Buying and selling a business: Part III

In this economy the merger, acquisition and divestiture (MAD) market is alive and well. Here’s the first of two methods that I’ll share if you’re looking to sell. I call it the gross profit margin (GPM) evaluation model.

The real world
As its name suggests, this model uses GPM to value the goodwill or blue-sky portion of the value for a service business. Service companies normally sell for one year of gross profit margin for the blue-sky portion of the company. Assets (office equipment, inventory and accounts receivable) and liabilities (loans, accounts payable) are handled separately from goodwill.

The GPM model, based on past sales, is an excellent way to value a service business with good historical documentation. Three to five years of financial statements are available and complete. Analysis of the financial statements determines that the internal ratios and percentages within them are consistent and in line with industry benchmarks. Customer records and files are complete and in good order.

After the appropriate documents are signed and/or exchanged, evaluate the company’s goodwill by reformatting three years of the seller’s profit and loss statements by putting them in the format of a P&L statement.

First, calculate the gross profit margin. Second, calculate and verify the items in cost of goods sold, and general and administrative overhead costs. This will accurately determine the company’s ratios and cost percentages, check them for internal consistency and compare them to industry benchmarks (see figure 1).

Determining the gross profit margin for smaller (up to $1 million in annual sales) target companies isn’t always as easy as it sounds. Often the owner’s salary is not a fair market value (FMV) salary. Also, it’s usually not split between the field and G&A overhead accurately. As a result, the GPM is distorted.

First, determine the fair market value for the owner’s time for actually working in the field. Simply multiply the owner’s hours working in the field by a FMV labor gross rate. This normally is the rate for a crew leader or a little higher.

Based on future sales
It’s not uncommon that good historical documentation is unavailable for evaluating the goodwill value of companies with less than $1 million in annual sales. Here, you base the price to be paid for the goodwill portion of the company, not on the gross profit margin of past sales, but on future sales.
Even if thorough documentation is available, many buyers prefer this method for new acquisitions, as it provides the seller with an incentive for staying with the buyer and maximizing sales. This method also appeals to many buyers because it’s “self-funding.” This means a percent of new sales is paid to the seller, in addition to any salary or other compensation. If there are no new sales, there’s no payment. However, if sales increase above historic levels, the seller has the opportunity to make more than if the goodwill was based entirely on historic sales.

The payout
The goodwill payout is usually spread across three to four years. Payment for equipment and any other assets are usually paid upon the consummation of the deal. I’ve seen the payment percentage structure for goodwill vary.

The incentive to the seller is to help the new owner sell as much as possible to maximize the goodwill payment, which is not a set amount.