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While tempting, selling your service business involves quite a bit more than simply clearing out the accounts and handing over the keys to a new owner.
President Fred Silberstein and Business Strategist Brian Cohen of SF&P Advisors, a brokerage firm for residential, commercial, and mechanical HVAC and plumbing mergers and acquisitions, explained the nitty gritty of what you need to know for a successful business-selling transaction in a recent webinar hosted by ServiceTitan.
The investment brokers discuss:
Top mistakes owners make when selling their business, and how to avoid them.
The importance of post-sale working capital.
How to properly calculate business valuation.
Private equity firms lining up to buy service businesses.
Silberstein says service business owners decide to sell their businesses for a variety of reasons, but many don’t understand how to value their company’s EBITDA, or Earnings Before Interest, Taxes, Depreciation, and Amortization.
“EBITDA is meant to measure cash flow, and the true results of the business,” Silberstein says. “That's what all buyers bid off of. It's an important distinction to understand EBITDA.”
Two things make up the purchase price for a service business: EBITDA times a multiple. The valuation a buyer pays is a multiple of your EBITDA, based on historical growth and expected future growth.
For example, Cohen shared a client case study for Astar Heating & Cooling, an HVAC residential repair and replacement company in the Northeast. In business since 1976, the company’s owner failed to make a profit for several years and sold to a private investor in 2016.
The new owner made three important changes:
Trained technicians to look for other potential problems in the home, and sell additional repairs or equipment to earn a commission.
Added plumbing to their services to further diversify the company.
Invested heavily in SEO marketing, and hired a marketing company to direct an aggressive direct mail campaign.
Valued in the $4 million range in 2016, Cohen says the company was trending over $10 million in revenue when SF&P Advisors helped sell the business to new owners last year. The company more than doubled in growth in less than a three-year period and increased its EBITDA by 20 percent.
Some key stats for the 2019 sale:
65 potential buyers (also the number of non-disclosure agreements).
9 indications of interest.
6 site visits with potential buyers.
Outcome: Astar sold for one of the highest multiples for a company of that size.
“As you grow your EBITDA, the valuations increase, and everyone will win when that buyer decides to exit somewhere in the future,” Silberstein says.
Cohen says the number of potential buyers for the smaller company in Middletown, N.Y., indicates the heightened level of interest of private equity firms in acquiring home service companies.
“When a company has their financial house in order, key management in place, and they're clear about what they want their next steps to be, this is what a deal could look like,” Cohen says.
10 mistakes owners make when selling their business
1. Taking your eye off the business, resulting in bad financials during the diligence period when everything is under a magnifying glass.
If your business shows steady growth of 10, 15 or 20 percent, it’s critical to continue those trends even if closing the deal appears imminent.
“It’s very important not to take your eye off the ball, it’s very important to keep going,” Silberstein says. “Make sure the results are going the same way, the same percentages, the same growth...you’re really under a magnifying glass while you’re in this process.”
2. Not operating in the ordinary course of business (i.e., giving key employees raises above historical levels as a way of taking care of them on the way out).
You may want to spread the love on your way out the door, but it’s not a good idea to give employees big raises before you go. It comes out during due diligence, and creates problems for you and the buyer.
“The buyer is buying off a certain EBITDA, and when you impact things like raises and giving things beyond the ordinary course, that has an adverse effect on your EBITDA,” Silberstein explains. “That's going to bring the EBITDA down and that's not what the buyer is buying off of.”
3. Not taking both levers of the deal—EBITDA and the multiplier—into account.
Every deal includes those two levers, he says.
“It’s kind of like a push-pull relationship,” Silberstein says. “My sellers control the EBITDA, and we like to push the multiple.”
For instance, a company valued at $5 million with a 10 multiple would have an enterprise value of $50 million. If the multiple is 5, the estimated value is only $25 million.
4. Not understanding the consequences of a legal entity (S-Corp vs. C-Corp).
If your company filed as a C-Corp, you can get into trouble with double taxation when you go to sell the assets, Silberstein says. Selling the assets, as well as distributing the money after the sale, qualify as separate taxable events.
“If you are a C-Corp looking to switch to an S-Corp, just understand there is a look-back period,” he says.
S-Corps only pay double the taxes on salaries and payroll, but not distributions or remaining profit.
5. Lack of key performance indicators (KPIs).
It’s critical to measure key performance indicators to prove the effectiveness of your business operations.
“Buyers like to see how you're managing the business, which KPIs you’re using, and how effective you are using those KPIs,” Silberstein says.
6. Not grooming adequate bench strength to take the business into the future post-transaction.
You’re ready to retire, relax, and enjoy life. Great!
Who’s the next guy? Is there someone to step into your role? Do you have adequate bench strength? What does that look like?
7. Financial literacy—not understanding the process you’re going through.
Going through the process of due diligence can be painful, but it is serious business. Everything must be confirmed, from operational diligence to paying payroll taxes properly, and everything in-between.
“I often tell my clients, it’s a little bit like a colonoscopy without the anesthesia,” Silberstein half-joked. “There's a lot of eyes on all the different processes you run, and we make sure those are all buttoned up.”
8. Overall business mix—dependency around new construction.
Current margins for companies involved in new construction are trending lower, especially in light of the economic slowdown from the global pandemic.
“If you depend heavily on new construction business, it’s not worth as much as a service and replacement business,” he says.
9. Not understanding the impact of working capital on the deal.
Working capital is defined as current assets minus current liabilities. It’s basically a business’ operating liquidity.
“Typically, buyers today are doing deals on a debt-free, cash-free basis. The cash is taken out from the working capital (the asset side), and the debt is taken out from the liability side,” Silberstein says.
10. Not understanding the importance of service contracts and the “fence” they create around the customer.
Buyers like companies with a large number of service contracts, because it represents deferred revenue from loyal customers—even though it’s treated as a liability on the company’s balance sheet.
The importance of working capital post-sale
As mentioned previously, it’s not advisable for business sellers to clear out the accounts and leave debts right before handing over the keys.
Buyers expect a normal amount of net working capital to be left in the business to meet short-term obligations and continue operations. SF&P advises taking a 12-month average of working capital, and then comparing it to your estimated closing amount.
“That could be over or under, and then you may leave a little bit of money behind or you may get a little bit more,” Silberstein explains. “Working capital affects every deal.”
The Net Working Capital Formula = Total Current Assets - Total Current Liabilities.
Working capital is a business’ operating liquidity, or current assets minus current liabilities.
Current assets might include cash or other items expected to be turned into cash within one year, including accounts receivable, inventory, and prepaid expenses.
Current liabilities are debts and obligations due within one year, including accounts payable, accrued expenses, payroll obligations, and current portion of debt.
How to properly calculate business valuation
The more revenue your company earns, the more interest it generates and the higher the multiple at which it trades, Cohen says.
Other actionable steps to take to increase your company’s valuation include:
Strong growth rate—“Bottom line, you need to always be growing,” he says.
Consistently higher margins—As you make more money, work toward consistently higher margins by charging more for your services.
Business mix (residential vs. commercial; new construction vs. service)—“Pure service and replacement businesses are going to trade for the highest multiple. Period,” Cohen says.
Strong, predictable cash flow.
Recurring revenues—How many service maintenance agreements does your company have? “If you’re not going after those on a daily basis, shame on you,” he says. “These are things that help predict what your cash flow is going to be.”
Low customer concentration—Do you have 10,000 customers or 400? If a client leaves, how does that impact your business?
Strong bench strength and management team—Lock key employees into employment agreements and non-compete agreements. “Get your people committed to you. It’s worth the squeeze,” Cohen advises. Also, build your business to succeed without you.
Sufficient working capital to support growth.
Strong brand name/identity—What’s your brand identity in your target market? “Having a longstanding, well-known name increases your value,” he says.
Non-union or union employees—“The preference for buyers is to deal with non-union businesses,” Cohen says.
Financial statements—Audited financial statements work better than internal audits when selling a business. One client who owned a nearly $20-million business got his financial statements audited every year, “because it’s how he keeps score,” Cohen says.
Backlog—A bigger backlog is better. Easily compare it to the year before to show potential buyers how much of that backlogged business turned into revenue.
Private equity firms lining up to invest in service companies
Cohen says he recently presented to about 200 private equity firms in New York, and he immediately received a dozen phone calls from investors new to the space. They told him they used to see 1,000 deals per month, but now see less than 200 per month.
“Fred and I talk about it all the time. Where is private equity going to invest right now? What space do they feel safe in?” Cohen says. “They’ve got a lot of dry powder sitting on the sidelines that needs to be deployed.”
With hundreds of new buyers entering the space, SF&P Advisors wants to help sellers navigate any unfamiliar waters. One of the biggest mistakes service company owners make is not knowing the real value of their business.
“If you don’t know what your business is worth, how do you know if the deal is any good or not?” Cohen asks.
Before going down a rabbit hole with an unknown private investor, Cohen advises calling him first at 954-226-3409.
“Text me or call me, we will have a private conversation, and we’ll get an idea of where you’re at,” he offers.
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