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Planning the purchase or sale of a closely held business.

Selling--or buying--a closely held company is a tricky business. Preparation and a fair appraisal can go a long way toward securing an advantageous deal for all parties.

Owners who consider selling closely held businesses face a wide range of alternatives and decisions. Ultimately, the success of the deal for both the buyer and the seller hinges on the establishment of a reasonable price, the acquisition of needed capital along with appropriate repayment terms, and a smooth handoff of the business from seller to buyer.

One of the first questions asked by all potential buyers and potential sellers is, "What is an appropriate price for the business?" A price that is too high will discourage potential buyers from proceeding beyond a preliminary review. In addition, if the seller does not decrease the price in a hurry, the business will, in many cases, decline in value as employees and customers learn of the desired sale and leave or transfer their business to competitors.

On the flip side, if the initial price is too low, the seller will dispose of the business quickly but won't receive full value from the purchaser.


To maximize the yield at the time of sale, certain preparations should be made. First, the entity or the portion to be sold should be appraised. Key determinants of a business' value are: expected future cash flow, income, net assets, depth of management, competition, customer base, and employee relations. Ideally, the purchase price should provide the buyer with an appropriate return on investment based on the risk he assumes.

Another smart move would be to study the condition of the economy and of the industry in which the business operates. A business may be more desirable during certain periods or economic cycles. For example, during the real estate boom in the late 1980s, businesses whose revenues were generated from real estate activities--including brokerage agencies, real estate appraisers, and construction companies--were sold for much higher prices than they would have commanded during most other times.

This phenomenon can benefit all parties. For example, a business' major customer may be able to minimize its costs, and offset future expenditures by buying all or part of its supplier. A business may be able to expand its customer base and its revenues by buying a competitor. If the marginal costs of generating these additional revenues are less than the total expenses currently incurred, the buyer will receive more value from the new business than the existing owner. Frequently, a deal can be structured so that the marginal profits obtained from the new acquisition will liquidate debt in a few years.


Although there is no one surefire method that can be used to value all businesses, taking the following steps will ensure a reasonably accurate estimate.

* Calculate the expected or normalized cash flow of the business, excluding salary and remuneration to the owner(s). At this time, you must adjust for any expected increases or decreases in revenues. For example, in one recent acquisition, the buyer utilized its existing sales force and knowledge of the industry to generate additional sales from the target business' customers. This information should be included in the buyer's own calculations of the target business' expected results.

Also, don't forget to add any additional operating expenses the buyer will incur after the sale. These include lease payments where the business' current owner is also the building's landlord, and salaries for employees who will replace a spouse or family who currently is not being paid for working.

Furthermore, any optional or non-business-related expenses or cash expenditures that the buyer will not incur must be deducted. These items include donations, and travel, entertainment, and automobile expenses for the owner(s), family, or friends.

Finally, add the total remuneration the owner(s) received and deduct a reasonable salary for the services they performed, assuming they were non-shareholder employees.

* Determine the loan value the cash flow would support at current available terms and interest rates. For example, if the business generates a cash flow of $50,000 per month, and if money is borrowed on a five-year self-liquidation basis at 9 percent interest, a loan of just over $2.4 million would be amortized.

* Adjust for any assets, net of liabilities, that will be obtained from the purchase of the business. The assets and liabilities should be taken at their fair market or replacement value, not book value. In many cases, the values listed on the business' financial statements do not approximate its fair market value. The fair market value of real estate could be understated on the business' balance sheet, while the value of other items, such as computers, could be overstated. This often happens if the business only receives a compilation or review.

In addition, any asset that can be sold immediately or is not utilized by the business can be used to offset the debt obligation. In a recent transaction, the buyer was able to liquidate large sums of unnecessary or excess inventory and equipment, which significantly reduced the debt obligation needed to acquire the business.

* After calculating the value of the business, this number should be examined closely for the following items: appraisal values that depend on the buyer making large down payments; and valuations based on apparently unreasonable projections of future growth in cash flow, since it depends on reduced expenditures or increased revenues.

Remember, for a sale to be successful, it has to benefit both the buyer and the seller. One party cannot expect to reap all the rewards.


In today's economy, one of the biggest problems facing closely held businesses is the difficulty of borrowing funds from banks and other traditional sources. As a result, if the buyer lacks the necessary funds and cannot borrow due to insufficient collateral and established cash flow, the seller must be prepared to receive the purchase price over time--generally in the form of a purchase money note or mortgage. Assuming the absence of adverse economic conditions and the presence of an honorable buyer who is capable of operating the business, this is not a bad alternative for the seller. Here's why: The tax liability on the sale is deferred over the period that the note payments are received, and the interest earned on the note frequently will be higher than what the owner would receive from a bank or money market fund. Part of the difference in the interest rate is to compensate the seller for the risk assumed.

Once the buyer and seller agree on the purchase price and terms of the sale, a smooth transition will work to everyone's advantage. The seller should work with the buyer to transfer supplier or agency contracts, to introduce the buyer to customers and suppliers, and to foster the development of these and other key relationships. It is in everyone's best interest for the business to prosper under the new owner, especially if there is a seller-financed sale. Accordingly, if the sale price and note payments are too high, the buyer will be unable to meet his obligations to the seller, and any benefits the seller might have anticipated from the sale will go up in smoke.

Often, the seller is required under the purchase agreement to work as a consultant for a stated period. Also, except in very extraordinary circumstances, he should always provide a covenant not to compete.

If the business is being sold to a key employee(s), the principles mentioned above apply, except that the transition may be quicker and easier due to the familiarity gained through existing employment. Also, both parties know each other, the buyer(s) has experience in the business, and the risk to all usually is reduced.

In certain situations, the buyer must decide whether or not to sell stock to an Employee Stock Ownership Plan. Although there are many initial and ongoing requirements associated with this procedure, the benefits in terms of tax savings, increased employee morale, enhanced recruitment, and improved productivity can outweigh the costs if the right circumstances exist.


There are many reasons for the purchase or sale of a closely held business. For an individual, or a group of individuals, the purchase of such a concern may be a way to fulfill the American dream of owning and operating a business. (This is especially pertinent, given today's climate of downsizing and plant closings in almost every sector of the economy, including some of the country's largest employers.) At the end of a career, a properly planned sale may help a businessperson to achieve financial security in retirement. Meanwhile, on the corporate side, a company may buy a private business to achieve synergy, to alter its product mix, and/or to increase profits and shareholder value.

Whatever the motivating factors, some basic ground rules help to expedite the process. Setting the correct price, of course, is particularly important. For example, if a seller thinks a corporation is extending a "low-ball offer," the corporation's credibility may be damaged, and further negotiations may be futile. In contrast, if a firm offers and pays too much for a business, it may have to finance the purchase through heavy debt, which, in turn, may decrease corporate income and value.

In sum, evaluation and analysis are crucial. A carefully planned purchase can benefit all parties concerned.

Robert J. Chalfin is president of The Chalfin Group, a Metuchen, NJ-based firm that specializes in valuation and consulting services for closely held businesses. He is also an attorney, a certified public accountant, and a lecturer in management at the Sol C. Snider Entrepreneurial Center at the Wharton School of the University of Pennsylvania.
COPYRIGHT 1993 Chief Executive Publishing
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1993, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Title Annotation:Wisdom from Wharton
Author:Chalfin, Robert J.
Publication:Chief Executive (U.S.)
Date:Jun 1, 1993
Previous Article:A new tax direction.
Next Article:An order of priorities.

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