22 Jun Mr. Business Seller, Meet Mr. Buyer
A business has a lot of moving parts – customers, products, location(s), vendors, employees, reputation, relationships, processes, competitors, legal status and history, tax status and history, systems, databases, websites, etc. If one wants to peer into the crystal ball of a business and see its future, one would have to assess quite a few things. What are the competitors doing? What new competitors are moving in? How competitive are the products? How strong are the relationships? How important are the relationships? How talented is the management team? Are any planning on leaving? Will they leave and compete against us? And so on, and so on.
Well, the business owner (seller) has lived and breathed the business for years. Nobody is better able to assess the future of the business than the owner.
Real estate, in comparison has far fewer “moving parts.” Investors can more readily assess the characteristics and risk factors of real estate than they can those of a business.
Every investment can be rated on a risk scale. As perceived risk rises, the price one will pay declines. The opposite is also true. So it makes sense that investors will generally pay less for the opportunity to enjoy cash flow (and capital appreciation potential) generated by a business when compared to real estate – all things being equal.
This bears out in the numbers. Investment real estate is selling in the U.S. these days at cap rates between 5% and 13%. The former, for very low-risk real estate investments that have tenants with exceptional credit and, therefore, cash flows, i.e., anticipated rental payments, that are virtually guaranteed. The latter, for higher-risk real estate investment opportunities.
We are talking returns in the 5% to 13% range for investment (cash flowing) real estate. So, a $100,000 income stream generated from an investment in real estate will sell for $769,231 ($100,000 divided by 13%) to $2 million ($100,000 divided by 5%). That’s a multiple range of 8 to 20. Businesses generally sell for cap rates between 15% and 33%, aka multiples from 3 to 7. So, business buyers will pay between $300,000 and $666,667 for $100,000 in annual cash flow generated by a business.
Why do businesses sell for lower multiples? Mainly, uncertainty. You, the seller, know more than anyone about the business, and what the future may hold for it. And you are selling. Hmmm. This gives Mr. Buyer pause. So, when we represent business sellers, it’s critical to convince the buyer candidates that the reason for sale has to do with personal reasons (as opposed to dim prospects for the business). We also want to find a very confident buyer.
Of course, businesses require more care and attention, generally, than real estate. You know this. Business owners must deal with more moving parts, and keep all those moving parts greased and working properly. The management burden is less for real estate (generally). Lower burden is desirable, so buyers will pay more for investments (cash flow or profit) that have lower burden.
An analogy I sometimes use to convey the “risk” point is this: Investor A (“RE owner”) owns a piece of real estate that he leases to the owner of a restaurant (“Biz owner”). The Biz owner must pay the required rent due to RE owner every month, or he will get evicted. This means the RE owner is paid even when the Biz owner does not earn a profit. And, let’s say the Biz owner has been in business for 20 years, successfully. And one weekend, several people get food poisoning eating at the restaurant. It hits the papers. Customers spurn the place and the Biz goes under. There is nothing left. It’s done. The cash flow from this investment for the Biz owner is gone forever.
What does the RE owner do? He re-leases the location to someone else.
Which investment is more risky? The business, of course.
Real estate has innate value based on location, and brick and mortar improvements. The value is more durable. It can take some hits and recover. Businesses can be grown and provide great cash flow, but the owners that can succeed in spite of the added complexities should earn higher rates of return. They should demand, or require, higher rates of return. And they do.
Mr. Business Seller, if you want Mr. Business Buyer to buy your business, you are going to have to help the buyer get comfortable that all is well. You must convince the buyer that the future prospects are bright, and that you are selling for personal reasons. Then, to lower the buyer’s risk a bit more, you may have to provide some seller financing. Put your money where your mouth is, so to speak. Strike a deal with the buyer that says, “Okay, if cash flow exceeds a certain level over X number of years, you pay me some more.”
Studies reveal that 70% of small and mid-size business purchase/sale transactions have some component of seller financing. I would say, in most cases, the sellers that did not accept, some seller financing left some money on the table.
I’ve heard many a seller say, “Well, (this or that) is the buyer’s problem.” But in this world, as a buyer’s perceived risk or level of uncertainty rises, the price a buyer will pay falls. That makes it the seller’s problem (presuming the seller wants to sell). So sellers need to help their buyers feel comfortable and confident. The result will be a higher sale price. A maximized business sale price.