In our 22nd episode of Private Market Insights, we move from the buyer’s perspective to the seller’s in a conversation with Tom Taulli, an entrepreneur and author with a diverse background in technology, business, and finance. Among other accomplishments, Tom is the Founder of BizEquity, a tech-enabled valuations company which continues to serve the small business M&A ecosystem. He is also the author of “The Complete M&A Handbook” where he described the end-to-end M&A process.
This episode is also a great opportunity to discover first-hand from an SMB veteran how various elements within a business’ operations and across the broader economy play a crucial role in shaping opportunities for buyers and sellers of small businesses.
Below are our key takeaways, but, as always, we highly recommend watching the entire episode, which has already become one of our most popular YouTube videos in the Insights series:
SMB Valuation – Balancing Art and Science
The process of valuing a small or medium-sized business (SMB) inherently involves a mix of both art and science, as Tom explains. Because the accuracy of small business financial reporting can vary wildly, conducting a proper valuation can be a challenge that requires holistic analysis, in addition to financial review.
Valuation is primarily about predicting future profitability and cash flows. SMBs, with their smaller teams and balance sheets, are riskier investments than larger corporations, resulting in valuations that often include a substantial discount. Additionally, the lack of a public market for small business investments means that liquidity options for investors are limited, further weighing on the valuation.
Another key factor in SMB valuation is the reliance on the owners, as their role, vision, and customer relationships are often crucial to the business’s ongoing success. An owner’s exit can create significant uncertainties, impacting customer loyalty and operational stability.
Tom addresses the differences between professional valuation services and do-it-yourself (DIY) online valuation tools. Interestingly, he doesn’t entirely dismiss the rough estimates provided by online calculators. While he acknowledges that expert valuation, involving comprehensive research and analysis, is more accurate, these tools, when using key financial metrics like revenue and EBITDA, along with adjustments for owner’s compensation, can offer a reasonable estimate of a business’s value. The key challenge is ensuring that the inputs to these calculators are accurate – without a deeper understanding of the company’s financials, a DIY valuation can be flawed.
Ways Small Businesses Can Influence Their Valuation
Tom emphasizes the importance of adjusting the income statement to truly reflect profitability. In many small businesses, particularly those set up as LLCs, profits often go directly to owners or are spent on personal expenses disguised as business costs, including salaries for family members who aren’t actively working in the business.
When a business is sold, such expenses are cut, revealing hidden profits. An effective valuation should take these adjustments into account, along with industry data and recent sales of similar businesses. Automated valuation software, now more advanced and user-friendly, can incorporate these elements when primed with accurate data, offering a clearer view of a small business’s worth. For purchasers, understanding these adjustments greatly affects the perceived profitability and valuation, underscoring the necessity for going beyond the basic figures.
Seller’s Mindset During a Business Sale
Drawing from his first business sale experience in his mid-twenties, without a broker or financial advisor, Tom reiterates that selling a business is not just a financial decision – it’s an emotional journey filled with complexities and uncertainties. Selling a business, which is often an owner’s largest asset, can be an overwhelming and stressful ordeal. For many sellers, their business is more than just a company; it’s a personal creation and a key element of their identity. Criticism or undervaluation from potential buyers can feel deeply personal and may lead to conflicts.
Sellers often wrestle with various concerns such as the buyer’s trustworthiness, the potential for a better deal in the future, and the opportunity cost of not continuing to run the business themselves. The sales process involves a lot of paperwork, due diligence, and negotiations, usually extending over a long period, which can also be emotionally-draining. A lengthy diligence process can also impact the valuation itself if negotiations distract the seller from managing the business and performance declines.
“Sometimes the buyer may call your ‘baby’ kind of ugly. And it’s like: ‘I’ve been working 24/7 on this business, how dare you?’”
Pre-Sale Oversights Sellers Should Avoid
Our guest notes that small businesses often have disorganized financials and contracts, which might make buyers skeptical about the accuracy of the records, potentially decreasing the business’s value in a sale. Tom recommends that business owners engage professional advisors prior to putting a business up for sale.
Tom also highlights that the choice of corporate structure is frequently neglected. From his experience, an LLC structure can complicate a sale and lead to tax implications. He suggests considering a Delaware C Corporation for its familiarity among buyers and its straightforward nature in the sales process. Moreover, he emphasizes the importance of understanding the tax consequences of a sale. Business owners should think about tax strategies early on, as the right corporate structure can greatly reduce capital gains taxes when selling the business. Engaging a tax advisor and a knowledgeable attorney early on can bring long-term advantages and facilitate a tax-efficient structure for the deal.
Seller’s Perspective on Selecting the Right Buyer
Tom considers that sellers focus on potential buyers’ ability to effectively run and improve the business after the sale. This prioritization can sometimes put the seller’s motivations at odds with their broker’s, who may prefer to close the deal with the highest possible bid. In situations where sellers are faced with buyers offering similar financial terms, he stresses the need to evaluate each buyer’s business experience and operational skills.
This assessment becomes especially important in deals involving installment payments, where the seller’s financial return depends on the continued success of the business. Tom points out that a track record of hands-on business management can be a key indicator of a buyer’s suitability. However, he cautions that not all professional experience may translate well into managing a small business. In the end, sellers need to conduct their own thorough investigation of potential buyers, relying on both factual evidence and their intuition to decide who is most likely to maintain and grow the business.
Sentiments as Economic Indicators
Tom believes that shifts in business owner sentiments can be early indicators of wider economic shifts. For example, the small business owners Tom worked with in 2007 started to worry about their forward-looking financial prospects in early 2008, pre-dating the actual declines in the Great Recession later that year. This change in mood, evident in comments on valuation forms, offered early warning signs of the looming economic downturn. This observation supports the idea that consumer and business owner sentiments can serve as valuable data for forecasting, particularly when they diverge from general economic outlooks.
Speaking about the changing nature of mergers and acquisitions since he published “The Complete M&A Handbook,” 2000, Tom notes that the fundamental principles of M&A have largely stayed the same. Future updates to his book would include insights on online valuation tools, digital marketplaces, and modern resources like LinkedIn and virtual data rooms.
Entrepreneurial Advice from Tom Taulli
- Solve Personal Pain Points: Tom emphasizes the importance of building a business around a problem you have personally experienced. This approach not only provides a deeper understanding of the issue but also ensures genuine motivation to find a solution. For instance, Tom’s own challenges with exams led him to develop software that assisted students in exam preparation, addressing a problem he intimately understood.
- Know Your Strengths and Limitations: Recognizing and embracing your own skills and preferences is crucial. Tom, for example, prefers to operate within the early stages of a business. He acknowledges that his strengths lie in starting and building businesses up to a certain point, after which he prefers to hand over the operational reins. This self-awareness is key to finding the right role within the business lifecycle.
- Identify When to Move On: Understanding when to step away or transition to a new venture is essential. For Tom, losing interest or excitement in the current project is a clear indicator that it’s time to move on. He advises entrepreneurs to be attuned to their feelings about their work, recognizing that staying passionate and engaged is vital for success.
M&A Market Outlook for 2024
Following a period marked by economic uncertainties, interest rate fluctuations, and the aftermath of the Covid pandemic, Tom anticipates a resurgence in M&A activities. He observes that the preceding years witnessed a notable decline in major deals, largely due to market volatility and pricing challenges. However, the landscape is set for a change, with early signs already indicating a revival in substantial transactions across various sectors, including technology and energy.
He also points out that private equity firms are likely to become more active, driven by the necessity to deploy accumulated capital. With the economy showing signs of stabilization and interest rates potentially easing, the environment seems conducive for a positive year in the M&A world.