Most small business owners have never sold a business. When it comes to thinking about selling or passing the business to a member of your family, it is new territory and with that, new terminology. Whether you are in the early stages of planning or actively engaged with a potential buyer, you will encounter a lot of financial jargon that you need to know for a successful transaction.
Here are some of the most common terms you will come across.
Add Back describes certain expenses related to a business valuation, typically these include discretionary income such as healthcare for family, club memberships, and a car lease for the owner. When using a Seller’s Discretionary Earnings approach for valuation, Add Backs are added to the owner’s salary and the net profit.
Asset Purchase Agreement
Asset Purchase Agreement is a legal agreement between a seller, often a business or business owner, and a buyer of selected assets. In addition to the price, the agreement will typically cover payment terms, representations, and warranties, conditions of the items at the time of purchase and may include support after payment has been made.
Diligence (Due Diligence)
Diligence (Due Diligence) is the process a prospective buyer goes through to review information related to the business such as financials, legal agreements, loan agreements as well as inspect the property, equipment, or supplies. The parties may agree as to what items are part of this process, how long the process may take, and how to resolve issues that may arise in the process in order to complete a transaction.
A prospective buyer will often want to finish this process before finalizing the price or a definitive agreement to acquire a business or assets.
Discretionary Earnings refers to the proceeds a business owner(s) decides to take out of the business in the form of salary or other compensation once other liabilities are covered. The owner may use her/his discretion to determine the amount, provided expenses and liabilities have been paid, and in what form.
For example, if the business has $10,000 at the end of the month after paying all the liabilities, the owner may decide to take a salary of $7,500, pay a car lease of $250 and leave $2,250 in the business account. This is an important term to understand as it applies to Seller’s Discretionary Earnings to calculate the value of a business.
Dissolution is the process of legally closing a business by filing required documents with state and local entities to prevent the business or its owners from incurring additional fees or liabilities. In order to complete the dissolution process, all taxes must be paid and up to date including any fees or penalties.
It is highly recommended to cancel any permits or licenses associated with the business as well as any liabilities such as leases, payroll, and other obligations.
Net Asset Valuation
Net Asset Valuation If a business owns assets (furniture, computers, equipment, supplies) they have a value that should be listed on the company balance sheet. In some cases, an owner (or potential buyer) may want to understand the value of these assets AFTER liabilities have been paid.
So, the Net Asset Valuation (NAV) is calculated by subtracting the liabilities (what the business owes) from the assets (what the business owns). If the NAV is positive (assets are more than liabilities) – an owner may choose to exit the business by selling assets, paying down liabilities, and then filing for dissolution. Any remaining cash may be kept by the owner.
Main Street Business
Main Street Business is a term commonly used to describe businesses that generate less than $5M in annual revenue and have fewer than 10 full-time employees. Most reports indicate that over 90% of U.S. businesses meet this criteria. These are also referred to as micro-businesses.
According to research from ExitGuide, two-thirds of small business owners state their biggest concern about exiting their business is knowing where to start and what to do.
Multiple is a term used, in most cases, to estimate or help calculate the value of a business and there are numerous multiples that are often based on historical data (previous transactions). So, what is the right multiple, and what is it applied to; revenue, profit, EBITDA? It depends, typically it starts with industry and category in that industry.
For example, a printing business may have the same revenue as an e-commerce business but the e-commerce business is likely to have higher profit margins and therefore, a higher multiple. If the industry multiple is 2.5, it can be applied to the EBITDA or Seller’s Discretionary Earnings to calculate the value of the business.
Seller’s Discretionary Earnings
Seller’s Discretionary Earnings is a very popular approach to calculate the value of a small business because it largely relies on what a new owner could expect to “take out” of the business as income. This may be a salary but may also include other forms of income (disbursements for example) and things like a car lease paid for by the business.
Seller Financing is a common way to finance the sale of a small business to a new owner. When a seller “finances the deal” they typically agree to take a regular payment over a set period of time which comes from proceeds from the business and paid out by the new owner.
Seller financing is an alternative to an asset-based loan or SBA loan from a bank or 3rd party lender.
Eventually, every small business owner exits their business and this can seem like a daunting process. New terms, financial reports, steps to take may be new to you. Just like you had to learn what it takes to run a business, you can learn what it takes to exit your business.
Take a deep breath and do your research, talk to fellow entrepreneurs and familiarize yourself with the steps and terminology and you’ll enter the process with confidence.