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Ever heard of the 5x fallacy?  Hint: It  has to do with business valuation. Using a multiple of X. Try this among your peers, other business owners, and ask your CPA. 1.Ask:  What is a good multiple I should use to estimate the value of my business? You will get all sorts of answers, 5 times EBITDA or 2 times revenue, all sorts of “benchmarks”. 2.Ask people at your industry association. What do they think is a good multiple for a quick estimation of value? 3.Next, assume you were going to buy out a competitor, similar to you in size, and profit. Ask yourself, how much would I spend my own cash for it? Or put another way, if you were to buy a similar business like yours to grow your business thorough an acquisition, to add $ X in added profit, with a reasonable rate of return on your money, what would you be willing to pay for it, in real after tax money? What we see, people are NOT willing to pay anywhere close to as much for another similar business as they think their current business is worth.  Even if the business is a good strategic fit. They want to get a deal, buy at a discount, pay as little as possible. The reason is not greed. Its because you can’t really be sure of “hidden” features in the target business. You don’t know what will “pop up” after you buy it. It’s been private and therefore not transparent. Some people call this the skeletons in the closet. This is why asset sales oftentimes are a protective move for buyers. Don’t buy the business, and assume the unknown liabilities. This can help mitigate some things, but still does not fully cover the risk of buying a private business.  So in reality there is a higher risk premium required with private business transactions and to offset this you need to pay less to cover the risk, or at least to try to offset it if you are buying or investing in a private business. Multiples don’t accurately account for this risk premium. Too vague. Most of the unknowns ( risks)  are because private business is just that, private. The customer base loyalty is not necessarily easily transferable for example. The operations, people, staff, managers, etc. are doing things their way, not necessarily how best to manage a business as a financial investment. There are always inefficiencies in processes and management. The goal is to identify them and have a reliable way to measure the impact of these inefficiencies on the value of the business. It is not always obvious or easy to do. Therefore using or relying on any sort of multiple of revenue, or EBITDA. or other financial metric is NOT anywhere close to giving you any real world idea what a business is worth on the open market, at time of sale or transition.  My suggestion. Don’t ever use multiples ever. It’s not real, it will lead to bad decisions and bad long term personal planning if you are relaying on a liquidity event ( sale of some sort of cash out) to fund your retirement or other financial goal. On the positive side, value growth can be manufactured using a formal process, over time. You can manage and control value build. Do an assessment of your business ( selling or buying it’s the same process), of the operational risks and intrinsic risks to uncover where value gaps exist in the enterprise. Use a dedicated formal process of evaluation with data that is real, and comparable.  Look deeply under the hood at how the business is managed. Do you ( or your purchase business), have things buttoned up, contracts in place with vendors, HR, and documented processes for all operational areas. Good financial reporting that ties profit to each activity is critical as well. Most private business do not do this all that well. There are always gaps and higher risks embedded in most private business. Intrinsic risk is not easy to quantify. Using a formal process to evaluate things in terms other than a financial metric like 5X, or other meaningless ” rules of thumb”.  Value can be manufactured and realized systematically over time.

I believe one of the most understood transition /exit planning areas for business owners is when the goal is to move it to children, or other close family members. Clients for whatever reason often think moving their business to a child or multiple heirs is just about creating an agreement, maybe including a trust, figure out the best tax strategy, and that’s it. Simple. Maybe once in a while it is simple but for the most part its the opposite, no matter the size of the value of the business. It’s not just business. To do it right to help insure that the next generation has the best chance of a successful future business and family “harmony”, requires the business owner, family and their advisors to spend the time looking at this future goal many unique viewpoints. Here are just a few questions more specific to a family transition /succession. It gets complicated, and emotional very quickly. What are the personal goals and objectives for the business succession? Do you wish to preserve family harmony? How important is that? What issues do you anticipate? Should children in the business and not in the business be “equalized”? Should children not in the business be given interests in the business? Is the business ready to be transitioned to the next generation? Is/are the “new owner or owners, ready? What if the business itself fails due to no fault of the child in the business?  If you are relying on payments from your heirs, this could be a BIG problem. What if something happens to the child/successor? Do the inheritors really have the desire to grow and manage this business. What family dynamics, divorce, or other potential personal situations should be “risk mitigated”. The fact is it is a very delicate process when the buyer/donor, is related to the buyers/inheritors. To my mind the best way to approach this effort is with a collaborative team of pros, who all equally share in the input, and direction of the final plan. Everyone needs to have equal status in providing solutions, observations and recommendations. One more VERY important point:  Be aware clients current trusted advisors may also think this is not overly complex and or may not want to not rock the boat and will go along with the idea it’s simple.   

Our borrowers often ask us, “Is it better to buy an established business or start up a business?” It’s a reasonable question for those looking to exit their current employment or invest in a business for another income stream. While it may make sense in specific industries to start a business, the benefits of purchasing an established business, along with the security it provides to a new business owner, make a strong case for searching for a company to acquire. Established companies typically have the following positive attributes: Existing customer base Established supplier channels Brand recognition Established market share Sustainable and predictable cash flow Employees that generally transfer with the sale Established reputation Seller consulting period (up to 12 months post-closing) Ability to start earning an owner’s salary from day one   In addition to the above benefits, if financing is needed, a lender will typically be willing to lend more for a borrower to acquire an established business than to start up a business, typically at a more favorable interest rate. The SBA allows a lender to finance up to 90% of total project costs to acquire a business. While SBA policy also allows 90% financing on start-ups, most lenders will require more equity from the borrower ranging from 20% to sometimes 30% of the project costs. Additionally, some lenders shy away from financing start-ups altogether, so your lender pool will be much smaller when seeking start-up financing. There are resources available to search for listings, one of the largest being BizBuySell. Engaging the help of a business broker in the market you wish to purchase a business is also helpful. A reputable broker or M&A advisor will often have access to off-market listings and a good pulse on available inventory on the market. Buyers should prepare to provide a list of their search criteria, including but not limited to industry type, revenue size, EBITDA, location, sale price, etc. If you are considering purchasing a business, it is never too soon to start building your team of trusted advisors and lenders. A deal team should ideally consist of the following: M&A advisor/broker CPA for financial due diligence and structuring of legal entities for tax purposes Banker, if financing is needed An attorney with business acquisition experience Lastly, if you purchase a business and utilize bank financing, the bank will engage a third-party valuation firm to confirm the company’s value. A valuation will assist you with determining if your offer price is reasonable or needs to be renegotiated.

Business acquisitions are among the eligible uses for Small Business Administration (SBA) 7(a) loans. In fact, the SBA 7(a) program provides many advantages for acquiring an established business, including its attractive terms, allowing a buyer to finance up to 90% of total project costs. Eligible Project Costs for SBA 7(a) Loans Include The acquisition of an SBA-eligible business and owner-occupied commercial real estate (owner-occupancy minimum of 51% is required) Working capital Closing costs SBA guaranty fee The franchise transfer fee, if applicable New equipment, if needed Inventory Loan Terms If the acquisition does not include commercial real estate, the maximum loan term is 10 years, fully amortized with no prepayment penalty. If commercial real estate is included, the SBA allows a blended loan term with 10 years for the business acquisition and 25 years for real estate. However, if 51% or more of loan proceeds are allocated to real estate, the SBA allows a 25-year term. Prepayment Penalties A prepayment penalty applies to all loans with a term of 15 years or greater. The penalty is 5% in year one, 3% in year two and 1% in year three, and none after that. In addition, the SBA allows a borrower to prepay up to 25% of the outstanding principal per year without penalty. Down Payment The SBA requires a 10% equity injection. The entire 10% injection can be from the buyer or a combination of a 5% buyer down payment and 5% seller financing if the seller is willing to have their note on full standby with no principal and interest (P&I) payments for the life of the loan. Eligible Sources of Buyer’s Equity Injection Include Cash in savings or checking accounts, seasoned for two months Home Equity Line of Credit (HELOC) if there is a secondary source of repayment not related to the business to be purchased Gifted funds that do not need to be repaid Seller financing on full standby of no greater than 5% of the 10% equity required Investor contributions from partners Personal guarantees are required by all individuals who will own 20% or more of the business to be acquired. Collateral Requirements SBA requires the lender to be in the first position on all assets to be acquired. In addition, if there is less than one-to-one collateral coverage, the SBA requires the lender to take a lien on all real estate owned by personal guarantors with 25% or greater equity. Pre-Qualification Documents To 

In their book The Execution Premium, Harvard’s Norton and Kaplan stated that 80% of companies never achieve the full value of their strategy.  That is a frightening statistic.  In our experience, the greatest reason is that short term needs take precedence over long term strategic choices. So, what can leaders do differently to be among the 20% that achieve all your strategic objectives? Embrace the discipline of strategy management. Consider these four principles of strategy management: Focus – Strategy provides focus to make the complex more manageable. It helps to manage the allocation of resources toward the most promising opportunities. Alignment – Focus results in organizational alignment. A clearly articulated strategy brings everyone together—owners, family, management, and employees—to work collaboratively to achieve the strategic objectives. Commitment – Alignment results in commitment to achieving the Mission, Vision, and Objectives. Commitment builds confidence and drives excitement about the future. Accountability – Commitment creates an environment where employees will hold each other accountable to deliver on their personal responsibilities. By embracing strategy management, you can become part of the 20% of companies to achieve the full value of your strategic plan.  Do you have an explicit strategy that you can clearly communicate to all your employees?  Does everyone understand their role in making strategy happen?  Are you holding everyone responsible and accountable to achieving the full value of your strategic plan?  Let us know what you are doing to make strategy happen. Please share this newsletter with your friends and associates as you see fit. Quote: “Without strategy, execution is aimless. Without execution, strategy is useless.” — Morris Chang, CEO of TSMC

Our motto is “Speed is our weapon”.  Every day I see this come to life with my clients from day 1 to closing. Here’s how we can help: Pre-qual listings within 24-48 hours upon receipt of your CIM, 3 years taxes and YTD financials Pre-qual buyers with our approving credit manager within 48 hours from receipt of their complete package Underwriting completed in 7-10 business days Larger M&A deals exceeding SBA 7A cap of $5MM can be accommodated with our companion conventional loan up to $4MM, for a total of $9MM financing 100% expansion financing for established buyers with a similar business Closings within 45 days for non-real estate transactions, 60 with real estate We also pay referral fees upon successful closing of all 7A referrals.  Call me to discuss a specific transaction or for additional information.  203-461-5097

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