By Mark Swepston
The value of a business is a moving target. Don't try to estimate it alone. Like buying your first home, evaluating a potential business acquisition can be scary at first, but you become more comfortable with it if you have the right help. The right advisors will earn their fees many times over. Choose an attorney with experience in small business acquisitions. This person can also recommend a qualified CPA or business broker if necessary.
Set Realistic Goals
Once you find a business that you want to acquire, the first thing you must do is set goals for yourself and your business. Be sure these goals are timely, reasonable, and obtainable, and determine if the new business will help you get there.
The bigger question is, "Do you have the skills to pull it off, or can you hire the skills you don't have?"
What are your goals? Do you want to increase your gross or net income, acquire assets, increase market share, expand into a new territory, or are you buying a business to "acquire" more employees?
It's also important to include an exit strategy, should you want to sell the business later.
Who Will Help You Run It?
Your highest hurdle will be ensuring that you have a management structure in place to keep the acquired business running and generating cash.
If you think you are buying to increase the size of your workforce and that you will be able to keep all the people from the acquired business, think again. In our industry, most companies do not have a management structure in place that can perpetuate cash flow after the sale. Most of us, as small business owners, don't make very good employees and know that the people who work for us are usually very loyal to the original owner and his/her style of business. Therefore, you should plan on losing 80% of the employees who come over from the acquisition during the first 12 to 18 months after the change in ownership.
You'll need to work hard to keep people who can add value to your organization. Remember, you will be making some changes and running the company in a fashion that is similar to your current business. The people at the company you acquire usually don't share your goals, or they would likely be working for you now.
Review all of the management personnel in depth, as if you were going to hire them. If you wouldn't hire them, don't keep them on. If the current owner has any "problem" employees, consider his/her assessment of those employees and act accordingly later.
Size is Important
About 10 years ago, when consolidators started combing the market for acquisitions, they sought out companies with sales of $2 million or more. Why? They felt larger companies would have a better management structure in place and they would present a greater opportunity for success.
Look for A Good Repeat Customer Base
If the majority of business income comes from repeat service customers — and preferably those who are prepaying with service agreements — the value of the business is greater than if sales are driven by new construction.
Residential service-based customers — who often purchass service agreements and replacement equipment — when served properly, should bring in an average of $10,000 during a 10-year period. The same is true for the commercial market; but the volume per customer can be much greater.
What about the new construction contractor? In most cases, the value of the business is much less. If you can provide HVAC work for builders at $25,000 to $50,000 less than they are paying over the next year (ignore the increase in your cost for now), you likely can "buy business" rather than go out and "buy a business" — and with less risk! But be careful. If you can do this, so can the next guy.
Some Assets Are Worth More than Others
Review the company's assets and determine their true value. You may want to look at them in the following way:
- Vehicles: You really don't need any used trucks. You'll probably be better off to buy or lease new ones.
- Equipment and parts inventories: Don't overpay. These items are seldom worth the amount shown on the books and you can buy new equipment as you need it. Much of it will just be in the way and will need to be counted several times before you dump it or give it away.
- Accounts receivable: Don't pay anything for these in advance. Become involved — pay the owner a fee (possibly 5% of the amount collected) to collect them for the "new" company. You want existing customers to value the relationship with the "new" company and it will help you get a first taste of their loyalty.
- Company name: This can have limited value, especially in markets of 500,000 or more. How fast can you change the name of an organization? That depends on your marketing budget. Our company name means less than our pride leads us to believe. Can you name four cellular phone companies that were in business 10 years ago? If you are getting what you want, do you really care if you are buying from K-Mart, Sears or Wal-Mart?
- Other assets: Review these in the same way. Be sure they're worth what you pay for them.
Try not to take on any liabilities except those that tie you into a good relationship with customers who have service agreements and extended warranties. When you do, be very careful. Determine an offsetting cash reserve needed to serve these customers in the fashion of your current operations.
To limit your liability, do the work for the seller and have him/her pay for the work. To be sure that you can collect it, have your attorney put a portion of the money from the sale into an escrow account.
Never buy stock. Stock in a small business is more of a liability than an asset. You are only interested in assets.
How to Determine Value
There are many methods to determine value and they all have different strengths. Studies show that the average price paid for an HVACR business is 32% of sales.
1. Cash flow method
A simple method is to multiply the cash flow by 3 to 5 times, depending on the business mix and size of the business.
The true value is the present value of the additional net cash that it will produce for you in the future. It may be an old fashioned term, but you need to find that synergistic fit — the one that will help you reach your personal goals and add real value in the future.
The most important asset for the average size HVAC business is the business that comes in each day. It is then up to you to run the business properly and earn a return on your investment.
2. Incoming call method
A quick way to project your sales is to categorize incoming phone calls (service, add-on installation, new construction, etc.) and then calculate a closing rate for each one.
Number of incoming calls ˜ multiple call factor x closing percentage x average sale = PROJECTED MONTHLY INCOME
The company example shown in Table 1 averages 200 incoming calls a month. Of these, 80 are service calls, 80 are for replacements or add-ons, and 40 are new construction calls.
To use this method correctly you need to:
- make your best guess at the "repeat call factor" by talking to the existing customer service people
- determine the sale closing rate
- determine the average income per service invoice, add-on or replacement sale and new construction sale.
Now, you must consider the "friends of the boss" factor. That's the number of customers you lose because the boss won't be there any longer. This is particularly critical in new construction.
If your prices are higher than those of the current operation, you could also face a customer loyalty challenge.
Let's say you can retain 75% of the current business: $94,600 x 75% = $70,950.
If your net income is 5% on this combination of business, the monthly cash flow you should expect is $3,547.
$3,547 x 12 months = $42,564 x 5 = $212,820.
Thus, $212,820 is the MAXIMUM that you should pay for this business based on this cash flow projection. There can be arguments for a higher value if the true net income of the current operation is higher. (For more detail, you may want to look on the Service Roundtable website, www.serviceroundtable.com. They have a similar Small Business Valuation model.)
Review the company's financial performance over the past three years. You should pay the current owner for the way he or she has operated the business, not the way you plan to run it in the future.
A word of caution: If the current owner shows a phenomenal net, and you have never run a business with the same results, you may need to factor it down. His or her net sales may be very difficult to replicate.
Arrive at a number that you're comfortable with paying for the business. Determine if you want any of the assets, and negotiate a price that fits your business plan. If you can't work out a price, and the current business owner thinks those assets are worth more than you do, let him or her sell those assets separately.
The Acid Test
Never pay more than you would be able to pay from the company's cash flow in five years, after a 20% down payment, and an anticipated 20% return on your money.
If you're buying a company's assets for $500,000, you should be able to put down $100,000, meet with the manager about four hours once a month and receive an annual return of 20% return ($20,000) on your $100,000 investment. You should also be able to amortize the loan over a 5-year period at the rate set by the bank.
The monthly payment on a $400,000 loan at 7.5% is $8,015.18 per month, or $96,186.16 per year. When you add this to the 20% return on your original investment, your annual cash flow should be at least $116,000 per year plus any salary you should receive for management.
No Deal, No Sweat
There may come a time when you and/or your advisor decide not to buy the business. It probably goes without saying that you can back out at any time.
If red flags start flying, or you can't come to reasonable terms with the owner, don't worry. In such cases, invest the money you had earmarked for the acquisition into your own company and focus on internal growth.
|Incoming Calls||Multiple Call Factor||Appointments Made||Closing Rate||Average Sale||Projected Monthly Income|
This article is based on the presentation, "How to Value a Company You Plan to Buy," which Mark Swepston gave at HVAC Confortech 2004 in St. Louis, MO, Sept. 15-18. For more information about Comfortech 2005, which will be held in Nashville, TN, Sept. 14-17, call 216/931-9550.
Learn from the leaders: In 2004, HVAC Comfortech presented more than 30 speakers providing educational seminars. All the sessions were recorded, and are available for purchase.
For pricing and ordering, visit the show website: www.hvaccomfortech.com
For more information on this topic, go to: www.valuationresources.com.
Mark Swepston is president and chief executive officer of Atlas Butler Heating and Cooling in Columbus, OH. He can be reached at: firstname.lastname@example.org.
Give us your feedback on this article at email@example.com