Trade sale – where do I start?

Many small and medium sized business owners work a lifetime building a business, yet often they are not aware of the variables and financial modeling intricacies that dictate the relative and absolute value of their business.  This knowledge is essential in a trade sale situation but much of the same type of knowledge is incredibly useful when dealing with lenders, as they use similar modeling tools to determine the credit worthiness of a business.

One of the objectives of modeling is to adjust for past extraordinary or unusual items so that you can predict what the business (or entity or segment) being modeled will look like under normal circumstances for a base year. You can then impact that base year based on forecasts for growth in income and for different expense categories.  This will enable a business owner to estimate what their business might be worth to an acquirer.

It is essential that the senior team of an enterprise have reliable, consistent data that has been thoroughly analyzed so that a proper modeling exercise can be undertaken.

Detailed below is a simplistic example of a valuation model much like the ones that are used by companies that acquire other entities (note that some models are based on net profit after tax and some might be based on EBITDA (earnings before interest taxes and depreciation).

Adjustments Pro Forma
Year 2017 (1) (2) (3) 2017
Revenue 37,200,000 3,100,000 40,300,000
Operating Profit 8,400,000 3,100,000 -800,000 157,143 10,857,143
Op Margin 22.6% 26.9%
Tax (based on 30% ETR) 2,520,000 3,257,143
Net profit after tax (NPAT) 5,880,000 7,600,000
Valuation
    Based on 8 times NPAT 47,040,000 60,800,000
    Based on 8.5 times NPAT 49,980,000
(1) – Cash to accrual conversion
(2) – Adjustment for arm’s length rent
(3) – Compensation – synergy

In this case the model is based on 2017 which saw the entity experience cash basis revenue of $37.2 million and an operating profit of $8.4 million or a 22.6% operating margin.   This would give rise to an entity with an absolute amount of NPAT (net profit after tax) of $5.88 million (assuming an effective tax rate of 30%).  But that is just the beginning of the story because of some adjustments that might be necessary to see the business more clearly:

Cash to accrual — the 2017 financials that total $37.2 million in revenue is based on the cash method (that is, cash that has been received and disbursed during the period) but most large entities would probably recognize an entity like this for its accrual revenue which is $40.3 million, so they would adjust the cash basis revenue and net income up by $3.1 million.

In this case the model is based on 2017 which saw the entity experience cash basis revenue of $37.2 million and an operating profit of $8.4 million or a 22.6% operating margin.   This would give rise to an entity with an absolute amount of NPAT (net profit after tax) of $5.88 million (assuming an effective tax rate of 30%).  But that is just the beginning of the story because of some adjustments that might be necessary to see the business more clearly:

Cash to accrual — the 2017 financials that total $37.2 million in revenue is based on the cash method (that is, cash that has been received and disbursed during the period) but most large entities would probably recognize an entity like this for its accrual revenue which is $40.3 million, so they would adjust the cash basis revenue and net income up by $3.1 million.

Occupancy – This closed held business is incurring rent (from a related party) that is lower than market.  Most acquirers would probably adjust for such an item to reflect “arm’s length” rent. To reflect market rent the acquirer would probably increase rent expense in their model, in my example I’ve increase rent expense by $800.0 thousand and so have decreased operating profit by the same amount.

If real property is part of the transaction, make sure that the purchase price reflects the market value of this real property.  Many acquirers have picked up bargains in real property from sellers that were not fully aware of what they were selling.

Compensation – This model shows a reduced compensation in future years for synergy for doing away with some duplicate functions. The amount of this adjustment in the above model increases the amount of operating profit by $157.1 thousand. If the multiple for entities like this was 8x base year NPAT, a seller might think that he is sitting on an entity worth $47.0 million (2017 NPAT of $5.88 million * 8). A seller might think he is being clever and squeeze a multiple of 8.5x NPAT from the seller for a total valuation of $50.0 million (2017 NPAT of $5.88 * 8.5). Yet, the seller might have been prepared to pay 8 times the adjusted NPAT which would have been $60.8 million (2017 adjusted NPAT of $7.6 million * 8) or about 22% higher than the amount that would be realized based on the unadjusted 2017 amounts even at an 8.5 times valuation.

Don’t take chances with the business that you have labored a lifetime to build. Make sure you senior team includes persons who can provide you with the financial, operational and strategic advice that you need to maximize the operation of your business and to make exceptional transactions like a sale or purchase as effortless as possible. You will also need a merger and acquisition specialist — they may not be inexpensive but they can often provide tremendous value and in effect, pay for themselves at the end of the day. They can help you clarify your transaction criteria and help execute an efficient search and sale transaction.