Then, we’ll go through the most important factors to consider when selling.
Factors that influence what you put in your pocket after closing.
So if you’re thinking about selling and want to know what your company is worth and how to prepare to sell, you should get a lot of value from today’s post.
- Valuation techniques
- Example SDE Calculation
- Determining your multiple
- Factors impacting the value of machine shops
- What to consider before you sell your machine shop
- Who will buy your machine shop
- Frequently asked questions when selling
Let's jump right in.
How to Value a Machine Shop
Let’s start out with the basics. How are businesses valued?
Over the years you’ve likely heard several “techniques”, such as using a “multiple of revenue” or a “multiple of net profit plus your inventory.”
While these methods may be a good rule of thumb, they are not accurate valuation techniques.
Today, we’re going to show you how to value your business using the Market Method.
The basic equation is:
Sellers Discretionary Earnings x Comparable Sales Multiples = Business Value
We’ll start by calculating Sellers Discretionary Earnings, or SDE.
Sellers Discretionary Earnings represents the total financial benefit your company provides one owner-operator. To calculate it, we add back certain expenses into your net profit. These expenses are commonly referred to as “Add Backs.”
The most common add backs are officer’s salary, officer’s health insurance, depreciation, interest, and amortization.
Other situational add backs include charitable contributions, 401k benefits, and large non-recurring expenses.
To drive this concept home, let’s do an example valuation.
Seller's Discretionary Earnings represents the total financial benefit your company provides one owner-operator.
Looking for EBITDA, or “Earnings Before Interest, Taxes, Depreciation and Amortization?” This metric is similar to SDE, except a manager’s salary is included in the expenses. In this example we will be focusing on SDE only.
SDE Example: ABC Machine Shop LLC
ABC Machine Shop LLC has asked us to perform a free business valuation. The company has two owners who work full time in the business and take a salary of $120,000 each. Last year, the owners decided to completely overhaul the company’s computers, servers, and software – an expense totaling $65,000. The company contributes a total of $20,000 to health insurance for both owners. This year, the company purchased a used 2013 Mazak Quick Turn S200 for $55,000 to replace a 2001 DOOSAN S310N. They’re now depreciating the machine at $35,000 per year.
If there is more than one owner in your business who takes a salary and works in the business, you must add back both salaries, and expense the cost to hire an employee to replace one owner’s responsibilities.
Add backs explained:
A – Both Officer’s Salaries are added back, and $60,000 is adjusted in to replace responsibilities of one owner.
B – Company’s share of owner’s payroll taxes added back
C – Interest expense is added back per IBBA guidelines
D – Charitable contributions considered discretionary
E – Depreciation expense is added back per IBBA guidelines
F – Owner’s health insurance expense added back
G – Amortization added back per IBBA guidelines
H – Large non-recurring expense of updating computer software added back
After adjusting the financials, the Seller’s Discretionary Earnings increased from $343,825 to $715,825.
Now our equation is:
$715,825 x Comparable Sales Multiple = Business Value
Need further explanation? Check out our in-depth guide on calculating SDE.
When using the Market Method, it’s customary to calculate a company’s SDE for the three most recent years, and weight each year on a percentage scale to come up with a “Weighted SDE.” For this example, we’ve only adjusted one year’s financials.
Finding your Comparable Sales Multiple
Now that we’ve calculated your Sellers Discretionary Earnings (SDE), we need to determine what multiple to apply.
To find multiples, we assess comparable sales of Machine Shops over the last ten years, producing between $1,000,000 and $25,000,000 in revenue, and sold through the SBA 7(a) program.
For the Machine Shop Industry, we found 61 comparable sales with the following statistics.
Highest Multiple of SDE: 4.50
Lowest Multiple of SDE: 1.86
Average Multiple of SDE: 3.08
Interested in the 61 Comparable Sales?
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Based on our information, machine shops on average sell for a multiple of 3.08.
Let’s use this to finish up our equation:
Therefore, the Market Method has estimated ABC Machine Shop’s value at $2,204,741.
You’re probably wondering: “Wait, why do some machine shops sell at a 1.86 multiple, and others sell at a 4.5 multiple?”
All businesses are unique, and there are many factors that impact the multiple they will sell for.
Next, we’ll discuss the specific factors that impact the multiple of a machine shop.
Frequently asked question: Do you add the value of the equipment to the purchase price?
Answer: No, the equipment value is not added back. The market method values a business on its earnings. Therefore, any equipment used to generate those earnings must be included in the purchase price. In other words, for the buyer to generate the earnings used to calculate our business value, they must have the equipment.
Factors Impacting the Value of Machine Shops
Think of the multiple as a measure of risk on future earnings. Low risk translates to a higher multiple. High risk translates to a lower multiple.
Each factor below is directly related to the perceived risk of taking over your existing operation.
One of the most important assets a buyer is purchasing are your employees. Experienced machinists, inspectors, tool room managers, and programmers are critical to the success of a machine shop.
If you have longstanding employees with certifications (such as National Institute for Metalworking Skills or “NIMS” certified machinists) your business is considered less risky.
If you choose to keep contracts with your customers, make sure they are assignable. Otherwise, you may not be able to transfer the contract to the buyer in an asset sale.
Are you the programmer?
Are you in charge of quality assurance?
If you don’t show up to work for a week, how efficient is the shop?
Can the shop even run?
Most sellers aren’t looking to work in their business after a sale. Assuming that’s true for you, a buyer will either need to be your replacement or find your replacement.
In short, the easier your job responsibilities are to replace the higher multiple your business will be able to achieve and the easier your company will be to sell.
Customers in mature industries are viewed as high-value customers.
Mature industries include military suppliers, aerospace, oil and gas, automotive, aggregate, or nuclear power.
Buyers also like to see contracts.
That said, most machine shops do not have contracts with their customers. So don’t worry - long-standing customers in stable industries are valuable with or without a contract.
The easier your job responsibilities are to replace the higher multiple your business will be able to achieve and the easier your company will be to sell.
A customer concentration issue generally means an individual customer contributes more than 15% of total revenue.
If you have a customer like this, the buyer and their lender will have questions about the longevity of the relationship, the stability of the revenue, and will ask to see how much that company has contributed over the last three to five years.
In most cases, customer concentration is not a deal breaker. Many machine shops have some form of customer concentration when they sell.
Organization and Processes
One of the most valuable assets of a machine shop is its processes, procedures, and organization.
For any recurring work in your shop, you likely have a set processes explaining how the part is manufactured, as well as individual programs for every operation. These processes and programs are a major part of your machine shop’s value. Make sure you have good recordkeeping and software backing up your digital assets.
When selling your business, also consider the organization of your financial books and records. Throughout the due diligence process there will be many financial requests from the buyer. The faster you can respond to their requests, the more organized you appear to the buyer. This builds their trust in you and your business.
Certifications such as ISO:9000 can be valuable to a buyer. These certifications set a baseline for the quality controls in your company and make buyers confident in your manufacturing standards.
That said, transferring an ISO certification can be tricky. An asset sale requires that a buyer purchase the assets of your company with a new corporation, and ISO rules and regulations state a buyer must inform their certification body (CB) of changes in the organization:valuable to a buyer. These certifications set a baseline for the quality controls in your company and make buyers confident in your manufacturing standards.
"The certification body shall have legally enforceable arrangements to ensure that the certified client informs the certification body, without delay, of matters that may affect the capability of the management system to continue to fulfil the requirements of the standard used for certification. These include, for example, changes relating to:
a) the legal, commercial, organizational status or ownership;
b) organization and management (e.g. key managerial, decision-making or technical staff);
c) contact address and sites;
d) scope of operations under the certified management system;
e) major changes to the management system and processes.
If you are staying in the same facility, transferring an ISO certification should not be too difficult. If you are moving to a new facility, you will likely need to get recertified.
Ultimately, the requirements to transfer will be decided by your certification body.
Condition of Machines
Sellers often assume that a shop with all new Haas ST lathes and a 5-Axis Mazak is more valuable than a shop with some older machinery.
The equipment is more valuable – that’s for sure – but machine shops don’t make money simply by having valuable equipment. They make money by producing high accuracy parts consistently and on schedule.
The most important factor about your machines is not their age. It’s that they are being utilized regularly and holding the tolerances necessary for your company to run parts that make you money.
You do need to continue investing in your machinery, but only when it makes you more efficient and you can afford to do it.
Which leads to my next point:
Financing and leasing
If you own a shop with several pieces of financed and/or leased equipment, this next line is very important:
In 99% of cases, your machines will need to be paid off in full at closing.
If a buyer is going to purchase your business through the SBA or some of financing, your machines must be paid off.
Why? Because the bank wants to be in first lien position if the buyer fails to pay back their loan. To do that, the assets must be transferred free and clear of any liens.
Typically, sellers pay the machines off at closing using proceeds of the sale. Buyers may agree to assume a lease, but their lender will get the final say.
What to consider before selling your machine shop
Looking for things you can do to prepare to sell? Look no further.
If you have leased equipment and are wondering what it will cost to pay off, ask your financing company (or companies) for a “payoff quote.” If you have any other liabilities, such as a loan or a company vehicle, you can add that as well.
Then, calculate your own business value using our guide or take advantage of a free MidStreet business valuation!
Finally, subtract your business value from your leased equipment – that’s your pre-tax net from the sale of your business, before attorney, broker, and other fees.
Your broker may be able to negotiate that the buyer assumes your lease (or leases) at closing, which would keep you from having to pay it off. Typically, this will result in the buyer’s lender including the equipment value in the loan. This means it gets paid off at closing and is included in the buyer’s debt service.
Cleaning up the shop
Before you list your business for sale, you may need to clean up the shop.
Our advice: Close your eyes and imagine this is the first time you’ve ever walked into your business.
Do the machines need to be wiped down?
Are their cobwebs in the corner?
When was the last time your tool room manager organized all these bits?
Try to dress things up. Like it or not, appearances matter.
Try to dress things up. Like it or not, appearances matter.
If the floor space is maxed out, or your concrete pad is at weight capacity, consider rearranging or moving out any old equipment before selling.
Most buyers are looking to purchase a business and grow it. If they feel the real estate is maxed out, this may affect their decision to purchase.
Bottom line: it’s better to have empty space for something new, than old machinery unnecessarily taking up space.
Who Will Buy my Machine Shop?
Most machine shops are going to be purchased by an individual.
This is typically the case across all industries in the lower-middle market. However, the larger the sale price of a business the fewer buyers who can afford to purchase.
For example, a $4,500,000 SBA 7(a) loan to purchase a machine shop requires a down payment of roughly $675,000. For many individuals, that’s just not attainable.
The second-most common group of buyers are strategic. Strategics are simply other businesses who would gain a strategic advantage from buying your company.
For machine shops, an example would include a metal fabricator that is looking to offer a wider array of services, or a manufacturer that wants to bring the manufacturing of their components in house.
Strategic buyers are often able to pay a higher price tag. That said, they’re often more sophisticated than your individual buyers. Many have bought and sold businesses before, meaning they know what to look for and how to get a great deal.
Strategic buyers can be an excellent option – just be sure your broker has experience working with all the different types of buyers.
The third-most common group of buyers are private equity groups.
A private equity group exists to purchase companies using money from private investors, grow them, sell them, and provide a return to their investors.
Over the last several years, private equity groups have received a lot of bad press. It’s not completely justified. Their employees and partners are people just like you and I, looking to help owners transition and make deals that work for everyone.
Private equity can be a great buyer for your company – that said, they are highly sophisticated and experienced in mergers and acquisitions. For this reason, it is in your benefit to engage all your professional advisors (CPA, attorney, tax attorney, broker, wealth advisor, etc.) in the process when working with a private equity group.
Frequently Asked Questions when Selling a Machine Shop
Will I have to stay on after the sale?
This is a negotiable portion of the deal. Buyers often want a seller to at least stay on after the sale for a short period of training. If you decide you’d like to stay on after the, this can be a major selling point to a buyer - especially private equity. Keep in mind that if the buyer is using SBA 7(a) program for financing, the SBA guidelines allow for a maximum of 12 months for the seller to stay on and train.
Will I have to pay off my equipment?
As mentioned above, in most cases you will be required to pay off your equipment when you sell.
Does a buyer get my accounts receivable?
It depends on the contract. In most asset sales the seller retains their accounts receivable. However, many buyers will include it in the purchase to make the transition easier.
How do I maintain confidentiality?
Confidentiality is constantly at risk when the time comes to sell. Be sure to give your professional advisors contact information only you have access to. Use common sense and be aware that the closer you get to closing, the larger the risk to confidentiality.
How do you calculate Work in Progress?
Work in progress is calculated in many ways. Here’s one example:
(Order Compensation – Materials) x Percentage of Order Completion = WIP Due to Seller
WIP Due to Seller + Materials = Total Due to Seller at Closing
How long does it take to sell?
On average, it takes anywhere from six to twelve months to sell.
Interested in learning more about selling a machine shop? Feel free to reach out to the author with any questions or comments at Erik@midstreet.com.