Quick Consultant: The Peril of Unrealistic Expectations for Business Valuations

Editor’s note: All names in this article are fictitious.

 

The buyer made a solid offer to purchase Dave Johnson’s printing business. The buyer offered him $285,000 for the business and said he had arranged all his own financing. Dave would not have to take back any notes. The best news was the buyer could settle within 30 days.

Oh sure, there were the typical arrangements to be made, including Dave staying on for a period of time to train, but all in all it was a very clean and fair offer. At least that is how the accountant, the broker, the attorney, and I felt. We all advised Dave to accept the offer.

I will tell you more about the business in a few minutes, but for right now suffice it to say that Johnson’s Printing & Graphics reported sales of $805,000 in 2010. What about previous sales and sales trends? Johnson’s printing firm reached $1.1 million in annual sales in 2005, but then began to experience, like so many firms in this country, a slow decline in sales. Of course, he blames most of the drop off in sales to a sluggish economy. Not sure I will accept that, but I will hold most of my comments for later.

Despite the feelings of the accountant, the broker, the attorney, and the candlestick maker that the offer was fair, there was one individual who was adamantly opposed to the offer—Dave.

“I can’t believe someone is making an offer that low. It’s an insult. I’ve worked to build this business up over 14 years, and so has my wife, and I can’t believe someone is only willing to offer me $285,000 for a business doing almost $1 million in sales,” he said. “Hell, I would rather just shut the doors and walk away than to sell for that small amount.”

 

Some of the Valuation Details

When I heard about Dave’s reaction, I was disappointed. Dave reacted the same way as so many other owners who have decided in the past couple of years to get out of the business. They react in anger or frustration after realizing that the business they have worked so long and hard to build isn’t worth what they had been counting on for retirement.

Dave and his wife simply refused to believe the numbers we were presenting and the valuation approach we were using. Although he strongly disagreed with our valuation, Dave was unable to provide a logical formula to justify the $400,000 price tag he had placed on the business.

First, Dave kept referring to the business as a million dollar business. Well, it may have done a million in 2005, but we don’t value the business on past performance, certainly not on sales achieved five years ago. If we were to “weight” Dave’s past sales and profits—something we don’t believe in—it still could not be referred to as a million dollar business. The facts are the business is currently producing $805,000 in sales and there is no assurance whatsoever that sales will ever return to 2005 levels.

 

Valuing Future Potential?

Every so often during our earlier meetings, Dave would say that a new owner could easily get the business back over $1 million. “Someone with the right talents, especially in sales and digital technology, could really take this business to the next level,” Dave said repeatedly.

I kept telling Dave that he couldn’t expect to benefit from the talents brought to the firm by a buyer. In essence, you are expecting a buyer to pay you extra for the talents he or she is bringing to the table. That’s not likely to happen.

One more thing you should know. There is a difference between value and a fair market selling price. The fair market selling price is nothing more than a meeting of the minds as to what the buyer agrees to pay the seller. In almost all cases, the buyer is buying the assets of the business, less those assets retained by the seller. Buyers rarely agree to assume notes and other liabilities of the business. Assumption of leases is probably the one exception. Many buyers will agree to the latter.

Value, on the other hand, is the total amount that the seller will realize, not only from what he receives from the buyer, but also from what he will retain after settling up all the key assets and liabilities on the balance sheet.

In Dave’s case, he will net an additional $56,000. How? Well, Dave will keep $118,000 in current assets (most cash, savings, and accounts receivable), and and he will agree to assume responsibility for $62,000 in current liabilities (accounts payable, sales tax, credit cards, etc.) Fortunately, there are no long term notes or obligations.

 

Questionable Receivables &

Payables

If Dave collects all of the receivables and pays off all the liabilities, he will net $56,000. Add this net gain from the balance sheet to what he has been offered for the business ($285,000) and the total value of Dave’s business is $341,000. Dave is actually quite fortunate in this regard since many sellers are upside down when it comes to the balance sheet—owing far more under liabilities than they have due back to the company—especially so after deleting a lot of questionable accounting entries.

Have you borrowed or withdrawn money from the business in the past (with little intention of paying it back) and it now shows up as a long term receivable, which consequently inflates owner equity? If so, you need to consider this when evaluating the the health of your business. So does your accountant!

Let’s look at the other side of the coin. Instead of taking money out of the business, let’s assume you loaned your company $45,000 in 2006 when everything started to slow down and you couldn’t make payroll. Worse, that $45,000 has grown over the past five years and is now $78,000, which appears on your balance sheet under short and long term liabilities as a note payable (with interest) to stockholders for that amount. Once again, you need to check with your accountant as to how this can be cleaned up. If there is little chance that the business will ever be in a position to pay it back, then it would be better to simply write it off on the balance sheet.

Face the fact that most buyers will simply not recognize a note payable to stockholders or owners, nor will they consider notes receivable from stockholders or owners when they appear under current or long term assets. The latter does nothing more than to artificially inflate the total assets of the business. If your company owes you money, then you need to settle that now, not later.

 

Our Valuation Approach

Below are the figures and logic behind our valuation of $285,000 for Johnson’s Printing & Graphics.

• Gross Sales: $805,000

• Calculated Owner’s Compensation*:

$92,400 - $103,500 (11.5-12.9%)

• Fair Market Salary for Owner/Buyer:

$54,516

• Net Assets to Be Sold: $145,000

• Annual Cost of Net Assets: $14,500

• Excess Earnings: $23,384 - $34,484

• Excess Earnings Multiplier: 4.85

• Excess Earnings X Multiplier:

$113,412

• Recommended Selling Price Range:

$258,412 - $312,247

• Average of Range: $285,330

* Total compensation for one working owner includes profits and salary, perks, benefits, and taxes paid to one working owner. It should never include that amount paid to a working spouse. Cannot include unreported cash. Be very conservative when calculating owner’s compensation. See “Print Shop for Sale” for details.

Space simply does not allow room for a full explanation of the Excess Earnings Approach; the method used to arrive at this valuation. Suffice it to say that, after a careful examination of all the facts, we suggested to Dave that a fair price for his business was $285,330.

Note that I did not say “asking price.” Although we were confident with the $285,330 valuation, we suggested he place the business on the market for $320,000, noting owner financing available. We assumed and anticipated that a careful buyer would make an offer, then the buyer would counter, and finally both parties would end up at this price.

Well, Dave told us all we were crazy. We reminded him that he would also get an additional $56,000 after settling up all assets and liabilities. He left our meeting in a huff and listed the business with another broker for the asking price of $450,000.

Obviously, if you have convinced yourself that $450,000 is a fair asking price, then any offer of $300,000 or less, no matter how thoughtful or justified it might be, would still be interpreted as an insult. So Dave’s reaction wasn’t a big surprise.

The ongoing problem is Dave’s inability to financially justify and explain why he thinks his asking price is reasonable. When asked to explain how a potential buyer could pay himself/herself a salary and have enough money left over to make the payments to Dave over a three to five year period of time, he just shrugs it off. “Not my problem. I did it, so should a new buyer.”

Apparently, Dave, like so many others, thinks that a buyer should not necessarily expect to withdraw a reasonable salary as a working owner while paying off the business. Well, I'm sorry, Dave, that just doesn’t compute, at least not for intelligent buyers. Now tell me again how a buyer will buy the business from you?

 

Still Waiting and Waiting…

Everything I’ve told you so far is absolutely true and based upon a real firm. The ratios and dollar amounts are very close to the real world situation. The only thing I haven’t told you so far is that all of this transpired nine months ago.

Dave did indeed turn down what we considered a legitimate purchase offer. The buyer ended up buying another printing firm in a nearby community. For a while, Dave stopped talking to the broker and was angry at me and his accountant. The original broker was equally upset and he stopped pushing or promoting Dave’s business. Yes, the business is still listed, but to the best of my knowledge, he hasn’t even had a nibble in the past few months.

Worse, with the economy still very soft, and with his growing reluctance to sink anymore money into the business, it looks like sales for Johnson’s Printing & Graphics will drop considerably below the $800,000 mark for 2011—the first time it has done so in 10 years.

Dave and his wife had planned to spend this summer up at their lake cottage, but instead seem to be working harder and harder just to keep sales where they are. Payroll is once again getting harder to make, and they seem to argue more than ever before. It wouldn’t surprise me one bit if a divorce was on the horizon. Businesses will do that to you.

For further information (not a sales pitch) visit www.printshopsforsale.net where you will find a Q&A section dedicated to valuing the typical printing business.

Senior contributing columnist John Stewart is president of Q.P. Consulting. He is co-author of the industry best seller “Print Shop For Sale” (www.printshopsforsale.net). Follow John’s blog on his website at www.quickconsultant.com. Contact him at 2110 S. Dairy Road, West Melbourne, FL 32904, call 321-727-2444, or email qkconsult@aol.com.

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