Business Valuation & Deal Structure: A Practical Guide

[00:00:00]hey guys KL Allen want to do a little quick video for you today about valuing and structuring a business deal makers what's up my vision is to completely and utterly disrupt the market for buying and selling small businesses all over the world so I want to give you a really kind of simple walk through about how this actually works so let's imagine you've gone and you found a business and it's doing $2 million per year in Revenue okay so that's really really good and then let's assume the business has got a 20% operating profit margin So 20% margin would be $400,000 per year in we're going to use the term ebit do that's the profit measure we're using earnings before interest tax depreciation and amortization of Goodwill so $400,000 is the E do now we know that businesses are worth a multiple of the ebit do every kind of business sector has a range but then it depends on the quality of the business within that range that determines whether it's attractive to buy it's transferable and the business could be worth zero up to you know whatever the multiple is three four five even the six times multiple if you're in the Ecom space or the SAS space and on average the multiples between two and a half and three was actually about 2.8 was the average small business multiple for all businesses sub $10 million in revenues in 2022 so this is an engineering business this is the example this is a deal I'm actually looking at right now the numbers are a little bit different uh just for mathematical ease so normally you'd be looking at around a two and a half to three times multiple for this business now before we do that calculation we've got to figure out is that the true ebit D number so we've actually got to go through something called a recasting process now on Wall Street where I did most of my earlier deal making work back in the '90s and the early 2000s the term we use for that is called proformer and what that means is we need to understand that once the sellers out the business what are the real profits going to be so for example in that number is the owner taking a salary if not you've got to put a GM in the business to run it for you uh you're going to be reducing that number before we apply the multiple uh if the sellers take in you know a million dollars a year out uh of that business in salary and that's reflected in the ebit DAR yet it's only going to cost you $100,000 a year for somebody to come in and run that business for you then that would be an addback so an add back to ebitdar let's call that AB an add back to ebitdar is when we're going to increase the profitability before we apply the multiple because the owner's been taking things out the business uh that are not going to Happ happen once we acquire it and then where we're going to be reducing the evitar because it's going to have additional costs for us to run that business going forward like the GM for example that's called a takeback so an addback is when the profit is going to go up a takeback is when the profit is going to go down so a great example of an addback would be um the the owner um is let's say the owner's spending $200,000 a year on his own compensation and that's before the ebit D line and then obviously he's going to take a distribution as the owner of that business so he's taking $200,000 out of his salary but it's only going to cost us $100,000 to replace him with a general manager so in this example we can have a Justified $100,000 addback okay a good example of a takeback would be let's say the business owner um works inside of the building and he owns the building right and the building is sat on the balance sheet of the business but he's not selling you the building as part of the deal you're just buying the business you're not buying the real estate the seller wants to keep the real estate because real estate always typically goes up in value he wants to keep the real estate and then he wants to charge you a rental fee you to stay in that building but in the ebit D calculation there's no rent so we need to to make a rent adjustment and that is a takeback because when you start paying that rent after you've bought the business your profitability is going to go down and we need to reflect that so let's say the takeback let's say the rent for this building again let's say it was $50,000 a year so in terms of the calculation we're going to add $100,000 as an ADB back and then we're going to take away $50,000 as a take back so now we know that our valuation in terms of an ebit do is $450,000 it's $400 plus 100 which is500 less than $50,000 so $450,000 is the ebit DAR that we're going to be using as part of the calculation if you're going through a business broker for the deals that you're looking at the broker has typically done all of this work uh for you and you'll see something called an adjusted ebit do and what's kind of interesting when you're looking at deals is you get the tax returns which are what I call the tax numbers and then you get the broker's numbers which are the real numbers and then you've got to kind of go through and you've got to adjust and negotiate those numbers so $450,000 is the um is the ebit D here so that's what we're going to call the adjusted ebit D and let's say we're feeling very generous and we're going to apply a three times multiple Market multiple to Value this business so three times um 450 is 1,350,000 now that we call Enterprise Value EV that's the value of the business it's not the value of the stock or the equity in the business we need to do some more calculations so when you think about Enterprise value of business that's like the asking price when you go and you buy a house so let's say you go out there and you're looking to buy a house and it's half a million dollars and the real got a nice kind of one pag here says hey this house it's um in the middle of Albany New York probably cost you more than half a million dollars in Albany but $500,000 is the asking price so that's like the Enterprise Value the equity value of the house is the value less the debt that the owner has on that house and it's the same in a business so there are three things that we need to adjust in Enterprise Value to get Equity value the first one is real estate so that's the value of the business if we were buying the real estate as well we'd be paying for that separately so if the real estate was worth $300,000 and we were buying that alongside the business we'd be paying 1.65 million so 1.35 for the business $300,000 for the real estate so if you've got real estate in the deal that's always a plus in our example we don't so that's a zero the next thing that we have in a deal is Surplus cash now this is very very common in the UK not so common in the US especially if you're buying an ESC Corp or an LLC and the reason for that is esops and LLC in America have a flow through tax policy so it's very common for a business owner to distribute out all of the earnings at the end of the year and then maybe learn a little bit of that back just to give the business a little bit of working capital trade going forward so normally when I'm valuing a business I want to see at least um one month's worth of Revenue or roughly about 10% of the revenue uh in cash so in that business I'd want at least $200,000 of cash in the business for me to trade it and play with it as the new owner but let's say that business actually had $400,000 of cash inside of it right so that extra $200,000 we're going to have to pay for this part of the deal so that's going to be an addition of $200,000 for Surplus cash okay so that's a positive as well and then the negative would be what liabilities are we going to be inheriting when we take the business on now sometimes you can buy a business called debt free cash free so the seller is going to take all the cash less that $200,000 that you need to run the business but then they're going to take the closing payment then they're going to discharge they're going to pay off all of those liabilities that you're going to inherit as the as the new owner so then you get the business effectively debt free but the problem with that is you're then going to have to go out and raise Capital to make that closing payment if there's liabilities already in the business it makes no difference to what the seller is going to get you're better off buying the business and inheriting the liabilities that are already inside of it so let's assume that's what we're doing in this case and this business has um $550,000 of liabilities so that could be tax notes due it could be a bank loan it could be uh the money that's outstanding onl higher purchase equipment um liabilities these are non-current liabilities so it's not AP um although I do just for AP in a uh in a in a b2c where the company's selling directly to to Consumers we'll get into that in another video um but I'm going to be inheriting $550,000 of debt when I take this business on so if I order that up I've got 1.35 million ion then I've got £200,000 of surplus cash no real estate and I've got £550,000 of liabilities so My Equity value what I'm actually paying to buy the stock in the company by the equity in the company is a million dollars so a million dollars is my valuation for 100% of the equity in the business right so once I figured that out now I've got to decide what's my deal structure okay so remember when you're buying a business there's three components you've got the liabilities that you're inheriting which in our case are 550k you've got the closing payment and then you've got the seller note and in some cases you can also have something called an earnout which if you have a valuation for the business that's lower than what the seller was expecting because they've got long-term growth and all these crazy things that might happen in the future we put that into something called an earnout and I'll do a separate video on that a little bit later but for now let's do it in these three ways so let's say we've got a million dollars left to cover between the closing payment and the seller note now it's in your interest obviously to have as little of the deal inside of a closing payment if you were going to do an annuity deal structure the closing payment would be zero or just a little bit of surplus cash that's going to be in the business now remember we already have $200,000 of surplus cash in the business that we're buying it's cash that we don't need it's included in the valuation so at the very least we can give the seller $200,000 at close because that cash is in the business we don't need to go out and raise it we don't need to put our own money in we don't need to partner with an investor we don't need to go to the bank we don't need to go anywhere that money is already in the bank so we can offer that to the seller at closing so the Le the rest is $800,000 so total deal as a summary um we've got $550,000 of the liabilities that we're going to inherit and then the million dollars that we paying for the equity in the business got a $200,000 closing payment that's what the seller is going to get at the closing table and the rest of it is going to be an $800,000 seller note now the beauty with that is because the business is generating $450,000 of adjusted ebit do we have a lot of cash flow that we can use to do that deal so what I would do my opening offer on this business would be to do that over four years which is $200,000 per year and let's say the guy wants a 10% interest coupon uh as well on that so 10% let's say we're going to be paying 2 $20,000 per year in celotes we're already generating $450,000 of cash flow if we're paying out $220,000 we've got a Debt Service cover ratio of just over two times about 2.1x right anything north of 1.5 you're golden and that's before you even grow the business you're buying a business in your lane and you can add a lot of value to the business you might be able to take that to $3 million in a few years or even four or $5 million in a few years when you do that these payments are not going to change it's like you're buying a house making mortgage payments to the bank if you fix that house up or something happens where the value explodes for that real estate the bank's not going to call you up and say hey I need more money now because your your house has gone up no not at all that's where an earnout would do that but we'll talk about earn outs in another video that's separate I don't want to confuse you but that is a really really good deal so let's summarize what have we done in here we've looked at a business $2 million in Revenue 20% margin cranking out $400,000 an ebit D so that was step one and then step two is we say well okay what are the real numbers what's the ebit DAR going to be when the owner leaves and we become the new owner so there's a $100,000 addback um because the owner's taking out too much salary and then there's a $50,000 takeback because we're going to have to pay rent stay within the building the real estate that the seller owns so that gives us an adjusted ebit d a pro former ebit d a recasted ebit d of $450,000 and then a sensible multiple for this type of business in this type of Market it's a 3X Market multiple so 3 * 450 gives us a $1.35 million Enterprise Value and then we those three adjustments adjustment one if there's real estate there isn't in this deal adjustment two is any surplus cash we have $200,000 of surplus cash so we're adding that and then the seller wants us to inherit the $550,000 of noncurrent liabilities that are set on the balance sheet so we're going to inherit those liabilities as well so we add all that up 1.35 plus 200 less 550 the million bucks to buy 100% equity in this business if the seller said well hey um I like your growth story I'll just sell you 80% and let me keep you the 20% in then what would you be paying $800,000 so that's the value of the stock if you're buying all of the stock it'd be a million bucks you're only buying 80% of the stock if the seller wants to carry a little bit back you'll be paying $800,000 but the beauty of this deal is there's tons and tons of cash flow that are already going through the business to comfortably make those seller payments and the deal that I would structure on this is hey we're going to we're going to do the 550 of liabilities I'm going to inherit those I'm going to pay the $200,000 of cash at the closing table which is cash that's already in the business that I don't need and then I'm going to put the rest on an $800,000 seller note $200,000 per year over four years plus a 10% coupon so that'll be $220,000 per year so that gives me a 2X cover ratio and then all I need to do which I'll then cover on another video is to keep this short is I'll then look at those liabilities and those liabilities by the way were actually over a 10-year term so I know as well I've got an extra $55,000 per year that I need to use from this cash flow to cover those existing debts that I've got as well so this is a really uh really really cool deal so I will be making uh that offer I hope you found this useful and I will see you soon on the next video till then watch [Music]