Buying a Business Process Explained

Don’t Just Buy a Business. Buy the Right Earnings.

Buying an existing business can be one of the most important financial decisions you will ever make. At KKBA^® , we believe a buyer should look beyond the asking price, historical tax returns and traditional industry “rules of thumb.”

Ultimately, you are buying future earnings.

The important questions are not simply “How much did this business make last year?” or “What multiple do businesses in this industry sell for?”

The better questions are:

How much does this business really earn?

How much of those earnings are sustainable?

How much will transfer to a new owner?

What risks could cause those earnings to decline?

And what are those earnings worth?

KKBA has developed an analytical approach designed to help buyers answer those questions before committing substantial capital to an acquisition.

Looking Beyond “Seller’s Discretionary Earnings”

The business brokerage industry has traditionally relied heavily on a calculation known as Seller’s Discretionary Earnings, or SDE.

KKBA believes buyers deserve a deeper analysis.

Simply adding an owner’s compensation and selected expenses back to reported net income does not necessarily tell a buyer what a business actually earns—or what it will earn under new ownership.

Expenses can be overstated, but they can also be understated.

An owner may be performing work that must be replaced by a salaried employee. Rent may be below market. Maintenance may have been deferred. Family members may work without adequate compensation. Necessary marketing, technology, insurance, staffing or capital expenditures may have been postponed.

KKBA therefore focuses on Normalized Income: an estimate of the economic earnings of the business after considering both legitimate add-backs and expenses that may need to be restored or normalized.

From Reported Income to Normalized Income

Our analysis begins with the company’s historical financial performance and works toward determining the earnings a buyer may reasonably expect from the business under normal operating conditions.

Reported Income

+ Legitimate Owner-Related Adjustments

+ Genuine Nonrecurring Expenses

− Missing or Understated Operating Expenses

± Related-Party and Other Normalization Adjustments

= Normalized Income

But even that doesn’t answer the most important question.

Two businesses producing exactly the same Normalized Income can represent dramatically different acquisition opportunities.

Not All Earnings Are Created Equal

Consider two businesses that each generate $500,000 of Normalized Income.

One has recurring contractual revenue, hundreds of customers, stable margins, experienced management, low owner dependence and consistent historical growth.

The other depends heavily upon several customers, relies on the owner to generate sales, experiences unpredictable revenue, has declining margins and requires significant upcoming capital expenditures.

Both may produce $500,000 today.

They should not necessarily have the same value.

That’s why KKBA examines not only the amount of earnings, but also the quality of those earnings.

KKBA FCF+^™ and Earnings Quality Rating

Our FCF+ methodology is designed to help evaluate the economic performance of a business beyond the traditional SDE calculation.

Once earnings have been normalized, our Earnings Quality Rating (EQR^™) considers factors that can affect the sustainability and transferability of those earnings.

Depending upon the business, these may include:

The objective is straightforward:

Determine not only how much the business earns, but how dependable those earnings are likely to be after the acquisition.

A Virtual Test Drive of the Business

You wouldn’t buy a car without driving it first. Unfortunately, you can’t own and operate a business for six months before deciding whether to buy it.

FCF+EQR is designed to give you something approaching a financial “virtual test drive” of the business before you buy it.

Instead of looking only at last year’s tax return or accepting a calculation of Seller’s Discretionary Earnings, FCF+EQR helps you look beneath the reported numbers to understand how the business actually produces its income.

It helps answer questions such as:

Where do the earnings come from?
How much of the revenue is recurring or repeatable?
How concentrated are the customers?
How dependent are the earnings upon the current owner?
Are margins stable?
Are the reported expenses representative of what a new owner will experience?
Are significant expenses or capital requirements being deferred?
How much working capital does the business require?
How predictable are the earnings?
Most importantly, how much of today’s Normalized Income is reasonably likely to transfer to you as the new owner?

A virtual test drive can’t eliminate acquisition risk, and it doesn’t replace your independent due diligence. But it can help you better understand the economic engine of the business before you decide whether you want to own it.

Transferable Earnings Matter

A company’s historical financial statements tell us what happened under the seller’s ownership.

A buyer needs to know what may happen under the buyer’s ownership.

That distinction is critical.

An owner’s personal relationships may drive revenue. A major customer may not be contractually committed. The owner may personally perform several important functions. Certain licenses may need to be transferred or replaced. Key employees may be critical to continued operations.

KKBA therefore considers the transferability of earnings as an important part of evaluating an acquisition.

The fundamental question is:

Of the earnings you’re paying for today, how much can you reasonably expect to own tomorrow?

FCF+/EQR Is Not a Quality of Earnings Study

KKBA ‘s FCF+/EQR analysis should not be confused with an independent Quality of Earnings study performed by a CPA or transaction advisory firm.

A formal QoE engagement may independently verify revenue, expenses, accounting practices, working capital and financial records through extensive financial due diligence.

FCF+/EQR serves a different purpose.

It is designed as an earnings normalization, earnings-quality and acquisition-evaluation tool to help identify the economic characteristics of the business and issues deserving additional investigation.

For appropriate transactions, KKBA may recommend that a buyer obtain an independent QoE study in addition to legal, tax and other professional due diligence.

Look Under the Hood Before You Buy

Financial statements are only part of the acquisition story.

KKBA helps buyers consider questions such as:

Are revenues recurring or must they be recreated every year?

How dependent is the business upon its largest customers?

Can the business operate successfully without the seller?

Are margins improving or deteriorating?

Are there expenses a new owner will incur that the seller does not?

Has maintenance or capital investment been postponed?

How much working capital will the business require?

Are key employees likely to remain?

Are important customer and supplier relationships transferable?

What could materially change earnings during the next 12 to 24 months?

These questions can be every bit as important as the historical income statement.

Financing the Acquisition

Finding a good business and determining its value are only part of the acquisition process. The transaction must also be structured so that the buyer has sufficient capital to acquire and successfully operate the company.

KKBA can help buyers evaluate potential financing structures and work with lenders experienced in business acquisitions, including SBA and conventional financing.

We can also help buyers understand the interaction among:

Purchase Price + Buyer Equity + Acquisition Debt + Working Capital + Debt Service = Financially Viable Acquisition

A business may be attractive but still be a poor acquisition if excessive debt service consumes the cash flow required to operate the company and provide an appropriate return to its new owner.

Our Business Purchase Process

Define Your Acquisition Criteria

We begin by understanding your experience, financial resources, objectives, preferred industries, geographic requirements and desired level of owner involvement.

Confidentiality and Buyer Qualification

Before receiving confidential seller information, buyers execute the appropriate Non-Disclosure Agreement and provide information regarding their acquisition qualifications.

Identify Acquisition Opportunities

Your KKBA professional helps identify businesses that fit your acquisition objectives and financial capabilities.

Preliminary Business Evaluation

We help you look beyond the asking price and determine whether the economics and characteristics of the business warrant further investigation.

Evaluate Earnings

Where sufficient financial information is available, the analysis can include normalization of reported earnings and identification of potential adjustments, risks and questions requiring further investigation.

Evaluate Earnings Quality

We consider factors affecting the sustainability, predictability and transferability of the company’s earnings.

Meet the Seller

Once an opportunity warrants serious consideration, KKBA coordinates discussions with the seller so that you can better understand the company’s operations, customers, employees, competitive position and future opportunities.

Structure the Offer

Your KKBA professional can assist in structuring a Letter of Intent reflecting the proposed price, terms, financing, contingencies, training, transition and other major transaction terms.

Financing

When acquisition financing is required, we can help coordinate the process with lenders experienced in business acquisitions.

Due Diligence

After reaching preliminary agreement with the seller, the buyer conducts comprehensive financial, operational, legal, tax and other appropriate due diligence.

KKBA helps facilitate the exchange of information and resolution of transaction questions, while encouraging buyers to engage qualified legal, accounting, lending and other professional advisors where appropriate.

Resolve Transaction Contingencies

Financing, lease assignments, licensing, regulatory approvals, contracts, inventory, equipment and other contingencies are addressed before closing.

Closing and Transition

KKBA works with the parties and their professional advisors to help move the transaction toward closing and an orderly transfer of ownership.

A Better Way to Evaluate a Business

We don’t believe a buyer should purchase a company simply because someone applied an industry multiple to Seller’s Discretionary Earnings.

A business is worth what its economic earnings, earnings quality, risk characteristics, growth prospects and transferability justify.

Our objective is not merely to help you buy a business.

Our objective is to help you understand what you’re buying.

Explore Businesses for Sale | Speak With a KKBA Advisor | Learn About FCF+/EQR

FCF+/EQR is an analytical and valuation-support methodology and is not an audit, review, compilation, appraisal, independent Quality of Earnings engagement, legal opinion, tax opinion or guarantee of future financial performance. Buyers should conduct independent due diligence and consult appropriate professional advisors before completing an acquisition.

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