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This blog takes a brief look at an alternative way to divest from one’s business. Let’s start by generalizing a little about how the market reacts to different sized businesses that are available for sale. I’ll categorize businesses into three groups:
Micro – This is a business that pays an owner and their family a salary plus there may be additional profit at the end of the year, but rarely more than say $100,000.
Small – This is a business that generally relies heavily on an owner’s connections and expertise. The business pays the owner a good salary plus earns an additional $200,000 to $500,000 in profit.
Medium to large – This is a business that may be controlled by an owner and their family, but has a strong management team. It does not rely on the owner to make the majority of sales and earns over $500,000 on a consistent basis.
Micro businesses typically sell for a multiple of a shareholder’s discretionary income (“SDE”). This is defined as the shareholder salary plus income that is available for distribution after maintaining adequate working capital and allowing for asset replacement. Historically, this might be in the range of 1x to 2x SDE.
Medium to large businesses generally sell for a multiple of maintainable EBITDA with adjustments to ensure adequate working capital and regular asset replacement. Generally the purchasers are either a competitor or financial investor. Acquirers tend to be sophisticated and experienced in negotiations.
Small businesses are often more difficult to sell. Financial investors are generally not interested because the scale of the business is small; the goodwill of the business might reside with the owner and the return is not high enough relative to the effort to manage it. Generally the highest price can be realized by selling to a competitor or strategic buyer. These buyers are often able to pay more because they can take the business and plug it into their system, hopefully creating some financial synergies.
For a variety of good reasons, you might not want to sell to a third party; they may not be interested, the price and terms being offered are not adequate or you want to pass the business on to long-time loyal employees. In these cases, consider a management buy-out (“MBO”).
I’ll start by saying, management buy-outs are not for the faint of heart. Your employees might not understand business valuations, how to properly interpret financial statements, how the deal can be financed, and most importantly, understand the fundamentals of business risk. Having said all that, it can be done and if planned properly it can be a win/win for everyone.
It is our experience that a successful MBO process requires a third party facilitator that is trusted by both sides of the transaction. We have been engaged in this capacity a number of times. Here are the steps:
Step 1 – There must be a good understanding of what the owner really wants.
Step 2 – The owner and potential purchaser must understand and agree on the process.
Step 3 – An independent valuation report or pricing analysis should be completed.
Step 4 – The owner has to be clear on an acceptable price, conditions and financial terms.
Step 5 – Present a plan to the management team.
Step 6 – Develop a financing and transition plan.
Step 7 – Assist the buyer, seller and their lawyers to close the deal.
The process has to be handled delicately for a number of reasons. First, management does not have a lot of negotiating power. Second, if there is no deal in the end, everyone has to keep working together. While not without its challenges, MBOs can often be a great strategy for everyone.
CPA, CA, CBV
Partner - Advisory Services
Mike has over 25 years of experience providing accounting and business advisory services, with a focus on the Canadian insurance industry.
CPA, CA, CBV
Alex Wong is a partner at Smythe Advisory and is focused on being a trusted business advisor to his clients.
CPA, CA, CBV
Director of Valuation Services
Paul Woodhouse focuses on providing financial advisory and litigation support services to clients.
Gagandeep specializes in M&A advisory engagements, as well as business valuations in the contexts of management buyouts and succession planning.
Arthur’s mandate is to assist Smythe clients in Western Canada in preparing for and executing business divestitures or acquisitions.