home more money since the repayment will not be subject to payroll taxes. Of course, ideally you should be doing both, withdrawing a salary and paying down loans to officers. But if you can only do one, the better option is to pay down the company loan.

Goodwill vs. Potential

What about "goodwill" as it pertains to valuing a business? The value of goodwill really comes after the fact, not before it. The value of goodwill is the amount of money a buyer is willing to pay above and beyond the value of the net assets of the company. In the simplest of approaches, goodwill assumes that most ongoing businesses have some value above and beyond the market value of net identifiable assets. It is this excess value that is considered goodwill.
Goodwill is also determined more by the buyer than the seller. Sellers often view goodwill as the value placed on various intangibles (the reputation of the company, the value of the company name, its history in the community, etc.). Buyers look for the tangible results of this goodwill; e.g.: profits, excess earnings, good growth patterns, and healthy balance sheets. Buyers are far more willing to pay for tangible assets than they are intangible ones.

Anytime a buyer sees value in the accounts and is able to project future profits or excess earnings as the result of steps he or she might take, they are acknowledging the existence of goodwill. The seller may tell a buyer that the firm has a great reputation in the community, has a broad customer base and an excellent future, and that these facts contribute to goodwill. However, the reality is the buyer may have a far different take on these factors, and thus arrive at a very different, and possibly lower valuation of the company.

When was the last time you analyzed your financial statements and equipment list and tried to place a value on your own firm? That long ago? For additional commentary on print shop valuations visit my Print Shop For Sale Q&A at: www.printshopsforsale.net/faq.html.