The thesis of this article is that the use of a reputable intermediary (business broker) adds value on an ex-ante basis by increasing both the likelihood of a successful outcome and the amount of the anticipated payout in the purchase or sale of a business.
Intermediary selection is critical as the quality and capabilities are highly variable within the profession. At the most basic level, the intermediary should be properly licensed and insured. The International Business Brokers Association ("IBBA") is the preeminent industry group. They offer two levels of accreditation (Certified Business Intermediary and Merger & Acquisition Master Intermediary). IBBA membership and accreditation are strong positive indicators of a reputable broker. Additionally, the buyer or seller should ask for, and follow-up with, references for the broker..
How might one measure success? Risk and reward are relevant metrics to apply. Since we are dealing in capital markets, it is appropriate to apply financial definitions to these terms. In the world of finance, risk is qualitatively described as the reliability of future outcomes. Quantitatively, it is measured in standard deviation units. U.S Treasury notes are considered risk free and would have a standard deviation of zero as future payment is certain. Other investments that present a greater risk would have a greater standard deviation.
Anticipated reward as a financial term is often expressed as Net Present Value ("NPV"). Future payments are discounted to reflect both the perceived payment risk and timing of payments. For those readers with an interest in mathematics:
NPV = S pi / (1 + r)i
where p is the payment in period (i) and r is the required return or interest rate. Value is an inverse function of both risk and time to payment. The NPV calculation is widely used and understood. The problem with using the methodology lies in determining an appropriate value for r.
Another more sophisticated methodology of quantifying reward prior to the deal is in terms of Expected Monetary Value (EMV). Using this methodology, a decision tree is drawn for the various potential outcomes. The forecast payouts are then multiplied by the forecast probabilities to calculate an EMV. For example, a $1 bet on red in roulette, which has a possible payout of $2 and a risk probability of success of 18/38, has an EMV of just less than 95 cents ($2*(18/38)) + ($0 *(20/38)). A $1 bet on a single number, which has a possible payout of $36 and a risk probability of success of 1/38, has the same EMV of 95 cents ($36*(1/38) + ($0*(1/38)) but a dramatically higher risk. Red is therefore a better bet as it has the same EMV but lower risk. The time value of money concept embodied in the NPV calculation can be overlaid as required onto EMV using a risk-free rate of return for r.
Let’s begin applying these lessons to our thesis that a reputable broker adds value. Although risk and reward are inextricably intertwined, let’s start with risk. The Hippocratic Oath states: "first do no harm." One risk in the sales process is that sellers may harm themselves by following a natural tendency to not disclose adverse information upfront in the business sales process. Such information will eventually come to light in the due diligence process or after the sale and potentially either derail the deal pre-sale or raise the specter of litigation post-sale. To limit risk due to inadequate disclosure, the intermediary will coach the owner to disclose, disclose, disclose.
Another risk is that a business can be harmed by breaches in confidentiality. For example, a buyer may have competitive motives and no true interest in purchasing a business. For this reason a reputable business broker will protect his seller client by requiring a potential buyer to sign a nondisclosure or confidentiality agreement. In managing risk, an intermediary is well positioned to screen unqualified buyers and obtain signatures on confidentiality agreements with teeth. The broker will also advise the owners of the risk inherent in marketing to direct competitors. In each engagement, a reputable broker will parse out the relevant information commensurate with the buyer’s demonstrated level of commitment. These actions will reduce the chance of having the sale process damage the value of the business.
As we saw in the roulette example, one should consider the ex-ante probabilities of achieving the various outcomes. Most small businesses that are listed for sale do not sell.1 Unrealistic price expectations are the most common issue. A business broker’s market knowledge should inject realism while concurrently enhancing the perception of the firm’s value and marketability.
The ideal valuation process is where the broker collects and presents the relevant information about a firm to an accredited third-party appraiser. The broker knows what drives value and their involvement will provide a justifiable higher price. Use of an accredited third-party appraiser lends credibility to the process and provides the client with comfort that the correct price is being placed on the business.
Two other reasons why listed businesses do not sell are a business’ failure to attract buyers and lack of financing for the buyer. A broker’s position in the marketplace provides constant interaction with buyers and an experienced broker knows how to best market a business. With respect to financing, a reputable broker will also be aligned with several lenders. The broker will obtain pre-approval requirements from lenders before going to market and qualify buyers based upon banking requirements.
Trust and communication between the parties and the broker are critical. Once engaged with a serious buyer, a good broker will maintain continuous contact with both sides. An attorney, who is limited by ethical rules from communicating with a party represented by another attorney, does not have this same freedom of communication. The intermediary can manage expectations on both sides while coaching and directing the parties through the sale process. This reduces the risk of a surprise and reduces anxiety induced by lack of process knowledge. The buyer and seller’s personal relationship must survive the sale process. An intermediary provides a buffer zone that will be tested during negotiation and due diligence.
Deals that drag are deals that die. A fully documented offering memorandum will speed the buyer’s quest for financing. A good broker will have thoroughly prepared the seller for due diligence and the information needed by the buyer. This should eliminate deal-killing surprises and keep things moving. The broker will also maintain regular communication during due diligence with both parties’ attorneys and other advisors to maintain deal momentum. If well prepared, the attorneys will likely borrow heavily from the broker’s work product when drafting schedules for the closing documents.
The consequences of not selling a business vary case by case. The EMV for using a broker increases with the level of seller compulsion to sell. The reason is that the broker has better odds of closing a deal and thereby avoiding the negative outcome of not selling the business.
Let’s now focus on reward. Sellers are interested in maximizing post-tax proceeds with a strong bias for cash at closing. They would like to have no residual risk. Once again we see conflicting goals. The all-cash stock sale will not command the same price as an asset sale with some level of seller financing.
Deal structure strongly influences value. An experienced broker can help in the search for an optimum in balancing these objectives. Advisors lacking M&A experience often recommend against holding any debt from the buyer as payment is not assured. This sends a strong adverse signal to both the buyer and their financing source. Banks are less likely to lend and buyers are less likely to buy. The result is reduced marketability and lower value. An experienced broker will point out that a seller note for ten percent of the transaction amount will typically raise value by a comparable amount while increasing marketability. Any EMV assigned to the seller note should therefore be welcomed as additional proceeds. Clearly, the balance swings against the seller as their portion of financing increases.
Business owners often look to their accountants to help them sell their business. Most accounting firms do not have a brokerage or investment banking group and therefore lack the necessary resources to effectively market a business. The accountants’ professional organization (American Institute of Certified Public Accountants) offers an accreditation in business valuation but few accountants have earned these designations.
The typical CPA is often put into a difficult position when asked for an opinion of value by their client. The CPA is often reluctant to admit their professional limitations. He may be worried about digging too deeply into reported discretionary expenses as this might force them into recommending that the client file an amended return. There may also be a concern about preserving the client relationship. Even if the accountant does a perfect job in determining value, the accountants’ report may lack the credibility of a third-party accredited appraiser.
In summary, a reputable broker has the means and motive to lower risk and increase reward for the client. In so doing, the EMV of their services should more than offset their fees and provide added value relative to the alternatives of for-sale-by-owner or attempts to market by other advisors such as bankers, accountants and attorneys.
One final word of caution: most attorneys focus only on reviewing the intermediary’s listing or engagement agreement. This is a big mistake. An attorney serves the client best by helping find and engage the right broker with the right listing agreement. The wrong broker with a great agreement will prove to be a lingering disservice.
1. Business Reference Guide, Tom West, Business Brokers Press, 2005.
Joseph McCaul is the president and founder of Joseph Associates International, Inc., an Illinois-reg-istered business brokerage & advisory firm focused on owner-ship transfers of privately held business. Joe McCaul holds an MBA from Case Western Reserve University and engineering degrees from the Polytechnic University. He is a member of the International Business Brokers Association, World Trade Center of Chicago and Naperville Area Chamber of Commerce.