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BUYING A SMALL BUSINESS

Selling Out

Inc.'s finance editor examines what has happened to those businesses that are offered for sale at the end of each issue.
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Every month, our back page features a company for sale. Here's how each business has fared

When it comes to buying and selling companies, there's a huge difference between the public and private marketplaces.

Just take a look at the U.S. economy during the past year and a half. The stock market charged into a heady, uncharted 8,000-plus terrain. Mergers-and-acquisitions activities raced along at a record annual level of $495 billion. Venture-capital investments proceeded at a breathtaking pace of $10 billion to $12 billion; initial public offerings raised $65 billion, another record.

The conclusion is inevitable: during a period like this one, in which investors were flush, bankers were willing, and boom was spelled M&A, it surely must have been the best of all worlds for those private-business owners who were ready to cash out of their companies.

Here's the shocker: all those record-setting economic trends, all those potential buyers with cash to burn, all those consolidating companies with national and international growth on their minds--they had little if any impact on the prospects of small companies with for-sale signs hanging on their doors.

Recent conversations with the owners and business brokers of the 14 companies featured in Inc.'s Business for Sale column during the gold-rush period from April 1996 through May 1997 revealed that only 3 had sold, although a couple more seemed, knock on wood, close to deals at press time. None of those sales was tied to an industry consolidation or a corporate expansion, although big companies did come window-shopping in a few instances. None of the 14 businesses had explored the prospect of going public or attracting venture-capital investors as an alternative to selling out.

Meanwhile, a few of the businesses were pulled off the market when their owners concluded that they'd be better off continuing to run their companies rather than selling at too-low prices.

The apparently dysfunctional marketplace doesn't surprise Jim Goonan, director of corporate finance and due diligence at accounting and consulting firm Grant Thornton, based in New York City. "In times like these, investors have very high expectations about what they should be able to earn on their money, which translates into a desire to negotiate for lower prices if they're thinking about purchasing a company," he says.

Meanwhile, he explains, "sellers who read about the high prices that some companies earn by going public or selling out to consolidating corporations tend to overestimate the value of their own companies because they also expect higher returns in this economic climate." Goonan concludes, "That means that economic conditions like these push buyers and sellers in very different directions. That actually makes it harder to do deals, even though there's more money available, at least in theory, to finance them."

What do the experiences of our 14 companies say about the larger marketplace? Our perspective, of course, is slightly askew: their annual revenues ranged from $141,000 to $4.8 million, clearly on the small side of the for-sale market. Still, it may be that if and when many small companies do sell, the reason is not the state of the economy but the companies' success in managing to track down a buyer who's a lot like the seller, with the same goals and interests but just a little more money to invest and a few more years to go until retirement.

"Very little has changed for small companies, regardless of all those economic records you read about in the newspapers," stresses Bill Wetzel, director emeritus of the University of New Hampshire's Center for Venture Research. "The reality is, those companies cannot--and never could--attract venture capital or angel investors, because they're much too small and they don't have the kind of extraordinary growth potential those investors are seeking. They could never carry out an IPO. So their sales prospects just haven't changed."

He adds, "Small companies are selling into a totally different marketplace from the record-setting one we read about in newspapers. The small-company marketplace consists of people who aren't necessarily looking for multimillion-dollar profits or massive capital gains. They want the lifestyle of a small-business owner and a nice salary, maybe with the potential for a comfortable, additional profit."

The only real expansion within that segment of the marketplace comes from downsized executives from large corporations, who might be shopping for a small business with their severance packages. But they're scarcely the kind of buyers who might go hog-wild with an offer: their own purchases are limited by the extent of their savings and their ability to get bank financing, always a tricky proposition for small-business owners.

There were clearly some companies--mostly big ones--that benefited from the United States' boom environment. "The two major trends driving many of those deals were industry consolidation and deregulation," explains Scott Adelson, managing director of investment-banking firm Houlihan Lokey Howard & Zukin, in Los Angeles.

According to Adelson's division, Mergerstat, which tracks mergers and acquisitions, the hot industries that benefited from those two trends during the first quarter of 1997 included banking and finance; brokerage, investment, and management consulting; and utilities. The average size of the deals? A whopping $216 million, compared with $131 million a year earlier. With that kind of deal profile, it's no surprise that our 14 companies--successful as many of them were--failed to appear on many buyers' radar screens.

One reason, notes Goonan, is that "there's not much difference between the due-diligence investigation that buyers need to perform with a big company and that required with a small one, and often the cash flow and growth potential tend to be better with bigger companies." Very small companies also suffer from buyers' anxieties that their success may be tied to the involvement of the founder, and big companies often benefit from the availability of more information about them within the marketplace, which helps ease buyers' anxieties. All that translates into a pattern of higher selling-price multiples (selling price compared with earnings, valuations, or some other benchmarks) for bigger companies.

But in the past few years, size hasn't been the only factor determining a company's potential to be sold. Recently, the economy clearly crowned some beauty queens among selling companies. Those included businesses in consolidating industries, which, even if they were very small companies, did tend to attract suitors. Also popular were those perennial favorites of venture capitalists and angel investors: companies in sexy, high-growth industries such as new media, biotechnology, high tech in all its permutations, health care, and a handful of other fields. (For a look at the toughest kinds of companies to sell, see "The Brokers' Dog List," below.)

Still, there are important lessons to be learned from the sales successes and failures of the 14 businesses for sale we recently surveyed. Here are some of the most compelling:

LESSON ONE:
Your customers might like to buy your company.

The Illinois retailer of flameproof underwear and other race-car safety equipment (featured in May 1996) had recast earnings of only $81,000 on sales of just over $400,000. Its sales tag of $200,000 plus $30,000 for inventory struck valuation experts as way too pricey; the business, they said, couldn't generate sufficient profit for a new owner to pay that much.

But miracles really do happen. After sales efforts stalled, the company's owner fired his business broker and took matters into his own hands. "I think I wasted my time with the broker, because he had much bigger fish to fry than a $200,000 sale," he says. "What I finally decided to do was go through my warm circle of friends and customers. That's when it all fell into place for me."

His own feelers uncovered several likely leads. The one that panned out was a deal that closed this past April. Here's the fine print: he sold the company for just 5% less than his original asking price. (One unspoken rule about valuations: Forget about all those appraisal guidelines. If somebody really wants your company, then it's as valuable as he or she thinks it is.) The seller scarcely noticed the small cut he took in price, since he had saved $20,000 in broker's commissions by handling the deal himself.

"The sale couldn't have been simpler, since these folks were my friends and longtime customers," he emphasizes. His buyer was nothing short of perfect: a retired chief executive with a lifelong love of race cars, who was able to buy the business under the best of all terms--with cash.

LESSON TWO:
You can't be too aggressive about publicizing your desire to sell.

Take the Hawaiian kayaking company (September 1996) with sales of just under $270,000 and a price tag of $169,000. When the owner and his business broker decided to send their sales package to Inc. in the hope of prompting an article, it was a long shot. But they realized a simple truth: the more buzz you can generate about your company, the better your chances of a sale.

By the second week in October, the company had a deal in place for a $160,000 sale to a couple who had read the Business for Sale column on an airplane flight between Portland, Oreg., and their home in Salt Lake City.

"It was almost unbelievable," recalls the wife. "We had made up our minds that we wanted to leave our corporate jobs and change our lifestyle. Then I read the article and asked my husband, 'Isn't that the company we went kayaking with during our last visit to Maui?' " (Remember lesson number one? It always pays to consider your customers--even the ones who seem slightly far afield.) Turns out that the husband's father lived in Maui, and the couple had been fantasizing about relocating there for years.

They called the broker the next day, and he could tell just how interested they were. "They asked all the right questions and made plans almost immediately to fly in and check everything out in person. That was a pretty good sign that they meant it," he says. As often happens in deals a broker is involved in, the owner deferred to the broker on financial matters and fielded the rest of the questions himself. The owner also took the prospective buyers along on various kayaking trips, to explore the mechanics of the business and, of course, keep their interest whetted.

Written offers flew back and forth by fax during a 10-day period, with the sale eventually closing at 5% less than the asking price--but for better-than-expected terms. "I'd been willing to finance $90,000 for five years, but these buyers were able to offer me much better terms than I'd hoped for," says the seller. After considering tentative offers from a few other buyers, he accepted this one, since it gave him more cash more quickly.

The deal closed like this: with $100,000 down and the rest to be paid in two equal balloon payments at the end of the first and second years after the sale. Best of all, the seller can bank on those upcoming payments: his company's buyers have strong business backgrounds and have already boosted sales by 30% by tapping into the group-excursion market.

The seller voices only one regret: his buyers insisted on involving their attorney, which, naturally, required him to do the same. "The lawyers didn't bring anything to the deal and wound up costing me an extra $5,000 and slowing down the eventual closing date by one month," he says. "That was too bad."

LESSON THREE:
You've got to protect yourself and your company at all times.

Kayaking companies aside, lawyers really can't hurt a business sale, and in those truly awful cases in which deals spiral out of control, they may provide the only protection sellers can count on. If you're wondering just how bad things can get, consider the sad case of the Northeast bagel-bakery chain (October 1996), on the market for $2.5 million.

If there was any company in this group of 14 businesses on the block that had sales prospects worth betting on, this was the one. After all, the bagel business has been hotter than, well, toast, with five national chains carrying out aggressive expansions, including regional acquisitions. With multiple outlets in a handful of desirable college towns and a hefty $2.8 million in sales, the chain looked like a smart buy in a consolidating industry.

But you can't bet on anything in this marketplace. The owners negotiated a deal that looked just right: the bidder--a small entrepreneur with financing in place, a second-in-command with expertise in the bagel business, and a willingness to pay top dollar--signed a contract and indicated his readiness to close the deal quickly.

"The day came when we were ready to close at 2 p.m.," recalls one of the two founding partners, "so we called a meeting early that morning for our senior people. That's when we notified them that we were selling the company and talked to them about what we expected to happen next."

But the sellers couldn't have predicted the outcome of even the next 12 hours. "We were 99% there, and then this guy called us up and pulled out of the deal," says the partner. He describes what happened next: "It was unbelievable. Here we thought we had a contract that guaranteed the sale, but it turns out the contract was written completely to protect the buyer's interests." (No wonder. His lawyer had drawn the contract up.) "The buyer was able to pull out for any reason at all, at any time before the close, with absolutely no penalty."

Months later, this would-be seller takes a deep breath and then says: "We never even knew why he pulled out. He didn't have to tell us. But the damage he did was unbelievable."

The owners had to perform damage control to hold on to their senior staff. They needed to go back to square one and try to recontact once-interested investors. Not surprisingly, perhaps, they lowered their sales price to its current level of $1.6 million. But so far, nothing's happened. "We keep telling ourselves, it's not over till it's over. But we learned the hard way that you need a contract with many more legal protections and penalties in place. We were too lenient because the deal looked gilt-edged," the owner admits.

How can a good company fail to sell in a consolidating market? "It happens all the time," says Goonan of Grant Thornton. "In theory, the market forces are right, but anything can disrupt a particular company's chances. Maybe the seller wasn't flexible enough. Maybe the timing was slightly wrong. The thing to remember is, consolidating markets are made up of lots of small companies. Maybe yours won't sell because somebody else's in the neighborhood does."

LESSON FOUR:
Don't delude yourself--or potential buyers--about your company's weaknesses.

The seller of the Georgia tennis club (July 1996) knew that. "I wasn't a tennis instructor, and I knew that I had never managed to realize the business's potential, because I always had to hire other people to give lessons," he says. "When I talked to possible buyers, I emphasized that I was just selling the real estate--that I wasn't trying to put a value on the business--and in fact that I was selling it for less than its appraised value because I knew that a new buyer would be taking a gamble."

That direct approach gave him a lot of credibility in the marketplace, credibility that his company alone probably wouldn't have possessed. (In fact, this was one of the businesses on the block whose selling prospects we might have bet against ourselves.) The bottom line: the owner closed a sale in late May for $325,000--a price less than 6% lower than his asking price of $345,000.

Best of all, he handled the sale himself from beginning to end. "I saved at least $35,000 in broker's commissions, which was great," he notes, "and I sold to a guy that I knew, who had been running a public court in Atlanta." He adds, "During the months when the club was on the market, I got inquiries from people from all over the country, but I knew in my heart that the right buyer would be somebody who lived here, who understood just how incredibly strong the tennis market is in this area. That person would recognize what kind of potential this club would have if it were owned by a real tennis person who could give lessons and not have to give all that money away."

The good news is, he's sold the club and moved on to a business--real estate investment--he feels much better suited for. But getting the deal done required real flexibility. The seller had originally planned to offer $87,000 in financing to the new owner; during the two months in which negotiations took place, he expanded that to $100,000. He has no regrets. "That was the only way to make it all happen," he says.

LESSON FIVE:
Recognize when the time has come to work on plan B.

A pawnshop and a cinnamon-bun bakery may not have much in common with each other, but the owners of each of these profitable businesses came to the same conclusion during the past year: as of now, they're the best owners they can find for their companies.

"I guess the problem is, there really aren't too many entrepreneurial types willing to take the time to teach themselves about the pawnbroking business," speculates the owner of the $890,000 pawnshop (April 1996). "I was really shocked that people didn't recognize this company's value." So were we. Thanks to Nevada's strict control over pawnshop licenses, the company possessed a market monopoly until the year 2026. Profit margins were also 25% and rising.

Without an acceptable offer in sight, the owner decided to merge the pawnshop with another, larger one he owned elsewhere. That accomplished his most important goal: freeing up his own schedule for more time with his family. "By consolidating both operations, I was able to combine managements into one single operation. We were also able to hold on to some valuable tax-loss carryforwards from the newer operation. In all," he says, "I have absolutely no complaints, because this really is a very profitable business."

The owner of the cinnamon-bun empire--actually, a bakery and restaurant based in a New Mexico ski region (August 1996)--also has no regrets about pulling his company off the market. Considering the strength of his business's reputation--his restaurant actually appears on local postcards--he feels he had nothing to gain from accepting any of the three "terrible" offers he received.

"I thought about one seriously because the price was pretty good, but in the end, the terms were just so awful," he recalls. "The buyer wanted to give me very little down and tie it all to these huge balloon payments. By the time I got through with the paperwork costs, I'd be in the hole. Then I had to ask myself, What if they couldn't make the balloon payments, ran the business into the ground, and ended up returning it to me in terrible shape?" Negotiations dragged on for nearly six months because the buyer seemed appealing in certain ways, including his "pretty heavy business background." But by the end, the owner reports, "I was sick of talking to him. If he had really been serious, we would have gotten closer to each other's positions."

Fortunately for this owner, two of his adult children had decided by that point that they wanted to get more involved with the business. "That was great because the main reason I wanted to sell was because of my arthritis--I just didn't want to keep working as hard as I was," he says. "The company itself is very profitable, and it's all for the best that I didn't sell if my kids want to be involved."

Jill Andresky Fraser is Inc.'s finance editor. Cheryl McManus provided research assistance for this article.

COMPANY: Florida Taxi Company
FEATURED IN: May 1997
ASKING PRICE: $200,000
# OF INQUIRIES: More than 60
RESULT: Serious interest, including some from other cab companies

COMPANY: Midwest Amusement Park
FEATURED IN: November 1996
ASKING PRICE: $5 million
# OF INQUIRIES: 10 to 12
RESULT: Still on market at the same price; recent upgrades include installation of a new $1.2-million roller coaster

COMPANY: Coastal North Carolina Blueberry Farm
FEATURED IN: December 1996
ASKING PRICE: $1.1 million
# OF INQUIRIES: 75
RESULT: Plenty of interest, but business still on market at same price

COMPANY: Chain of Cosmetology Schools
FEATURED IN: February 1997
ASKING PRICE: $749,000
# OF INQUIRIES: 86
RESULT: About 10 serious potential buyers; negotiations stalled while waiting for owner's (recently filed) tax return

COMPANY: Minichain of Cinemas
FEATURED IN: March 1997
ASKING PRICE: $3 million
# OF INQUIRIES: 66
RESULT: Price reduced to $2 million; several serious bidders in the $1.5-million neighborhood, but owner won't lower price further

COMPANY: Northeast Bagel-Bakery Chain
FEATURED IN: October 1996
ASKING PRICE: $2.5 million
# OF INQUIRIES: 30
RESULT: Sale fell through hours before scheduled closing; price has been reduced to $1.6 million

Source: VR Business Brokers, Newport Beach, Calif., June 1997.
The Brokers' Dog List
In a marketplace in which small businesses often have a tough time finding buyers, some kinds of companies are the most difficult to sell. Here's a short list that you won't want to find your company on:
TYPE OF COMPANY REASON FOR DIFFICULTY
Personal service Sales may be too reliant on owner's involvement
Franchises Involvement of third party complicates matters
Construction Sales--and value of company--are contract-driven and may seem unpredictable
Any company whose asset value is too high for its cash flow Financing costs in top-heavy asset deals (involving real estate or other pricey assets) look too great to be met by cash-flow prospects
And the Rest?
Here's how the remaining eight companies featured in our Business for Sale column from April 1996 through May 1997 have fared

COMPANY: Nevada Pawnshop
FEATURED IN: April 1996
ASKING PRICE: Negotiable
# OF INQUIRIES: "Many"
RESULT: Pulled off market for lack of acceptable offers; merged with owner's other pawnshop

COMPANY: Illinois Race-Car Safety-Equipment Retailer
FEATURED IN: May 1996
ASKING PRICE: $230,000
# OF INQUIRIES: 1
RESULT: Sold for 95% of asking price in April 1997

COMPANY: Arizona Golf-Club Manufacturer
FEATURED IN: June 1996
ASKING PRICE: $1.1 million
# OF INQUIRIES: "Maybe 300"
RESULT: Pulled off market; owner decided to restructure the business himself, with the help of an overseas investor

COMPANY: Georgia Tennis Club
FEATURED IN: July 1996
ASKING PRICE: $345,000
# OF INQUIRIES: 50 to 60
RESULT: Sold for $325,000 in May 1997

COMPANY: Bakery and Restaurant in New Mexico Ski Region
FEATURED IN: August 1996
ASKING PRICE: $2.4 million
# OF INQUIRIES: 116
RESULT: Pulled off market; owner's children decided to get involved

COMPANY: Hawaiian Kayaking Company
FEATURED IN: September 1996
ASKING PRICE: $169,000
# OF INQUIRIES: 86
RESULT: Sold in October 1996 for $160,000

COMPANY: Regional Collection Agency
FEATURED IN: January 1997
ASKING PRICE: $2 million
# OF INQUIRIES: 25
RESULT: One deal fell through; owner took business off market

COMPANY: Rocky Mountain Video Distributor
FEATURED IN: April 1997
ASKING PRICE: $650,000
# OF INQUIRIES: 50
RESULT: Several strong candidates; owner believes a deal is imminent


Resources

Selling or buying a private company is hard to do. So don't rely simply on whatever your emotions (or business brokers) tell you. Here are three top-notch books that can quickly boost your expertise:

  • How to Buy a Business: Entrepreneurship Through Acquisition, by Richard A. Joseph, Anna M. Nekoranec, and Carl H. Steffens (Dearborn Trade, 800-245-2665, 1993, $19.95), offers a shrewd look at key considerations to keep in mind when purchasing a small business. (Among them: the benefits of broadening your search beyond your fantasies.) It also details how to find and evaluate prospective acquisition candidates. Would-be buyers should find the long chapter on financing the acquisition especially helpful. Don't make an offer without it.
  • The Buying and Selling a Company Handbook (Price Waterhouse, 1995, $3) can't be beaten when it comes to explaining the tax and other financial considerations relating to company sales and purchases. True, it's technical and can get so complicated it's off-putting. But if you spend some time working your way through it, your chances of success will inevitably improve. Isn't that worth a migraine? For a copy, call the communications department of your local Price Waterhouse, or call 212-819-5000 and ask for the marketing department. Or write to Douglas Calvin, Price Waterhouse, Middle-Market and Growing Cos. Group, 1251 Ave. of the Americas, New York, NY 10124.
  • How to Sell Your Business for More Money in Less Time with Fewer Problems, by C.D. Peterson (McGraw-Hill, 1990), is out of print, but it's worth trying to find it at your local library. What Peterson lacks in style, he more than compensates for by quickly and clearly answering an enormous range of questions a prospective seller might ask. Among the most useful chapters is one that addresses an all-too-typical quandary: "I did everything within legal bounds to keep my reported earnings--and therefore my taxes--as low as possible. How can I show buyers what my business is really worth when my books show such low earnings?" If the work sheets and sections describing the intricacies of business-valuation methods seem too complex, skip them and focus on meatier matters.

If you'd like to read the original Business for Sale columns covered in this story, they appear in the magazine, April 1996 through May 1997. You can also find the stories in our on-line archives; type Business for Sale for keyword search and select Sort by date.

HOULIHAN LOKEY HOWARD & ZUKIN, Scott Adelson, 1930 Century Park West, Los Angeles, CA 90067-6802; 800-455-8871 76

Last updated: Sep 1, 1997




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