For most small business owners who are thinking of selling their business the first step is to contact a broker and find out how much their business is worth. After years of receiving letters in the mail, emails and unsolicited phone calls from business brokers announcing that there are thousands of ready buyers eager to acquire their business, it is finally time to think about opening the floodgates and letting the offers come in. The first step though, is calling one of these brokers back and giving them the good news that the business “might” be up for sale. “Don’t get too excited”, the broker is told, for the owner is only considering selling. But he or she is finally open to at least thinking about it, and would like to arrange for the broker to come out and discuss the process. Most importantly, they want to know how much their business is worth.
Now if the business is turning over more than £2m per year, is well-established and under management, there are reasonably well-established guidelines for valuing the business. The valuation will be based on a multiple of its net pre-tax earnings, with some adjustments depending on its industry and its net assets. The most important factor is its size, since smaller businesses command a lower multiple (say 3-4 x net profits) than larger businesses in the same industry (up to 8 x net profits). If the business is in a particularly attractive (fast-growth) industry, or if it has some genuinely attractive characteristics that warrant a higher multiple, then this will be taken into account.
The broker wants to win the business, which means convincing the business owner both to sell the business, and to sell it specifically with him. While there will certainly be some room for negotiation around the broker’s fee, the broker knows the owner’s main consideration is the sale price – in other words, the higher the price he can achieve for the owner, the more likely the owner is to give him the “listing” (and the more likely he is to put it on the market at all). This incentive is well known the world of estate agency of course – the agent who over-prices a property to entice the owner to give them listing is a common phenomenon.
But in business brokerage this incentive is stronger, since the broker takes part of their fee in advance. This can range from £1,000 up to more than £45,000 up front, with the remainder of their fee (a percentage of the sale price) due at completion of the sale. This means the owner’s incentives are even less aligned with the broker than the estate agent – simply getting the listing means income for the broker, regardless of the eventual sale.
The owner’s incentives are even less aligned with the broker than the estate agent – simply getting the listing means income for the broker, regardless of the eventual sale
Now most brokers are not charlatans, and although their incentives are not well-aligned with those of the seller, they genuinely do their best to sell the businesses they take on. After all, a larger proportion of their income will come from the final sale, even though a portion of it is from getting the listing.
Except in one important case.
Very Small Businesses (Sub £500k)
Most businesses advertised for sale (indeed most businesses that exist), turn over less than £1m per year, and the majority of these turn over less than £500k per year. For these businesses the above valuation rules should be thrown out the window. Businesses at this level simply do not sell for the PE multiples that we are told to expect in books. Multiples of 3 x net profits (plus net assets in some cases) simply do not apply to very small business – and yet these profit multiples are what owners expect… and what business brokers tell them.
For businesses turning over less than £500k per year, the normal valuation rules should be thrown out the window
Business brokers who serve these clients have the same incentives as described above. They want to sell businesses, but firstly they want to get listings. They send marketing materials to thousands of small businesses just to win the opportunity to pitch to one, and when they get this opportunity they want to win the business. And their methods for winning the business are the same – they pitch the benefits of their service, they negotiate on fees, but most importantly they claim they will be able achieve a high sale price. They win the listing, collect their up-front fee, and proceed to attempt to sell the business.
The problem is that most of these very small businesses never sell. Larger businesses are more stable, more predictable, and are worth a 3 or 4 x multiple of their net revenues (and higher multiples for larger businesses). Even if the owner has been pitched at a price of slightly higher than this by an ambitious broker, with negotiation very often a suitable price can be agreed. But very small businesses very often do not sell at all. When they do change hands, it is rarely for a multiple anywhere near 3 x net profit – more often it is closer to 1 x the net benefit to the owner (with some adjustments for net assets and earnout periods).
Very small businesses very often do not sell at all. When they do change hands, it is rarely for a multiple anywhere near 3 x net profit
The smaller a business is, the more susceptible it is to risk. Minor changes in the market are not able to be absorbed as easily. Customers are usually not as long-standing, or as diverse. Often the owner is very involved in the business and it would not perform well without him or her. There is little reason for an acquirer to pay for the following three years’ profits if these profits are far from certain. Because of all of these factors there are simply fewer willing buyers for very small businesses (“willing” meaning willing to actually proceed with the purchase, rather than just having the funds for the purchase), relative to the large numbers of them for sale.
This means that when all is said and done, most of them do not sell. Their owners continue to run them, sometimes for many years. If prospects do not change and the owners eventually decide they can't or do not want to keep going, these businesses are closed down or effectively given away in one format or another (sometimes to family, sometimes to staff, sometimes even to competitors).
Brokers know this when they take on the listings for very small businesses... The up-front portion of their fee is in most cases the only fee they will receive
Brokers know this when they take on the listings for very small businesses. The up-front portion of their fee (which can be as much as £2,500 even for very small businesses) is in most cases the only fee they will receive. They know how difficult it is to sell these businesses, and they know that most of them do not sell.
This is why it is highly misleading for business brokers to pitch the owners of very small businesses based on an inflated profit multiple (even if this multiple of 3 x or even 2.5 x is what the owner wants to hear). Inflating the price of a residential property (or a larger business) in order to win the listing is one thing – but there is a liquid market for these assets and with some negotiation an acceptable price will usually be found. But inflating the price of a very small business – an asset for which there isn’t such a liquid market – in the full knowledge that it will most likely not sell at all, is immoral. Doing so in order to simply attain the up-front portion of the fee is even worse. And yet this appears to be what many of the business brokers targeting smaller businesses are doing. While they do attempt to sell the businesses of course, they know that most of them won’t sell, and they still list them for inflated prices anyway.
We would advise business owners turning over less than £2m per year to very seriously consider not using a business broker to sell their business
We would advise business owners turning over less than £2m per year to very seriously consider not using a business broker to sell their business. If using an advisor we would recommend using one that will help you prepare for the sale by changing your business in ways that actually makes it worth more and enables it to become more saleable. Systematising the business so that it is operating effectively under management will position it head & shoulders above other businesses of a similar size, and make it suitable to a far greater number of acquirers. Often there will be ways to quickly and substantially increase profitability. In other cases the business simply has to get bigger before it is sold, and there are ways to do this that we will explore in future.
When the business is ready to be sold, the key is finding multiple parties who are very interested in the business and willing to bid on it. There are many elements to this but the keys are (1) de-risking the business to as great an extent as possible for the next owner and (2) actively seeking out as many interested parties as possible. For very small businesses these parties may include competitors and even customers, and often they can be identified and targeted more effectively by the business owner than an external broker. Given their differing incentives, we believe the business owner will usually be far more motivated to manage this process effectively than a broker, and (with a little knowledge) can achieve a much better result.
If all of the elements in points 1 and 2 are executed well, even a sub-£500k business can achieve an exceptional sale price. After all, it will be an exceptional business among its peers (since it is de-risked) and its sale will have been handled exceptionally well. In these rare circumstances it may be possible for the business to achieve a price that reflects a PE multiple usually associated with a larger business. But much of this will depend on the work done prior to the sale, to improve and de-risk the business. And the sale itself must be handled flawlessly.
Even a sub-£500k business can achieve an exceptional sale price
If this doesn't occur then the sale will follow the same path followed by most sub-£500k businesses (even most sub-£2m businesses): it will be listed by a relatively demotivated broker who has already received all of the money he expects to extract, it will be listed for a price that is far higher than most businesses of its size actually sell for, and since neither steps (1) nor (2) above have been executed well, the business will not be worth this price and it will not sell.
Business brokers can add value to the process of selling a business in the £2m+ range, but for smaller businesses we believe their costs far outweigh the value they add.