If you’re new to the world of buying or selling a business, you might come across unfamiliar terms. Some of these terms are crucial, and understanding their meaning can be incredibly beneficial. To help you out, we’ve put together a brief lexicon of common terms used in business transactions, which will shed light on their usage.
Common Terms Used When Buying Or Selling A Business:
Add-backs
All or a portion of expenses that are added back to net income in an effort to place the figures as close as possible to the economic earnings that were actually derived from the business.
Asset Sale
This term has two definitions. The proper definition depends on its usage: A. The means by which a business owner transfers ownership of tangible and intangible assets, and possibly some liabilities, to another owner without transferring the ownership entity. B. The sale of a business enterprise that is no longer a viable ongoing concern at a price based solely upon the value of the tangible assets.
Blue-Sky
That portion of a “claimed” value or requested price that cannot be supported, or generally shown to exist, through the application of established valuation methodology. Alternatively, it is that excess value, above the business’ financial value, paid by a strategic buyer based on the buyer’s perceived future value of that business.
Business Valuation
A process and a set of procedures used to estimate the economic value of an owner’s interest in a business. Valuation is used by financial market participants to determine the price they are willing to pay or receive to effect a sale of a business. See Broker’s Opinion of Value.
Cash Flow
A business’ net income plus non-cash charges (depreciation, amortization, depletion). Can be defined (if so qualified) as before or after such items as taxes, debt service (interest only or principal & interest), or extraordinary items. (Should not be confused with net cash flow, a.k.a. free cash flow).
Confidential Business Review (CBR)
A CBR is drafted by a brokerage firm or business broker to market a businesss to prospective buyers. It contains information about the business, including its products, markets, competition, and financial performance. The CBR is provided only to qualified buyers who have signed non-disclosure agreements. See Confidential Information Memorandum (CIM).
Confidential Information Memorandum (CIM)
Sometimes call “the book” or pitchbook is drafted by an M&A advisory firm or investment banker for a sell-side engagement to market a businesss to prospective buyers. It Contains financial information, including analysis of historical results and future projections. See Confidential Business Review (CBR).
Contingency
A requirement that must be met or removed before a closing can take place.
Due Diligence
A process where a buyer inspects a potential transaction. Often includes a detailed review of accounting history and practices, operating practices, customer and supplier references, management references and market reviews.
Earn-Out
A contractual provision stating that the seller of a business is to obtain additional future consideration based on the business achieving certain future business goals. An earn-out is a mutually beneficial tool to getting a deal done if it is structured appropriately. Is maximizes the selling price for the seller and it matches the Company’s future earnings with the payments made to the Seller. An earn-out should not provide a financial “burden” on the Company, but should be structured as a sharing of the future earnings. (Earn-outs are prohibited by the SBA.)
EBITDA
EBITDA, short for earnings before interest, taxes, depreciation, and amortization, provides a measure of a company’s current operating profitability. It calculates the net earnings before deducting interest expenses, taxes, depreciation, and amortization. Although not a universally accepted accounting principle, EBITDA is extensively utilized to evaluate a company’s performance based on its existing assets and prevailing operational conditions.
Enterprise Value
Enterprise value (EV) is a measure of a company’s total value, often used as a more comprehensive alternative to equity market capitalization. EV includes in its calculation the market capitalization of a company but also short-term and long-term debt as well as any cash on the company’s balance sheet. EV is a popular metric used to value a company for a potential takeover.
Exit Plan
A strategy to depart an existing situation. The creation of an overall strategy that prepares a business owner and his/her company for the time when that business owner is no longer involved in the operation of the company. Examples of unplanned exits include death, divorce, management disputes, influx of competition, technological obsolescence, loss of a major customer, or other unforeseen economic events.
Fair Market Value
The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts. (NOTE: in Canada, the term “price” should be replaced with the term “highest price.”)
FF&E
Furniture, fixtures, and equipment (FF&E) are the physical assets that a company possesses for its daily operations. Examples of FF&E include manufacturing equipment, computers, office furniture, display fixtures, and other durable items used in the company’s day-to-day activities.
However, the book value of FF&E assets may not always reflect their true worth since aggressive depreciation is often applied to expedite cost recovery. In reality, these assets may have a longer service life that extends beyond their full depreciation. Therefore, when valuing a business, it is preferable to determine the accurate value of assets based on their actual potential rather than their book value.
Goodwill
A. Those elements of a business that cause customers to return in sufficient volume to generate profit in excess of a reasonable return on tangible assets. B.That intangible asset that arises as a result of name, reputation, customer patronage, location, products and similar factors that have not been separately identified and/or valued but which generate economic benefits.
Intangible Assets
Non-physical assets such as franchises, trademarks, patents, copyrights, goodwill, equities, mineral rights, securities and contracts (as distinguished from physical assets) that grant rights and privileges and have value for the owner. See Tangible Assets.
Intellectual Property
Intellectual property is a broad categorical description for the set of intangible assets owned by a company and legally protected from outside use or implementation without consent. Intellectual property can consist of patents, trade secrets, copyrights, and trademarks or simply ideas. The concept of intellectual property relates to the fact that certain products of human intellect should be afforded the same protective rights that apply to physical property.
Key Person Discount
An amount or percentage deducted from the value of an ownership interest to reflect the reduction in value resulting from the actual or potential loss of a key person in a business enterprise.
Lease and Sale Comparables
In real estate, comparables (or comps) are properties that share similar characteristics and features with the one currently being considered. They are used for comparative purposes in market analysis. It is recommended to have a real estate agent, qualified appraiser, or surveyor perform this analysis.
When considering buying, leasing, or selling a business, comparing similar properties can provide valuable insights into the appropriate valuation of the real estate included in the business sale.
Multiple
Also Known as Enterprise Value (EV) Multiple, is the inverse of the capitalization rate. It is usually the ratio of the price to earnings, particularly for public companies. It can also be the ratio of selling price to DE for a small business. A multiple can be used to estimate the value of a company. Most often, however, a multiple is a generated value as an outgrowth of the valuation of a business.
NDA
A non-disclosure agreement (NDA) is a commonly used term in business transactions that everyone should be familiar with. It is a contractual agreement that protects sensitive or confidential information shared by a seller with a buyer. This information, which includes financials, strategies, client lists, supplier details, and employee information, is crucial for the buyer to evaluate the opportunity. However, if this information falls into the hands of competitors, it can be harmful.
An NDA outlines what information is considered confidential, how and with whom it can be shared, and its duration. By having an NDA in place, sellers feel more at ease sharing confidential and sensitive information with potential buyers.
Owner Financing
Owner financing, also known as seller financing, occurs when the current business owner provides a loan to the buyer for a portion of the business purchase price. The remaining amount is covered by the down payment and other financing sources, if needed.
Owner financing is increasingly common in business acquisitions. It benefits the seller by attracting buyers who may not have sufficient funds to cover the entire purchase price. It is also advantageous for the buyer as it enhances the attractiveness to banks and financial institutions for additional financing.
Although the terms of seller financing may vary, it typically covers 30% to 60% of the purchase price, with a term of 5 to 7 years and interest rates ranging from 6% to 10%.
Private Equity
An investment in non-public securities. Also, an investment asset class typically reserved for large institutional investors, such as pension funds and endowments, as well as high net worth individuals. Includes investments in privately held companies, ranging from start-up companies to well established and profitable companies, to bankrupt or near bankrupt companies. Examples of private equity include venture capital, leveraged buyout, growth capital and distressed investments.
Quality of Earnings
The quality of earnings refers to the proportion of income attributable to the core operating activities of a business. The amount of earnings attributable to higher sales or lower costs has higher quality, rather than artificial profits created by accounting anomalies such as inflation of inventory. Quality of earnings may be considered poor during times of high inflation. Also earnings that are calculated conservatively are considered to have higher quality than those calculated by aggressive account policies. A key characteristic of high-quality earnings is that the earnings are readily repeatable over a series of reporting periods, rather than being earnings that are only reported as the result of a one-time event.
Rollup
A process used by investors (commonly private equity firms) where multiple small companies in the same market and/or industry are acquired and merged. The principle aim of a rollup is to reduce costs through economies of scale. (also Roll-up or Roll up)
Rule of Thumb
A mathematical formula developed from the relationship between price and certain variables based on experience, observation, hearsay or a combination of these; usually industry specific. A rule of thumb is a common procedure or practice to empirically value a business. These procedures are based on past valuation experiences and estimates in that industry, rather than using more complex calculations.
SDE
Seller’s Discretionary Earnings (SDE) refers to the net income of a business before deducting the owner’s compensation, benefits, discretionary income or expenses, and depreciation, interest, and taxes. SDE, sometimes called owner’s cash flow, is determined using information from tax returns, income statements, and other financial documents.
SDE encompasses the owner’s compensation, discretionary expenses, and perks such as meals, entertainment, company car, personal travel, and health insurance. For potential buyers, SDE represents available funds for debt payment, operating capital, and personal income.
Valuation
The act or process of determining the value of a business, business ownership interest or intangible asset(s) using one or more valuation methods
With a better understanding of some of these key terms, you’ll be better equipped when it comes time for you to buy or sell a business. Contact John Geiwitz, The Jacksonville Business Broker, to help guide you through each step of the buying or selling process!
