Calculating Capital Costs When Selling a Business
How do you manage capital costs and selling a business?
Almost without exception, a business sells for a Fair Market Value or FMV. FMV is recognized in law as mainly meaning that a business will only sell once the buyer and seller understand exchange full information not only about the business and how it works etc. but also about key information that’s important to each party so they can make their final decision. FMV also means that neither party has to or must do the deal, that is, neither party is subject to an outside pressure that’s forcing them to make a decision.
For example, if the seller owns a business and owes a third party such as a lender or the IRS money, this may be seen as an outside pressure that’s forcing the seller to sell the business and so it affects their decision to the point the business is not being sold for FMV.
Just recently I’ve seen three sellers trying to sell their business but unable to get close to their expected price because of decisions they made with their business.
The first examples concerned a grocery store that the owners owned for just on 14 years. As part of owning the business it also included the real estate. One of the challenges trying to sell their business was that during their 14 years of ownership that had done very little capital improvements. This meant they had not upgraded lighting, flooring, heating and air-conditioning or made other capital investments to present the business as an attractive place to come and do business.
The financial performance of the business was strong making well over $250,000 per year. The business had no competition or its nearest competition was well over a 2 hour drive away. The business had well trained and qualified employees; which was another asset in the business. The only negative that prevented the business from selling was that it required a series of capital investment to upgrade the look and feel of the business as this had been delayed too long. What was frustrating to the sellers was that there was good buyer interest but no buyer was willing to offer close to what the seller wanted as it meant they would have had to make the capital investment improvements which they felt the seller should be willing to cover part of that cost as it had been delayed too long and so much was required.
This same situation occurred with a pizza restaurant I was asked the sell. The business had been under the same ownership for 38 plus years. The business was closed on Mondays but had a very loyal clientele that came back year in year out.
When the business valuation was put together it came in at over $725,000. However the market was not willing to pay that price as little to no capital improvements had been made and they were well over due.
In this case the seller was highly motivated to sell as they were in their early 70’s and so they accepted an offer that was about $225,000 lower than the valuation so they could retire. Part of the complication in this transaction was that the owner of the business and the landlord were unable to agree on who should pay for all the capital improvements. The seller wanted the landlord to cover some of the costs but because a new lease was in place with a number of years to go before it was renewed, the seller had no bargaining power.
Importance of making capital improvements
The cost of capital improvements is like any other cost when owning and operating a business. It’s tempting for the business owner to delay the work as it takes a lot of time and effort, generally costs more than expected and is a distraction from the day to day operation of the business. A good lesson can be learned from the larger companies as it simply forms part of their doing business. Where I live in Sacramento, CA it’s easy to see Starbucks in full swing, making capital improvements and investments even though it often doesn’t seem this work is necessary.
Planning for capital improvements
If you adopt the right approach, making capital improvements can be a win/win/win. If you lease the property you will know when your lease is up for renewal. Plan to have a discussion with the landlord about capital improvements and see if they are willing to contribute to part of the cost. Most landlords are as it’s in their interest to keep the building as presentable as possible because if they ignore it, it will lower the amount of rent they can charge and the price they can get if they try to sell it.
Some capital improvements such as a solar or renewable energy upgrade can attract subsidies or rewards from utilities or government programs.
Benefits of capital improvements
Making capital improvements also provides an opportunity to have conversations with your customers and get their feedback. Bella Bru is a coffee shop I frequent new where I live in Carmichael, CA. The business is open 7 days per week and I rarely see the owners but I talk to their employees each and every time. At the moment the business is going through a major upgrade that’s taking months to complete. Rather than be too negative, the employees explain what’s happening and why and present it as positively as possible. That is, they are handling the disruption very well.
Strategies if unable to do capital improvements
Capital improvements generally move in the cycle of the business. If you are unable to perform capital improvements, here are some strategies.
- The first strategy is to acknowledge they are necessary and not simply ignore there is a need. If you plan to sell your business and they are not done, say this to the buyer. If you pretend it doesn’t exist, what else will you pretend doesn’t exist?
- Capital improvements cost money. Be prepared to provide the buyer a discount on your asking price if they spend their time managing and organizing the capital improvements. Encourage the buyer that this is a good idea by suggesting they can do the capital improvements on their timetable plus the buyer can get to choose the design, colors and materials.
- Some capital improvements will need to be depreciated and some can be lowered in the year of purchase to reduce the amount of tax the business pays. Highlight these benefits to the buyer.
- Mention to the buyer that doing the capital improvements will attract new customers and have existing customers spend more. Customers love a new environment for doing business.
- If you wish to be brave and have the interest, suggest to the buyer that they buy the business and you’ll organize and manage the capital improvements as a separate project after the sale of the business closes.
Capital costs are critical
Capital improvements are necessary part of being in business. They are too frequently avoided or delayed too long as I’ve mentioned above, to the point where it has a negative impact on the business.
This negative impact shows up in the amount a buyer is willing to pay; if indeed they are willing to negotiate to buy the business in the first place and influences the amount they are willing to pay as Fair Market Value.
Are you thinking about selling your business and move to your next challenge? Would you like to know the value of your business? If you would like more information please visit my website Business valuation.
For more immediate help you are welcome to send an email to Andrew Rogerson or give me a call on 916 570-2674.
