What about the balance sheet?
The most common method of valuing small businesses is to use a multiple of earnings or EBITDA.
June 19, 2018 By Victor Harding
In short, it is the income statement showing earnings that is key to arriving at such a valuation. Naturally owners then look at their balance sheet and ask what about the value contained there? While it is true that the balance sheet does sometimes hold extra value, the point of this article is to illustrate that there is not as much extra value as some owners think.
The truth is in most cases and with most buyers, the balance sheet will not hold as much extra value as the owner might initially think. Let’s break the balance sheet down and look at each section — short and long term assets and liabilities — to see why.
Many owners don’t realize that buyers expect there to be a “normal” amount of working capital in the business when they buy it. Working capital deals with current assets and liabilities and is generally defined as cash + accounts receivable + inventory – accounts payable and accrued liabilities. In most successful businesses, this is very much a positive number. At the very least the ratio of current assets to current liabilities should be 2 to 1. Anybody who has tried to run a business with lower or negative working capital knows how important this item is.
Having adequate working capital in the business at the time of sale is particularly true of “share” deals where the buyer is usually buying everything on the balance sheet. The last thing a buyer wants to have to do is pay for a business and then, on the first day he owns it, inject another sum of money into the business for working capital to keep it afloat. If there is inadequate working capital in the business at the time of sale, the purchase price will often be reduced.
If a buyer is doing an asset deal, the buyer can, to some degree, pick and chose what assets and liabilities they want to buy. Generally in deals for alarm companies the buyer will buy the alarm accounts, the good will attached to the business (including the telephone number and company name) and maybe the inventory and a couple of vans. So here, working capital does not come into play so much. But in an asset deal where the buyer is keeping the target business in place and operating it as a separate business, they will want working capital in the business when they buy. It is wrong to think that requiring working capital only goes with share deals.
“Normal” working capital required to run a business can vary enormously. Alarm companies that don’t get involved in big installation jobs and don’t need to carry large inventories usually require small amounts of working capital. However, for integration companies that install large jobs and therefore carry a lot of work in process inventory and also have receivables that can easily stretch into 60 days or more, the working capital requirements are a lot more. With one integration company I sold, the buyer reasoned that they needed $1.5 million of working capital and it was hard to argue with them.
So the moral here is, don’t go into the sale of your business thinking that your working capital is going to land you a huge extra bonus of purchase price. It is true that some companies do have “excess” working capital (more than “normal”) at the time of sale which should be fed back to the seller. Books have been written on what a “normal” amount of working capital should be.
Let’s move to the longer term or fixed assets and liabilities on your balance sheet. Most deal practitioners assume that when you value a business using a multiple of earnings, the fixed assets used to produce those earnings are included in the purchase price they offer. This seems inherently sensible to me. So the bottom line here for security dealers whose major fixed asset other than buildings are vans, you are not likely to get extra money for your vans when you sell.
Regarding longer term debt — debt below the current liabilities section on your balance sheet — generally any balance here is required to be paid off by the seller at time of sale or reduces the purchase price.
What I have laid out here are general guidelines as to what to expect in terms of value from your balance sheet at the time of sale. There are exceptions to these guidelines, but generally, if you are dealing with an informed buyer, there will be less extra value on your balance sheet than you first might think.
Victor Harding is the principal of Harding Security Services (firstname.lastname@example.org).
This article originally appeared in the May 2018 issue of SP&T News.
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