Though value and valuation are fundamental to our economic lives and free-market system, the concepts are misunderstood and constantly misapplied. It can be said that only a precious few possess a true working knowledge of valuation, and from these few come the capitalists who earn 99 percent of the income. They do so by combining their knowledge with risk capital and putting both to work. The personalities are on the front pages of our newspapers and financial magazines.

Why is business valuation shrouded in confusion? Amazingly, our high schools and colleges really don’t teach it — outside of basic microeconomic theory. And contrary to common belief, the basic curriculum for accountants and attorneys doesn’t include business valuation. Most graduate business schools cover only the valuation of publicly traded securities, and many people are surprised to find that bankers aren’t trained in business valuation, and they almost never look at business value when assessing a loan.

Aside from the dearth of clear education on the subject, valuation — and business valuation in particular — has some characteristics that foster confusion.

Value Is Subjective.

Valuation is not exact, but rather subjective. It is like beauty; as they say, ”Beauty is in the eye of the beholder.” What is the value of the watch on your wrist? The diamond ring your spouse gave you? The value of the 1971 Lincoln Continental sitting in your backyard, unprotected, for the past eight years? It was your father’s last car and his prized possession.

Few People Are Exposed to Factual Business Sale Data.

That so few of us own businesses means few experience the purchase or sale of a business firsthand. Businesses are not bought and sold as frequently as real estate or cars, and when they are, the data are both complex and protected as confidential. Conversely, real property sales are almost always made for cash at closing, and the price is of public record (automatically recorded at the county government level).

High Interest + No Factual Data = Misinformation.

For whatever reason, people in our culture are immensely interested in people and money. Business sale transactions involve both. Third parties naturally want to know who and how much. Credible data are often unavailable and so the void is filled quickly by misinformation circulating as fact. Add to this that the buyer or seller may allow or even seed false data that paint him or her in a favorable light.

Complexity of Biz Sale Transactions.

Unlike cars and houses, businesses usually don’t sell for 100 percent cash at closing. It’s very common for the price ultimately to be contingent on events that occur after the date of sale. The portion of a purchase price not paid at closing is referred to as “terms.” As such, the actual sale price is often very difficult to determine. In these cases, the actual sale price can be determined only after all contingent events occur and the “terms” payments are calculated and paid.

Every Business Is One-of-a-Kind.

Most things we buy have very close substitutes. Even a house and used car can be considered to have close substitutes. This makes the task of valuation much simpler. We can compare one to another and sale price history. In contrast, almost all businesses are unique. They rarely have close substitutes. Applying the “comparable sales” method is much more challenging.

So the next time you hear someone say, “Jimmy sold his business for X,” take it with a grain of salt. It’s entirely possible even Jimmy doesn’t yet know the price he received.

Business valuation is the process of assigning a dollar value to a business by estimating what someone would pay to obtain the ownership rights. For the most part, an asset or group of assets has value only if it:

1. Can be sold and turned into cash, or
2. Generates cash.

The former is called liquidation value and the latter is called going concern value.

Going Concern Value.

A business has value as a going concern only to the extent that it generates cash. If a business is to be operated as a going concern (i.e., its assets won’t be liquidated), then its value is a function of the amount of cash or profit it will generate over time.

Liquidation Value.

The amount of net cash obtained by selling the assets of a business piecemeal (not as a going concern) is liquidation value. “Net cash” means the sale proceeds minus expenses incurred in carrying out the sale. For example, the value of a parcel of real estate would be the price for which the asset could be sold, less any expenses of the sale such as commission, legal and closing fees.

Many assets don’t generate income, such as a home that is lived in by its owner, or baseball cards, automobiles, furniture, equipment, etc. Assets, like these, that don’t generate income, have no going concern value — only liquidation value. The value of these assets is determined by the cash that could be generated from their liquidation.

Liquidation Value vs. Going Concern Value.

It can be said that every business has two potential sources of values: liquidation value and going concern value. We use the term “potential” because a business does not necessarily have value of both types. For example, a business that consistently loses money may not have value as a going concern. Theoretically, such a business may have a negative going concern value. But this is meaningless because the owner of such a business would quickly sell it to eliminate the economic erosion. The value received would be the liquidation value, or the sale price less sales expenses.

But it is important to mention that a business that is losing money COULD sell as a going concern (i.e., for more than its liquidation value). This would occur only if a buyer believed that he or she could operate the business profitably as a going concern. For the seller to obtain a price exceeding what could be obtained via liquidation, this buyer would have to be willing and able to pay more than the liquidation value. This would mean the buyer was willing and able to pay the seller for value the buyer brings to the business because of the buyer’s skills, abilities, assets or competencies. Often, shrewd buyers will not do this unless they are worried that a competing buyer might purchase the business or group of assets for a price greater than liquidation value.

The concepts of going concern value and liquidation value also can lead to interesting predicaments. For example, consider a business that has assets that could be liquidated (i.e., “sold off” individually) for $2 million but generates only $100,000 per year in profits. What is the value of this business? If the assets of the business are to be sold off, the value is clearly $2 million. If the business will not be liquidated, then the value is simply the income stream it generates.

So what is the value of a $100,000 annual income stream? The answer depends on: (1) certainty with which the $100,000 will be received in the future (risk), and (2) value today of dollars received in the future (time value of money). Both of these topics will be covered in future issues of The Business Owner Journal.

There isn’t one. At least not a credible one. Some advisors, writers and business owners try to peg a multiple for an industry, but it’s rather arbitrary – even silly. At least for companies with less than, say, $500 million in revenue. Here are the reasons:

1. Factual data about the price and terms at which small and midsize private businesses sell is very difficult to find. This is because the businesses are almost all private and the data are not released to the public. Similarly, the data are not compiled anywhere. There are two exceptions to this:
   • When the acquirer is a public company. This will be a minuscule subset for almost every industry. Still, when these transactions occur, some meaningful data can at times be gleaned.
   • Some “business brokers” will anonymously and blindly submit their “done deal” data to one of two databases of business sales Ð BizComps and PrattStats. Although these data are interesting and “worth a look,” few industries have enough data points to allow meaningful extrapolation. More significantly, the data are not reliably inputted. Of course, this doesn’t stop Inc. magazine from attempting to compile and annually publish valuation data from these datasets.
2. Businesses sell for a wide range of values for a vast array of reasons. Even if ample quality data were available, they would be of little value.

To illustrate point #2, my firm has proprietary data on five business purchase-sale transactions in the metal heat treat industry.

Here are the summary data:

The selling companies’ revenues ranged from a high of $135 million to a low of $600K. Only two of the six companies were profitable. Sale prices ranged from a high of 1.25 of sales to a low of 0.3. For the two profitable companies, the purchase price multiple of EBITDA was 6.1 and 3.4.

Are these data meaningful to the hopeful seller? Well, the range of values is quite large. I guess one could simply shoot for the highest multiples, but this completely ignores the reality of what the market will bear for the particular characteristics of the selling company. Note that Company E in the table, which was not profitable, sold for a higher multiple of revenue than the profitable company C.

If the owner of a heat treat company were offered 50 percent of revenue and 10 times EBITDA, is it a fair price? Should the seller accept it? Again, it depends on the characteristics of the firm. If the subject company has significant revenue that’s growing rapidly, but very low earnings, maybe not. The examples can be infinite.

What if the company that earned the highest multiples in the sample dataset left money on the table because it did not handle the sale in a manner that would yield maximum value?

In short, simple answers to complex questions such as “what price is fair” just don’t serve us well. A credible expert in the purchase and sale of private companies can assess the characteristics of a particular company and estimate market value. Just watch out for firms or advisors that charge large lump sum up-front fees. They have incentive to tell you an inflated estimate to get you to hire them.

Private, profitable businesses that have little or modest growth typically sell for three to five times earnings – depending on the industry, size, proprietary nature of the products and other characteristics of the business. But again, for companies with high or growing revenue and modest profit, these EBITDA multiples may not provide meaningful guidance. High growth can command earnings multiples well in excess of six.

For more data on the drivers of and detractors from value, purchase a copy of Path to Absolute Maximum Sale Price, published by Acquisition Advisors.

Real Estate. In three classic situations, real estate can bite you. First, location is critical, but you can’t convey it to the buyer at a price certain for a sufficiently long time into the future. Second, you are obligated to a long-term lease, but the buyer wants to relocate the business. Third, you own the facility occupied by the business, the buyer wishes to relocate it, and you’re not confident you could find another buyer or tenant.

Unresolved Litigation. Business buyers avoid acquisitions that include assumption of unquantifiable liabilities. Unresolved disputes, litigation and threatened litigation are unquantifiable liabilities. That is, they carry a cost — in both time and money — that’s difficult or impossible to estimate.

Environmental Liability. Business buyers test the ground and groundwater beneath any business they consider purchasing. If contamination is found, the deal is as dead as the tree your letter of intent is made from. If there’s any chance you could have an issue here, consider going ahead and investigating the facts now and remediating any problems.

Assignment of Contract. Anytime a landlord, lessor, franchisor, distributor or licensor must approve a sale or transfer of control, the deal is not entirely in the hands of the buyer and seller. The time to avoid or minimize the clauses is when the agreements that contain them are established, or at the very least, well in advance of an attempted business sale.

Title Issues. Whenever rights to an asset are critical to the ongoing revenue stream or profitability of a business, buyers want total assurance that after their contemplated purchase they will have use of the asset. In some cases, assurance of exclusive usage is required. To the extent that buyers can secure use of the important asset but at an inflated price, the business purchase price goes down commensurately.

Unlicensed Use of Copyrighted Works. If you’re using a software program or other intellectual property on an unauthorized basis, your buyer may not be willing to “risk it” as you have been doing. Most buyers — during the pre-purchase audit — identify all intellectual property used by the company and then investigate whether the company’s use is authorized. If unauthorized use is identified, most buyers want to figure out the total cost of “going legit.” Such may include penalties plus ongoing costs. If the expense can be pinned down pre-closing, the purchase price can be reduced dollar for dollar. If it cannot, you may have a problem.

Debt Prepayment Penalties and Re-Price Triggers. Typically, interest-bearing debt of the seller is paid off in full at closing (by the seller, using monies paid by the buyer). If said debt has a prepay penalty, it could put a dent in the seller’s sale economics. Conversely, if the seller enjoys debt financing that’s attractive to the buyer, so-called change-of-control covenants could spoil the party.

Double Taxation. Uncle Sam takes a healthy cut whenever a gain is realized, but few sellers pull back from the closing table because of the taxes, that is, except when the selling entity is a C-corporation. C-corporation sellers face double taxation when the buyer buys assets. Yes, the seller could require the buyer to purchase the stock instead, but it’s not that easy. Buyers pay less when they are forced to acquire C-corporation stock. There are a few strategies for reducing taxes in a C-corporation asset sales (see “Reducing Taxes in a C-Corp Sale,” May/June 2006 issue), but it’s an uphill battle. The best strategy is to convert to S-corporation status well in advance (eight or more years) of the anticipated sale date.

Minority Shareholders. If you don’t own 100% of your company, your deal could get held up. First, if the parties choose to effect the sale by purchase of stock, any minority shareholder could hold up the deal if you don’t have agreements in place that force them to accept terms agreed to by the controlling shareholders. This is because buyers almost always want to buy 100% of the outstanding stock. Second, minority owners can hold up asset sale transactions if a so-called super-majority provision exists in your governing documents.

When it comes to selling a business for maximum value, timing is everything. Start the process when the business’ performance is trending up, the economy is strong and buyers are aggressive. Get multiple buyers working and you’ve got it made — so long as you’ve cleared away the deal killers in advance.

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David L. Perkins, Jr. wrote this article. Kenneth F. Albright, a tax lawyer and transaction lawyer, partner at the firm of Albright, Rusher and Hardcastle, contributed his expertise.

Most successful business owners are good people. Caring people. I’ve worked with thousands of them.

Jerks tend to implode, eventually. Traits of care, honesty and integrity aid the business owner in surviving and succeeding over the long haul, so most who “make it” are “good folks,” as we say in the South.

Yes, most successful business owners are also driven to achieve material and financial success, but such is not the extent of who they are. They care about the people around them, such as their employees. They contribute to charitable causes.

When the time comes for business owners to sell their businesses, they worry a lot about the impact it will have on their employees. In most cases, I’ve found the owner’s “ideal exit” would have many of the following elements:

• maximum price
• confidential until closed
• all employees keep their jobs at same or better terms
• key manager or manager(s):

  assist in the sale, keep it confidential and earn a bonus at closing

  are hired by the buyer to continue running the business

  gain or increase their ownership in the business

  have a “good” experience with the new owners, who are committed to growing the business

• buyer is “good people” and succeeds in growing the business
• business continues to operate at its current facility or community
• seller retains an ownership stake in the ongoing business and such pays off handsomely

The amazing thing is, all off these are achievable for many business owner-sellers. Certainly, at least, when the business is stable and earning $1 million per year or more in annual profit. The buyers of businesses this size or greater are many, and most want the established management team to remain and continue to run the company.

The biggest barrier to making this happen for a business owner is — aside from finding the right M&A firm that has the knowledge, skill and staff to run the processes and put this type of deal — convincing him or her that it IS possible. That he/she can maximize the sale price AND secure these additional elements. The keys to making it happen are:

• Proper preparation and packaging
• Run a process that works the top buyer candidates simultaneously
• Skillfully communicate and negotiate the seller’s deal term desires
• “Sell” the skill of the management team and its desire to remain
• Negotiate on behalf of the management team

Buyers want to do business with good people. Buyers who trust that the person or persons whom they are buying out will pay more. Buyers who see that the selling owner cares about more than just money, such as the employees, view the seller as trustworthy. Of character. And this is why going for more than just money can result in an ideal sale. That is, a maximized sale price PLUS so much more. Everyone wins: the seller, buyer, employees and the community.

For more on this topic, go to AcquisitionAdvisors.com. Sign up for the free e-newsletter The Quiet Exit. It provides advice on how business owners can go about selling quietly, professionally, for absolute maximum.

As it turns out, buyers have a lot in common. Below is a list of characteristics that, when present in a business, entice buyers to pay more. Conversely, a lack of these characteristics detracts from the price received. These “value drivers” are listed in rough order of importance.

1. Growth: Revenue and profit growth is the number one driver of value. Establish a pattern of growth and you will establish a substantial premium for your business. Of importance as well is rate of growth relative to that of the overall economy and, more particularly, of the industry in which the company participates.
2. Profit and Profit Margins: Buyers buy businesses to make money. The higher the established profit, the more the buyer can and will pay to obtain those profits for his or her benefit. Profit margins are important as well. Are they higher than the industry averages? Gross and operating profit margins that consistently exceed industry averages will command higher values.
3. Customers: Diversification of customers and customer tenure, loyalty and credit worthiness are important considerations when valuing a business. What would the impact on the company be if the largest customer were lost? If the answer is very little, then the company has virtually no customer concentration risk and, therefore, a higher value will be merited. If the answer is substantial, buyers won’t want to bear that risk without being handsomely compensated for doing so. Generally, if a company does not have a customer that accounts for 10% or more of revenue or profit, then there is little concentration risk.
4. Management Quality and Depth: Buyers are concerned with whether the proven profit stream will continue after purchase. To the extent the business has a diverse group of top managers and employees that will continue with the business, the buyer’s perceived risk will decline. The result is a willingness to pay more for the business. Management depth, quality, tenure, experience, success record and education are all criteria of importance.
5. Healthy, High-Growth Industry: Industry health and growth makes it easier to grow revenue and profits. Equally as important, competition tends to be not as fierce in expanding industries. There is enough business ‘to go around’ … so profit margins are higher. Find and serve an expanding industry and your job will be easier … as will your sale price. The stronger the industry, the higher the values.
6. Multiple Industries: If the product or service offerings of a company are sold into multiple industries, a higher value is justified. The business can grow to twice the size (assuming each industry niche is of equal size) and enjoy meaningful industry diversification. For example, a maker of titanium tubing has traditionally sold to industrial customers, but has recently successfully penetrated the sports equipment marketplace. This business will command higher values.
7. Proprietary Products: The more proprietary in nature of the products or services, the higher the value. In other words, is what you offer unique to anything offered by anyone else? Unique, of course, in a way that is meaningful or valuable to a certain customer group or groups? For example, a non-exclusive distributor enjoys little differentiation or protection from pricing pressure, whereas a manufacturer of a proprietary line of products should enjoy a more defensible market position and … higher profit margins.
8. Product Mix and Diversification of Gross Profit: The greater the number of products and services the company sells, and the greater diversity of contribution to overall gross profit, the lower the risk inherent in business. Businesses with a healthy product mix and good gross profit diversification deserve and earn higher valuation multiples.
9. Market Niche; Market Position; Brand Awareness; Identity: If a company fills a definable niche, commands a special leadership position in a niche or niches, or has strong and favorable brand awareness in its market, the business probably enjoys higher profit and growth rates. As such, buyers will pay more.
10. Low Debt: While debt is not really a value driver, it substantially affects the net-cash received by the seller. When a business is sold, the seller basically sells the net equity of the business. Whether the sale is affected via a sale of the business’ assets or shares of stock, something must be done with the debt of the business. If the buyer assumes the debt, he or she will do so as a form payment to you, lowering the cash you get at closing. Further, in an asset sale you’ll owe federal and state taxes on the amount of debt assumed by the buyer. If the buyer does not assume the debt, the seller will have to pay off the borrowing WITH AFTER TAX DOLLARS.
11. Interim Results: Buyers are interested in what the business will do in the future. The best indication is the present. Strong current performance can justify higher prices, and a dip in performance will quickly deflate value.
12. Off Balance Sheet and Contingent Risks: Risk and uncertainty lower values. If elements such as the following exist, correct them … or wait for the issue to subside … before attempting to sell your business:
    

    • existing or pending litigation.
    • real or possible environmental liabilities.
    • lease problems or uncertainties.
    • industry or market uncertainty.
    • customer concentration.

13. Future Maintenance Costs and Capital Expenditure Requirements: For the business to earn the profits projected by the buyer, or to continue to expand, how much money must be spent? Can the existing assets and staff handle the production requirements for the foreseeable future, or will new dollars have to be spent to replace, expand or … worst case … relocate? Future capital expenditure needs will have to come out of future profits, lowering the value of the business.
14. Quality of Financial Information: Financial statements present the financial condition and performance of a company. To the extent that a buyer feels certain that these reports are accurate and may be relied upon, his or her perceived risk will be low. So, keep detailed and accurate books and records that will breed comfort and confidence in them. The result is a willingness to pay more for the business.
15. Appearance: Does the business “show well?” Is it attractive in appearance? Is the facility clean, painted and bright? Does the office appear clean and organized, or cluttered and unprofessional? Are the logo, marketing materials and website up to date and convey a positive, vibrant image? Just as a clean and waxed car sells for more, so will a business.
16. A Growth Plan: Buyers are interested in the future. Lay out a path for significant future growth and profit and … if the buyer believes he or she can make it happen … he or she might be willing to pay more. At times, much more.

The above list is not meant to be all-inclusive, but is fairly comprehensive in scope and touches on the key areas of value and risk typically investigated and considered by buyers of businesses.

Build a Brand: Brand is your company’s personality, or your product’s. It’s who you are and what you stand for. Just as people remember and want to associate with people who have real personality, customers patronize companies that have style and stand for something. They like the comfort of knowing what to expect. Companies with a strong, unique brand get noticed, attract new and loyal customers, and get more traction for each marketing dollar.

Innovate, Don’t Emulate: “Me too” never gets you much. Nobody’s willing to pay a premium for commodity products or services. But develop new products, services, and solutions, and introduce them with excitement and you’ll enjoy the spoils that only leaders and innovators get.

Penetrate New Markets: You’ve built a business serving a niche market. The easiest way to supercharge revenue is to take those same products and adapt them for a new, larger market.

You’ll have to work hard on devising a smart marketing plan, and might have to make changes to tailor them for the new audience, but most of your development costs will already have been covered, so when sales start to take off, the lion’s share of gross profit will fall to the bottom line.

Invest: Growing rapidly soaks up cash. In fact, growth is impossible without either re-investing profits or obtaining capital from other sources. If you’re not prepared to take the risk of doubling down on your investment, you’re not ready for breakthrough growth.

Experiment: Andy Grove, founder of Intel,says, “Business is just one great big experiment.” Great new discoveries aren’t found by playing it safe. The only way to find new, superior methods is by trying new things and being willing to fail. And as Roger Von Oech says in Whack on the Side of the Head, the best way to get a great idea is to get a lot of ideas.

Learn from Others: The world is full of examples of breakthrough success. Spend your time learning about what others have done to achieve it, and consider how those ideas might be applied in your business. Attending your industry trade show is a must, but innovations that sweep through one industry might take a while to jump to others. Why not periodically go to lunch with a leader in another industry and pick his or her brain about innovations? You could even attend the trade conference of another industry.

Hire Thinkers, Visionaries, Dreamers: Some people are born with a mind for innovation. Some are born with a need to put the pedal to the metal. Hire these people. Listen to their ideas and give them opportunities to explore and experiment. Develop a culture of innovation, risk tolerance and rejection of the status quo.

Quality Control: Customers must know what they’re going to get from you. And as you know, disgruntled customers talk and tell with much greater verve than happy ones. That is why great companies work hard to standardize and control the customer experience. Look at Starbucks. Every store looks the same. A cup in Chicago tastes the same as a cup in London.

Focus: Determine what you do best and stick to it. Don’t create confusion among your customers and employees by offering products or services not in your core area of expertise. Domino’s Pizza is a great example. They deliver fast. They don’t sell quality or price but “deliver in 30 minutes or less.” Home Depot is another great example. They could sell just about anything in their huge, well-located warehouses. But they sell only home and garden supplies. When you need home and garden supplies, you know exactly where to go.

On the other hand, Sears tries to be everything to everybody, an approach that simply does not work today. Stake your claim on a niche, stick to it and focus on getting better at it every day.

Go After Large Groups of Customers: If you’re going for breakthrough growth, go after a large target group of customers. It’s just common sense.

Go Where There Is Less Price Sensitivity: Less price sensitivity means higher margins and in most cases faster sales cycles. You can achieve this by developing products that are unique and that deliver value well in excess of the price, or by going after customer groups more interested in values such as convenience, safety, or status, than in price.

Scalability: When your sales start taking off, will you be able to deliver the goods in a timely manner? The ultimate in scalability is software delivered by Internet. So long as you have a server that can handle high volumes of orders and downloads, volume can explode and nearly all the profit will fall to the bottom line. This is what you want. Hourly consulting by a respected expert is not very scalable. Put the expertise in a book or software package and now the expertise of the consultant is scalable. The ultimate example of lack of scalability comes from my uncle. During the crazy dotcom days he excitedly shared that he had worked out a deal to sell via Amazon the hand-crafted duck calls of a renowned duck-call whittler. My uncle would pocket about $20 each. After a moment I asked my uncle, “How fast can this guy whittle?”

Master the Art of Alternative Marketing: Few small businesses can afford to drive growth using traditional marketing such as television, radio and print ads. The good news is that there are, and always have been, alternatives. At least for those that can think out of the box. And today there are more alternatives than ever with the rise of the multitude of new forms of electronic communication. Yes, small companies seeking high growth can find it, and in most cases have no choice but to find it, through smart and savvy forms of alternative, bootstrapped, niche marketing that can produce great bang for the buck.

For example, many companies are finding success in direct-response type advertising using Google or Yahoo, which can be very cost-effective because one pays only for action (i.e. per ‘click’). As Neil Schaffer explains, demonstrations and free tasting — in stores or at trade shows — can also be a good way to showcase a new product or even a prototype. If one can couple the demo with press coverage, testimonials, focus group type feedback, coupons or even purchase orders, then by killing more than one bird with one stone can make the ‘free’ activity very cost-effective. Finally, legendary liquor entrepreneur Sidney Frank built both Jägermeister and then Grey Goose into billion dollar brands by shunning traditional marketing and going directly to the college campus (Jägermeister) and high-end bars and fashionable parties (Grey Goose) and “demonstrating” the product to consumers and bartenders.

To achieve radical growth, you have to try many of the above ideas, but the main thing is to be innovative, imaginative and different. And when you think you have it, back it with enthusiasm, energy, a great catchy marketing plan, and a good bit of capital. It’s done every day in the world. You might as well do it, too.

Every business buyer wants to know, “Mr. Seller, are you going to be working for us or against us?” Without certainty that it’s the former, few buyers will be willing to purchase at any price.

There are also two related but altogether different issues at play:

1.    What is the true interest, or desire, for the seller going forward?

2.    What are the legal rights of the seller going forward, or constraints therein?

Buyers want to know the answers to both questions.

The first question is important but more difficult to assess. The second is easier to assess, but its importance swings with the degree to which certain post-closing actions could harm the buyer/purchased company.

Seller Non-Compete Agreements

Business buyers should be very cautious not to place too much reliance on legal protection provided by a non-compete with a seller. Many a non-compete has been rendered unenforceable by the courts when challenged.

Why? Because one of the basic freedoms that our laws grant us, as humans, is the right to employ ourselves and support ourselves by engaging in commerce. Free trade.

While courts have been more willing to uphold non-compete agreements that arise in business purchase/sale transactions, skilled legal advice is absolutely essential for business buyers wishing to protect themselves with a non-compete type of agreement.

Similarly, business sellers need to think long and hard – and consult with legal counsel – before agreeing to forgo their right to freely ply their trade and enter into commerce.

Among the myriad of issues that the business buyer will want to nail down in the non-compete agreement with the seller:

• undisputable documentation of ample payment in exchange for a seller’s agreement not to compete

• limited time of non-compete (2 or 3 years)

• limited geographic area

• limited industry sector

Courts of law will throw out a non-compete in its entirety if they deem the agreement too broad, long or onerous on the seller.

Tax Implications

Also at issue with non-compete agreements is taxation. Non-compete agreements are generally taxed as ordinary income to the seller (less than desirable) and expensed as incurred by the buyer (more favorable). But in some cases, the seller may be able to gain capital-gain taxation (favorable) by wrapping the non-compete payments into the general goodwill of the business and/or labeling and justifying all or a portion of the payment as “personal goodwill.” In these cases, the buyer would be prohibited from expensing these payments as incurred (not favorable) but amortizing them as goodwill payments.

In this way, how the non-compete is structured becomes a negotiating point between buyer and seller.

Deals are complex, risky and time-consuming. Smart buyers and sellers will be aware of these issues and deal with them in a way that maximizes their interest. It starts with educating oneself and obtaining skilled and experienced specialized assistance.

In cases where such is required by a governmental agency, lender or bonding company, the answer is pretty simple – you have to pay to play. But for the vast majority of business owners, it’s a choice. The correct answer to “should I” is not readily apparent. It’s a judgment call.

First, by way of review, the issue is one of “quality of financial statements.” Of course, by “financial statements” we mean your income statement, balance sheet and statement of cash flows. Generally, compiled statements are deemed to be of higher “quality” than company-prepared statements. Reviewed statements are viewed as higher quality than compiled, and audited statements are viewed to be of higher quality still. Here’s a description of each:

Company-Prepared Financial Statements: Also referred to as internally prepared and/or management statements, these have not been organized, reviewed or validated in any way by a certified public accountant (CPA). Of course, your accounting firm could have helped you set up your accounting system and the methods you use to keep your books and generate your statements. Or you could be an accountant yourself and your company-prepared statements are well-organized, prepared according to GAAP, and represent fairly in all respects the performance and financial condition of the business. But unless an accountant or accounting firm compiles, reviews or audits the statements, they are simply company-prepared and – given that no independent person of authority (i.e., certified public accountant) attests to their “quality” – investors and creditors have little way of knowing what methods were used to prepare them or how fair or accurate they are.

Compiled Financial Statements: These are financial statements that have been created by an accountant or accounting firm from the company-prepared statements. The firm simply took the information provided by the subject company and created financial statements that conform to how statements are supposed to be organized. “Supposed to look like” is dictated by GAAP. Compiled statements don’t carry any warranty or pledge of any kind by the accountant or accounting firm as to accuracy or whether or not the books were maintained or developed in conformity with GAAP. In essence, one could say compiled statements are just made to look pretty and professional. And, as we know, this is worth something since people judge a book by its cover.

Obtaining a compilation for a small or midsize private company might cost between $1,000 and $7,500, depending on the audit firm, geographic location and complexity of the subject business.

Reviewed Financial Statements: As the name implies, reviewed statements have been reviewed by an accountant or accounting firm. The extent of the review is limited, not nearly as thorough as a full audit. Reviewed statements should and will include a letter from whomever did the review. This letter will explain the extent of the review, notes about how or where the statements may deviate from GAAP, and any opinion or representation that the reviewer can provide about the statements. When reviewing reviewed statements, one should keep in mind that a review is limited and does not guarantee accuracy.

Obtaining a review for a small or midsize private company might cost between $4,000 and $20,000, depending on the audit firm, geographic location and complexity of the subject business.

Audited Financial Statements: Audited statements have undergone in-depth review and testing by a qualified third party. Similar to reviewed statements, they should be accompanied by a letter from the auditor. Among the important things revealed in the letter is the extent to which the auditor is able to render an opinion of the accuracy and fairness of the statements. An unqualified opinion means that the accountant has no reservations or concerns. As far as third-party assurances go, an unqualified audit opinion is the highest level of assurance about the quality of a firm’s financials. A qualified opinion means otherwise, so take caution.

The audit firm also issues a letter to management, which can be helpful to the owners and managers, and contain suggestions for improving accounting methods and processes.

Obtaining an audit for a small or midsize private company might cost between $7,000 and $50,000, depending on the audit firm, geographic location and complexity of the subject business.

Even GAAP Leaves a Wide Gap
Business owners, investors and creditors should keep in mind that two identical businesses could generate financial statements that look very different. Furthermore, both could receive unqualified audit opinions. How could this occur? Well, quite easily, really. GAAP allows considerable room for management to interpret and apply GAAP rules, primarily because many of the rules require management to assess situations and apply the rules accordingly. To be sure, different people see situations differently. One executive could deem a receivable highly collectable while another feels strongly that the account is at risk. The accounting would likely reflect the divergent views. Similarly, one firm could be aggressive in how it applies the rules – in an attempt to show maximum current income, for example – while another set of managers could be conservative and less motivated to maximize today’s book profit and/or equity.

Quality and Credibility of the Auditor
As we all learned in the 1990s, the credibility and quality of the audit firm is an all-important factor. Arthur Andersen audited the books of Enron (among others) and year after year issued unqualified opinions. We later learned that its accounting was an abomination. Those who relied on the statements, and trusted the opinion of the auditor, lost billions.

As another case in point, in a recent M&A transaction (i.e., business purchase/sale) that I was involved in, the selling company had an audit. All things being equal, the existence of an audit is a good thing to the extent it adds to one’s ability to rely on the statements to present a fair picture of the financial health and performance of the business. This was true in this case, but the buyer also noted that the audit firm was not one we recognized or could easily find much information about. Not even a Web site.

Then, early in due diligence, the buyer found that the cost of the audit was well below standard rates – another red flag. So the buyer conducted his own audit and found material deviations from GAAP. The auditor was a solo artist and old friend of the controlling shareholder of the selling company. In the end, there really was no audit conducted. Still, the books and records of the business were fairly well organized and buyer was able to assess the business, develop his own view of its performance and health, and eventually complete the purchase.

For the Business Sale?
I commonly hear business sellers say, “I got an audit because I was told buyers require it.” Well, I’ve worked on a lot of business purchase and sale transactions, and my experience is that selling firms do not need an audit. First, few small and midsize private companies have reviewed or audited statements. As such, buyers of small and midsize companies (along with their debt and equity sources) are used to dealing with company-prepared financials. Second, whether or not the selling firm has compiled, reviewed or audited statements, the buyer will have to investigate how the selling firm prepares its books. No buyer will just rely on the audit stamp as proof that the financials are “fair.”

And so, I would say that – for the business owner who wants to sell his or her business in the near future – reviewed and/or audited statements are a “nice to have,” not a “need to have.” The bigger issue is the overall health of your business and whether your books are kept according to GAAP and in a fair and reasonable manner. Buyers just want to know how much money the business is making. So long as you can help them get a pretty good feel for this, your accounting and financial statements will serve their purpose.

For General Principles?
For many businesses, there are no clear and convincing reasons to pay for improved financial statements such as a compilation, review or audit. And so, I think it comes down to personal preference. Some business owners like to do everything “first class.”

“We do things like the big boys,” I think I heard one business owner say as he proudly presented his audited financials.

To be sure, it’s not going to hurt. The question is what is the highest and best use of those dollars? In some cases, maybe it’s an audit? Or in some cases, one might be able to consider it more of a personal expenditure of the owner. Let’s say the audit has no real business purpose and the business owner would not pay for it unless there were excess profits to be had. So, in this way, the business owner could take the $50,000 out of the business as a return on investment or pay for the audit. The business owner can do whatever he or she wishes with his money – save it, buy a boat, give it to charity or buy an audit.

Do you have an opinion on these matters? If so, send them to editor@thebusinessowner.com. We’ll share them in the next issue of The Business Owner.

Brent Johnson, assurance partner with HoganTaylor, contributed his expertise to this article.

In asset purchase, the buyer purchases “the business” by purchasing every single asset used by, necessary for or “making up” the business. By doing so, the buyer ends up in effect owning the entire going concern. A business, after all, is simply a bunch of assets brought together and used by the owner and employees to produce goods and/or services.

Purchased assets often include desks, computers, pencils, calculators, staplers, tools, equipment, furniture, fixtures, cars, trucks, inventory, etc., including the rights to software, customer lists, accounting packages, vendor lists, web domains, websites, trade names, logos, marketing materials, phone numbers, etc. The purchased assets are listed in the purchase agreement, as are any excluded assets (i.e., listed as “excluded assets”), and most buyers will include in the purchase agreement language that explains that the purchased assets can be broadly defined as all of the assets of XYZ business (less any asset that is expressly excluded).

Of course, the buyer will also need to make arrangements to secure the employment of any employees he/she may want to continue to work in the business. This is not difficult to accomplish. Similarly, whether the facilities are leased or owned, the buyer needs to reach an agreement, or agreements, to secure use of the facility – assuming the buyer does not intend to immediately relocate it. Furthermore, to the extent there are other important agreements or contracts that the buyer wants to continue to enjoy or work under, such will need to be provided for – whether by assumption, transfer or negotiation and execution of entirely new agreements. Common items are phone service, utilities, sale representative agreements, supply agreements and credit agreements.

In stock purchase, the mechanics are much easier. The buyer simply buys the stock (or LLC units or S-corp shares, whichever is the case) of the legal entity that owns all of the business assets. This, of course, assumes the business is in fact held in – or owned by or within – a legal entity (i.e., is not a sole proprietorship).

Stock purchase virtually eliminates the need to transfer title (i.e., purchase) to all of the many different assets used in or by the business. It also can eliminate the need to transfer, renegotiate or reapply for things such as permits, utilities, facilities leases and employment agreements. Of course, some contracts may have so-called “change of control” provisions that will require special attention.

Liability Considerations. Business purchases effected by stock can be more challenging for the buyer from a liability containment standpoint. It can be more difficult for the buyer to avoid assumption of unwanted, or unknown, liabilities of the purchased business. For this reason, stock purchase transactions can be riskier and also require higher levels of
due diligence.

Tax matters. Taxes are a major consideration in business purchase transactions. This is because taxes cost real money and impact cash flow and rates of return. Business purchases effected by the asset method almost always provide for lower taxes for the buyer going forward. This is because the asset purchase allows for a step-up in the tax basis of the assets and, in turn, generates depreciation deductions. Business sellers, on the other hand, typically have to pay higher taxes on asset sale transactions, so these issues become points of negotiation – even contention – between buyer and seller.

Of course, virtually any liability may be transferred back to (or retained by) the seller by contract (i.e., in the purchase agreement), so just because a purchase is effected by stock does not mean that all pre-purchase liabilities will be borne by the buyer, but it would require considerable seller cooperation and skilled crafting of the definitive agreement.

IRC Section 338 Election. Although there can be some advantages (mainly ease of title transfer) to the business buyer who effects a purchase by stock, most prefer the asset method for the reasons mentioned above (liability containment and tax advantages). Similarly, in some unique instances, the seller is indifferent as to method, but most often the seller prefers a sale by stock (for tax reasons).

Sometimes in these situations, Internal Revenue Code (IRC) Section 338 is useful. This federal tax law allows parties to elect a stock-method business transfer taxed as if it were an asset purchase. The trick is the buyer has to pay the tax bill that arises from the step-up on the basis of assets, which occurs under asset purchase transactions (or, of course, stock purchase transactions taxed as asset transaction by an IRC Section
338 election).

Why would a buyer agree to this and also take on the stock sale liability issues? Well, only if he, she or it has incentive to do so. For one, the buyer would have to get comfortable with the liability issue. Two, the buyer would have to feel okay about the tax bill. Such can occur if or when the seller provides the buyer with incentive to do so, for example, a reduced purchase price. The tax bill issue also can “go away” in instances where either the purchased entity or the purchasing entity has tax losses that can be used to shelter the gains.

Buying a business is a very serious, complex matter. Seek the advice of legal, tax, and merger & acquisition experts such as Acquisition Advisors (www.AcquisitionAdvisors.com).