For small business entrepreneurs in search of growth, the prospect of acquiring another small- or medium-sized enterprise can be appealing. Such a transaction might double the client roster, enable the firm to expand into new product or service areas, or give it much-needed capital for further expansion.
Regardless of the end goal for an acquisition, it’s important to enter the buying process with a solid understanding of some basics, such as why the acquisition target is for sale and how to value the entity.
Surge in Small Business Acquisition Opportunities
For small businesses seeking other small firms to buy, there is an abundance of options. In a 2005 study by Prisciotta and Weber, almost 40 percent of family business owners said they expected to exit their firm within the next five years, creating a transfer of wealth worth $4.9 trillion within 20 years (DeTienne & Cardon, 2012). Likewise, researchers Knott and McGrath reported in 2004 that more than one-third, or 9.6 million, of U.S. firms had at least one owner age 50 or older (DeTienne & Cardon, 2012). Plus, an estimated 18 percent of financial assets held by U.S. households €is invested in privately held firms, many of which were founded in the 1950s and 1960s by entrepreneurs who are, or soon will be, contemplating exit€ (DeTienne & Cardon, 2012, p. 353).
Many Shades of €For Sale by Owner’
When they decide to retire or phase out of their enterprise, business owners have a variety of exit plans. For the acquirer, a quick study of the acquisition target’s exit strategy can shed light on the type of entrepreneur one is buying out.
Below are some of the more popular exit plans (DeTienne & Cardon, 2012):
€ Initial public offering (IPO) or acquisition by a larger firm, both of which are considered to be relatively high risk because the entrepreneur’s equity often remains tied up in the deal and if a deal sours, there can be meaningful financial impact
€ Liquidation, generally considered an option for businesses that might not be performing very well and therefore have limited opportunities for an outright sale
€ Family transfer to children or other relatives, an option which can be viewed positively by customers and the marketplace because the family will tend to maintain the firm’s core ideology and values
€ Employee buy-out, achieved through a sale to certain eligible employees or through an employee stock ownership plan (ESOP), often appealing to entrepreneurs who want to be sure to leave their company in the most experienced hands
€ Independent sale, a simple, low-risk option whereby the entrepreneur typically hires a business broker to cast a net for buyers and manage the details of the sale (DeTienne & Cardon, 2012).
As of approximately 2012, the average sales price for a small- to medium-sized business was $250,000, not including inventory and real estate, said Tom West, founder and former president of the International Business Brokers Association (DeTienne & Cardon, 2012).
Evidence points to a positive correlation between higher education of the entrepreneur selling his or her business and a tendency to pursue an IPO or acquisition exit strategy (DeTienne & Cardon, 2012). There also is a positive correlation between older age of the entrepreneur and tendency to pursue an IPO or family transfer exit strategy (DeTienne & Cardon, 2012). One theory for the latter trend is that entrepreneurs working into their 60s and 70s want to stay engaged in their businesses, and their exit strategy is not based primarily on a desire to retire altogether or to maximize the financial payout (DeTienne & Cardon, 2012).
How can these research findings apply to the small business in search of an acquisition? If the buyer is not interested in having the ongoing involvement of the entrepreneur, for example, the buyer might be better off looking for deals in which the seller simply wants to retire and €sail off into the sunset.€ This type of buyer would do well to work with a business broker to identify independent sale opportunities.
Valuation: Measuring the Tangible and Intangible
In determining how much to pay for a small business, it is critical to evaluate the financial fundamentals, but it’s also important to consider non-financial metrics, such as corporate culture and the worth of intellectual property.
From the financial valuation perspective, an often-used approach is the discounted cash flow method, in which the buyer evaluates the cash value of the acquisition target today and then discounts that value by a certain number of years at a reasonable rate of interest (Harrison, 2003). Finance-based valuation also focuses on the four standard accounting statements, including the balance sheet, income statement, cash flow statement and statement of owner’s equity. In evaluating the cash flow statement, it’s a good idea to watch out for quirky variables such as over-inflated salaries paid to family members (especially when it’s not clear what valuable responsibilities the individual is performing) (Harrison, 2003). On the other side of the coin, the buyer should be wary of the impact of underpaid owners who do not pay themselves enough out of the business’ proceed because the buyer might need to pay someone else at their market worth to do the same job (Harrison, 2003).
When making a strategic acquisition, buyers will want to understand the acquisition target’s financial position as well as €softer,€ hard-to-measure variables such as brand awareness and the stability of customer relationships. Intangible assets such as strong market presence and human capital also are important to value. A qualitative study of 19 executives who participated in small business acquisitions found the executives placed a high value on intangible assets but struggled to find an accurate way to quantify them (Thom & Greif, Intangible Assets in the Valuation Process: A Small Business Acquisition Study, 2008). One of the researchers involved in this study developed a method for valuing intangible assets, taking into consideration assets such as corporate culture, brand strength, market position and openness to change, among others(Thom, Beyond the numbers: A Phenomenological study of intangible assets for small manufacturing, 2008).
Use of this method can help the small business buyer to pause and consider some important variables that have the potential to make or break the prospect for future success of the combined businesses. For example, if the company’s market position is leader driven rather than company driven, there could be significant risk that the enterprise will falter if and when its current leader exits the business in the post-acquisition period. In addition, if the target acquisition has a €not invented here€ culture, it could take years to integrate new processes and even to gain acceptance of new leadership. If the buyer doesn’t have the luxury of time to work through that cultural transition, he might want to keep shopping for another small business.