Understanding fair market value will enable you to establish a realistic sale price for your business.
Understanding the value of your business is critical when considering a sale. So many business valuation articles begin with defining fair market value, and this makes sense. Understanding what fair market value is, will enable you to establish a sale price for your business that is grounded in reality.
As defined by the IRS, the Fair Market Value of any business is: “the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, and both parties have reasonable knowledge of relevant facts”
It’s a perfect definition in that it actually makes sense; both parties are aware of all relevant facts and no one is acting under a compulsion to buy or sell.
It’s a fair deal all the way around. Banks understand fair market value and a valuation grounded in reality is more than likely to attract bank financing than one that is not.
Banks lend based on the forecasted ability of the acquired business to produce enough cashflows for the buyer to pay back the loan used to purchase the business.
If the valuation is unrealistically high, the likelihood of the buyer defaulting increase as the cashflows from the acquired business may fail to meet the bank’s debt coverage.
Let’s assume the following, a residential service and replacement HVACR business that generates $2M in revenues and produces 10 percent in earnings before interest and depreciation expense (EBITDA). The enterprise value of such a business would range between $800,000 to $1,000,000.
For the purpose of this example, let’s assume the business owner is selling the business to his general manager and the general manager intends to take advantage of an SBA 7(a) loan. An SBA 7(a) loan is a government guaranteed loan program enabling banks to lend to small businesses throughout the United States.
What is so special about an SBA loan? The lending bank is protected by the SBA in event the borrower is unable to pay the bank back. Because of this guarantee, the banks are able to lend based on cashflow as opposed to collateral. Which brings us back to the example.
Let’s assume the business owner asks the general manger to pay him $900,000 for this business (based on a professional valuation) and let’s further assume the general manger has saved $90,000 of his own money to put down.
With $90,000 of his own money as the down payment, the general manger will have to borrow $810,000 in order to purchase the business.
Going to a bank that participates in the SBA 7(a) lending program, the general manger will be able to secure the $810,000 if the valuation makes sense.
For the purpose of business acquisitions, a bank lending under the SBA 7(a) program can provide as much as a 10-year term, which means the borrower has 10 years to pay back the loan based upon monthly principle and interest payments.
Based upon these points, the borrower will make 120 monthly payments (10 years) of $9,197 or $110,368 a year.
- Business EBITDA = $200,000
- Total Purchase Price = $900,000
- Loan Principle = $810,000
- Buyer’s down payment - $90,000
- Term = 10 years (120 months)
- Monthly Payment = $9,197
From a valuation point, the total purchase price of the acquisition of $900,000 might make sense, but does it make sense from the lending bank’s perspective?
The lending banks decisions as to whether or not to make the loan will be based upon the ability for the principle and interest to be paid back.
In this case, the EBITDA (cashflows) of the acquired business is $200,000 which exceeds the $110,368 required to be paid back to the bank annually (12 x $9,197).
A crucial variable in a bank’s loan approval process is the debt service coverage ratio (DSCR). This is the ratio of annual operating income or EBITDA available to pay back the proposed and existing annual debt payments and if necessary, the ability of the business to pay the owner a comfortable salary.
Banks will typically look for breakeven coverage as well as a cushion. For the example above, a loan to buy the business requires an annual repayment of $110,364 and the annual operating income is $200,000.
- Annual Operating Income (EBITDA): $200,000
- Annual Debt Service: $110,364
- DSCR = (Annual Operating Income/Annual Debt Service) OR $200,000/$110,364 = 1.81x
The Debt Service Coverage Ratio in this instance is 1.81x meaning the annual operating income of the business can cover the annual debt service and provides an additional cushion if cash flow were to decrease in years to come.
Brandon Bolen, who heads up the service contracting lending vertical for Live Oak Bank (liveoakbank.com) explains, “From a bank’s standpoint, the buyer and seller coming to an agreement on a fair purchase price is vital to the purchase taking place. We see all the time the importance of an expert valuation. If a purchase price is too high, the bank won’t be able to approve the loan if the business being purchased can’t repay it. A fair price allows us to close the loan and fund the sale proceeds right to the seller. The seller is able to reap the benefits of the value they have created while allowing the buyer the opportunity to continue the business’ legacy.”
Whether you plan to sell your service contracting business or buy one, the first place to start is to understand the fair market value of the business.
From a seller’s standpoint, a valuation grounded in reality is not only more likely to attract the right buyer, but also bank financing that so many buyers rely upon to get the transaction close.
From a buyer’s perspective, the right purchase will be valued in such a way that the borrowed funds used to make the acquisition are paid back on a timely manner through the cashflows of the acquired business.