Searching for an add-on acquisition for a client, I ended up in the 1960’s-era office of the 80-year-old second generation owner of a galvanizing business located in Texas. He was welcoming and not the least bit worried about confidentiality. He told me about his business, gave me a tour of the plant, and said he “had a business broker” and wished to sell as he needs to retire and his son doesn’t want it.
It's not a looker. Has been operating in its current location since the ‘80s. Doesn’t look like much money’s been spent on it since then. Yet the production areas were busy.
The facility has large in-ground chemical-filled tanks into which sizable steel pieces are dipped. The owner explained that what they do is very specialized and “in demand.”
The next day, the business broker emailed me the financial statements for the past few years, and other information. We visited via telephone.
The business is a c-corporation. Learning this was a warning sign that the seller may not be completely on top of things. The real property occupied by the business is owned by and within the business entity. The business has been annually booking about $3M in revenue and putting $175,000 “on the bottom line.” The broker said the business “throws off” $350K per year. He arrived at this number in part by adding to the annual earnings the $150K in salary and benefits the business provides to the active owner-manager. They ask $1.5M for the business and $2 million for the real property. That’s $3.5M in total. They have an appraisal on the real property, which the broker provided to me.
Is their ask reasonable?
First, we assess for ourselves the profitability of the business. There are various types of earnings or profit to consider. One is Sellers Discretionary Cash Flow (SDCF). It’s commonly used or “looked at” with businesses that are “run” by the owner. SDCF is the earnings of the business;
a. Before the working owner receives any compensation or benefits
b. Before interest expense
c. Before income tax (if it’s a c-corporation)
d. Before depreciation expense, i. e. non-cash expense
e. Expenses not necessary for the ongoing operations of the business added back
As you can see, SDCF is pretty “grossed up.” Of the various types of earnings, it will be the largest dollar-wise. So, naturally, the multiple of earnings paid for a business will be much lower when SDCF is the earnings type used; as opposed to other earnings calculations such as EBITDA, EBIT, Normalized EBIT, book net income, etc. SDCF for the subject business is $325K. This is NOT cash the business “throws off,” it is cash (earnings) generated by the business that the owner can choose, at his or her discretion, to a) pay himself, b) fund maintenance capex, and c) pay debt service if he chooses to use debt.
EBIT and EBITDA are earnings AFTER owner compensation. We say EBIT and EBITDA are burdened by owner compensation. EBITDA for the subject business is $175,000. Incidentally, EBIT is $175K as well as it has no depreciation as the asset are fully depreciated. Now, the amount business owners pay themselves varies. For this reason, buyers and appraisers adjust or “normalize” earnings by adding back the actual compensation paid to the owner-manager and subtract an estimate of “fair market” manager compensation. Let’s say it would take $200K to attract and retain a capable manager for the subject business. Our adjusted (or, normalized) EBITDA, then, is $125K.
Next, the business uses machinery and equipment that wears out. Money will have to be invested, over time, to maintain the productive capacity of the plant and equipment, i. e. maintenance capital expenditure (“maintenance capex”). The balance sheets show about $1M has been spent on the fixed asset of the business; probably decades ago. It makes sense to burden the earnings by maintenance capex. That is, an annual amount that, over time, will be sufficient to fund the necessary improvements and replacements. Let’s say the number for the subject business is $250K per year. Subtract this and our normalized EBIT is now negative $125K.
So, it appears we have a business that – at least as it has been recently performing -- is not generating enough earnings to pay a fair market compensation to the business manager and fund maintenance capex. So, in theory, this owner could give you this business and the real estate for free and you’d have to find a way to raise the earnings to be able pay yourself (or someone else) a “fair market” compensation and be able to reinvest a sufficient amount back into the business (or fund a reserve) to ensure long term viability. And they want you to pay $3M for this? There is no cash flow available that could provide a return on investment (on the equity contributed to a purchase) or pay debt service (on money you borrow to buy the business).
Consider this as well: the business owns the land it occupies. No rent expense. A business and real property are totally different economic animals. As such, it makes sense to separate them financially. To do so, burden the earnings of the business by an estimate of the fair market rental rate for the real property. The real property then receives income that supports its FMV and the business earnings are “normalized” with a fair market occupancy cost. Value the business based on these normalized earnings.
Let’s say a fair market rental rate for industrial property worth $2M is $200,000 per year, triple net. So, normalized EBIT for this business is now NEGATIVE $325K. Keep in mind – real property that is adapted for economic use should receive income (revenue) commensurate with its value/utility. If a business owns the land and facility it occupies, burden the earnings of the business with a fair market rental rate so you see accurately the “true” or “real” profit of the business separate from the real property.
In other words, this galvanizing business appears to be worth … nothing. It is not even close to generating a profit after earnings are burdened by fair market manager compensation, fair market rent for the facility it occupies, and an annual average of the costs of maintaining (upgrade and replace) -- over time -- the productive capacity of the plant and equipment. The seller is in la la land, he’s wasting his time and the time of many around him. The broker or M&A advisor should save the seller from this fate. Either they don’t know what they are doing or is not strong enough to push back. Maybe, they are just hoping to lay low, have a listing, and possibly be there if when something someday gets traded.
Our analysis is reinforced when we see that the property appraisal values the improvements at $0 and the land at $2M. Any buyer would scrape the improvements off the land and re-develop it. Why? So, they could obtain a return on investment that would justify the $2M price.
Hmmm. No buyer of the land will want to own or keep the business because the business does not earn enough profit to pay rent sufficient to support the fair market value of the real property. One can also assume alternative properties capable of serving the productive needs of the business would be of a similar value and, as such, the business would not be able to financially support. Similarly, no buyer of the business – at any price -- could reasonably assume it would be able to also buy the real estate for its FMV. Yes, even if the price of the business was $0.
The price for the land AND the business (combined) is the value of the land. Actually, it’s the FMV of the land less the cost of clearing it off so it can be developed for its highest and best use. Even if a buyer of the business were found, they would need to enter into a lease that gave the business use of the facility, but the business cannot afford to pay an FMV lease rate. If the owner lowers the rent to below FMV in an effort to facilitate the sale of the business, he won’t be able to sell the real estate for more than the value of the income stream … which will be less than if the business was closed and the land were sold to a buyer that could do with it as he or she wishes unencumbered by a lease.
Had enough? Well, quickly then, if I may? The seller has even more challenges.
A) Buyers will have great trepidation about the use of chemicals and that the property may be contaminated.
B) No buyer would be willing to buy the legal entity, i. e. stock. So, even if a buyer were found he would only be willing to purchase the assets. This would leave the seller with a punishing tax bill given the assets are in a c-corporation and depreciated.
C) The business has no salesperson nor reps nor marketing person on staff. As such, the earnings are not burdened by said expense. Every buyer will want to grow the business, or at least have some outbound sales effort to replace customers that may “go away,” for whatever reason, as they do. How’s he going to afford such?
D) The facility and equipment appear to be in rough shape. A material amount of money may need to be invested immediately.
Keep in mind: buyers are cautious. They don’t have to buy, rather must be enticed by an attractive deal. That is, a safe opportunity to make a good or, at least, fair return on investment. With, as Warren Buffet explains, a margin of safety. For a small private business, in the 25% to 40% annual rate of return range. That’s in ADDITION to being compensated fairly for the time the business requires of the owner. Investors can put their money in the stock market and sit on the beach and earn average annual returns in the 10% to 15% range. Higher with small cap stocks.
Actual names, locations and business types are not used.
Questions? Email David@AcqAdv.com.
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