How to Sell Your Business

Featuring Lutts’ Logic:

How to Sell Your Business

Who Can Help You Do It

A Great Young Growth Company

First, thanks to all the readers who wrote to say you liked my hitchhiking memories last week.  Interestingly, there was no negative feedback, and that’s rare!

Today, in part to balance that lighter topic, I start with a serious story about business, which will be particularly interesting to owners of small businesses.

I frequently get mail from business brokers who want to help me sell my business, and I always throw it away.  I consider Cabot to be a family
business; we’ve been serving individual investors for 38 years and I expect we’ll keep on doing so for decades to come.

But I recently took a phone call from a salesman who was very good at his job.  He invited me to an all-day seminar west of Boston that would provide attendees with detailed, valuable information about how they should prepare their own businesses for sale . . . regardless of whether they used his company or not.   I told him that my business was not for sale, but that I might be able to write about the topic for my readers.  He said that was fine with him; he’d still like me to come.

So I went to the seminar last week, and here’s what I learned.

When the average business owner sells his company, he does it all wrong.  He targets a buyer, often a larger competitor.  He hands over his tax returns, income statements and balance sheets for the past few years.  And he decides on a selling price by using a basic formula for business valuation based on either revenues or earnings, often fine-tuning it by referring to other transactions in the same industry.

The formulas say a healthy business might sell for between one and two times revenues, or four and eight times earnings.

But the result of relying on these formulas, according to the seminar’s presenters, is that 75% of private businesses are sold for less than they’re worth.  And the reason is simple.  Most owners don’t know what their business is worth!  Furthermore, when it comes to selling, they’re amateurs, often doing this for the first time.  Contrarily the buyers are often professionals, who’ve done it before.  So you know who comes out ahead in those deals.

As Warren Buffet put it–and you know he’s bought plenty of companies–“If you don’t know the value of your business, I’ll steal it from you.”

I’ll tell you the “right” way to sell your business below, but first let me say a little more about the seminar.

There were 27 of us business owners in attendance.  We were chosen, according to the presenters, because businesses of our type are in demand today.  And we were found through the Hoover’s division of Dun and Bradstreet, based on SIC (Standard Industrial Classification) codes and geographic location.  Businesses in demand today include health care companies, service companies, data processing companies and transaction processing companies.  Not in demand–and presumably not represented in the room–are construction firms, heavy equipment companies and travel agents.

But I couldn’t be sure, because we were strongly advised not to talk to each other about our business!  You see, if word leaks out that a company is being sold, the suppliers worry; they may stop extending credit.  The employees worry; they may start polishing their resumes and jumping ship.  The customers worry; they take their business somewhere else.  And the competitors see it as an opportunity to steal those customers away.  So it’s vitally important that the process of selling a business remain secret throughout the whole transaction.

What we did share, aside from first names, were the ages of our businesses.  A few were less than five years old.  The majority of businesses were between five and 20 years old.  One was over 40, one was over 50, and one was 105!

To the company running the seminar–whose name I will reveal later–each of our businesses was potential inventory.  They wanted to put us on the shelves of their store so that their browsers would become buyers.  In an average seminar, 20% to 25% of attendees do become clients … or inventory.

And who are these potential buyers?  Interestingly, they tend not to be competitors of the firms they buy.  In fact, they tend to be companies looking for diversification. Roughly 80% of the time, the buyer is in a different industry!

In its database of buyers, this company has 47,800 public companies, 811,000 private companies, 11,000 private investment groups, and thousands more (I missed the number) private equity groups.  The typical buyer buys 10 companies a year. . . by examining hundreds.  As a result of this network, and its expertise, this company is the #1 broker of businesses with values under $25 million, and the #2 broker of businesses with values under $50 million.

In short, they’re good.

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So what is the right way to sell your business?

First, you recast the income statements for a few prior years.  Recasting is the perfectly legal method of taking out the expenses that disappear when the owner disappears . . . minus the cost of replacement.  This includes the owner’s salary, health insurance, auto expenses, country club fees, travel, entertainment, dining, etc.  Also, overpayment of certain long-time employees, charitable contributions, advertising that’s really community charity (like Little League sponsorships), personal mailing expenses, legal fees, accounting fees and, finally, cash that goes from the register straight to the owner’s pocket.  When these are all taken out, the profits look a lot bigger.

Then you recast the balance sheet as well, adding in intangible assets like branding, computer database, copyrights, delivery systems, distributorship, experienced staff, franchises, know-how, licenses,
location, low employee turnover, loyal customer base, mailing list, name reputation, supplier base, technology, tooling, trademarks and training procedures.  When these are added in, the balance sheet looks a lot healthier.

Then you create a five-year pro forma, a projection of the company’s financial future as it can be achieved with a new owner’s capital.  In short, you “Explain the past, sell the future.”

Then, using traditional methods of valuing discounted cash flow, you calculate the present value of the enterprise.

But that’s the not the price you ask a buyer to pay!  You want to sell your business at a premium to its enterprise value.

And how do you do that?

Most importantly, sell at the right time, when the market is hungry for companies like yours.   

Second, never give an asking price.  If you do that, you set a ceiling, and the price will be driven down from there.  Instead, ask the buyer to set the price.  That will establish the floor, and you can drive it higher from there.

Then invite a multitude of buyers to the virtual auction table.

The seminar presenter, a company called Generational Equity, typically circulates an Offering Memorandum to dozens of qualified buyers and ends up with perhaps a half dozen bidders at the virtual auction.

When the right bidders are at the table, the premium will be substantial.  In part, this is because the P/E ratios of public companies are higher, and in part because so many big companies are debt-laden, making well-capitalized small companies particularly attractive.  Today there’s lots of sidelined cash out there looking for deals.  According to Generational Equity, there’s $1 trillion in global private equity available.

Generational Equity has 310 employees, with headquarters in Dallas and offices in Westport, New York, Irvine, California and Chicago, and they might love to help you sell your business.

But if you don’t use them, they recommend you consider their competitors, like Boston Consulting Group, Arthur D. Little, Booz Allen Hamilton, McKinsey & Co. and Predicast.

As they put it, if you decide to use a professional seller, it will be the least expensive route, once final price is factored in.

Today’s investing idea is a small Chinese company, for two big reasons.

First, it seems to me that the world’s crumbling debt structure is bringing down a lot of elephant-sized companies, and I know from experience that healing those companies will take time.  Small, well-capitalized companies, as I mentioned above, are more attractive today.

Second, China will undoubtedly climb out of this recession faster than the U.S., so young companies in China will likely be some of the fastest out of the starting gate.  In fact, some are already running.

One of these is ChinaEdu Corporation (CEDU), which was profiled by Paul Goodwin, editor of Cabot China & Emerging Markets Report, in a recent issue.

Here’s some of what Paul wrote:

“ChinaEdu provides services that support the online degree programs of Chinese universities. As online programs become more popular, business has expanded quickly. Founded in 1999, ChinaEdu works primarily on program development, technology, marketing, student support and finance for the 11 universities with which it has strategic relationships. In 2005, the company began direct operation of private primary and secondary schools and online interactive tutoring and test prep services. The company cites a World Bank study indicating that about 260 million of China’s 1.3 billion people are actually students at some level in the educational system. That’s a significant base for a thriving support business.”

When Paul wrote that, back in January, the stock was “stuck at 5, trading at a minuscule average daily volume of 26,000 shares.”  Since then it’s topped 6 1/2 and pulled back to build a new base at 6, which is encouraging.  On the other hand, average daily trading volume has shrunk to 18,000 shares, which increases the risk.  Technically, the stock has too much risk today for most investors, in part because the broad market is weak, too.  But I feel good about education stocks in the long run so Imention it today to give you a stock to consider when the market turns positive.

Long-term, the company’s future is bright.  Revenues grew 37% in the latest quarter and the after-tax profit margin was a solid 9%.  If this were a healthy bull market, the stock would be an attractive speculation for experienced small-stock investors.  Today, it’s simply a stock to keep an eye on.

Yours in pursuit of wisdom and wealth,

Timothy Lutts
Cabot Wealth Advisory

Editor’s Note:

Cabot China & Emerging Markets Report was the top performer of all investment advisory newsletters in both 2006 and 2007, bringing subscribers who followed Paul’s advice gains of 78.6% and 74.1%.  For most of the past year, however, Paul’s subscribers have been heavy in cash, and they remain there today, preserving their profits and capital.  But that doesn’t mean they’re idle.  With every new issue of Cabot China & Emerging Markets Report, subscribers are kept up to date on the most likely leaders of the next bull market, a bull market that will start, as they always do, when it’s least expected.  If you’d like to own the top-performing Chinese stocks as they rocket ahead in the next bull market, I strong recommend that you join them.  To get started with a no-risk trial subscription, simply click here.


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