Pricing A Business For Sale - Key Factors All Play A Role!
Correctly Pricing A Business Is Important If You Really Want To
Sell It!
As a consultant I talk to many business owners, brokers, and
agents on a daily basis about valuing businesses. It always
amazes me on how some of these individuals come up with the
values on small businesses being sold. No wonder only 30% of all
businesses sell! In many instances no consideration is given to
the total picture - like will the available cash flow of the
business be able to pay the debt of a loan, will the deal as
structured or priced even be attractive to financing sources,
"cash" price vs. "note" price and how these factors figure into
the equation!
I have seen many "professional valuations" where the price just
doesn't make sense - and sellers wonder why their business for
sale just sits there with no action!
Market Approach
There is a solution that is grounded in the fundamentals of
economics, and time tested in the marketplace, where the
influences of supply and demand ultimately determine where a
business belongs on the price scale. One economist explains this
market approach by comparing a business to a machine which has
the purpose of making money: The more money it makes, the more
it's worth. And that explains why, for example, there is a
strong demand for a very profitable distribution business with
few hard assets; and why it is worth more in the marketplace of
available businesses, than a large machine shop that would cost
nearly $1 million to duplicate, but can't make a living for its
owner.
Adjusted Net Income
The first category of information needed is called adjusted net
income, and is the total amount of cash produced by the "money
machine." It's a figure that includes the profits, the owner's
salary and all of the many cash-related benefits which are
enjoyed by the principals of small businesses. Those benefits
can include the use of a company car, the company-paid premiums
for health, life and auto insurance, plus personal expenditures
tucked into travel and entertainment, subscriptions and similar
business "expense" categories. Interest expense should be added
to adjusted net income, along with accounting entries—such
as depreciation and amortization—that can divert money to
the owner's pocket so that it never appears on the bottom line
of the P & L.
While some of these items vary from business to business, any
owner knows which categories of expenses in his or her financial
records include sums of money that should be added to adjusted
net income. Many business owners also know of cash income that
never sees the business records in any way, shape or form. Some
owners feel they should get credit for these sums in the
calculation of value. But it's a poor policy to collect
unreported income and then attempt to have it included in
adjusted net income for evaluation purposes. When selling, your
buyer prospects want any statements you make about your business
to be supported by evidence in the form of accounting records
and other reliable sources. To admit that you are doing business
"off the books" not only exposes you to problems with the IRS,
it also sets a bad tone with prospects who—if they are
going to be interested in your business-- need to believe your
practices and record keeping are above reproach.
Adjusted net income is usually the first thing any buyer wants
to know about when investigating a business; and not just the
past few months' worth of income. A seller should be prepared to
demonstrate a history of earnings, and have the documentation to
back it up.
Multiplier Method
The next piece of the equation comes from the expectations
working in the marketplace to shape the multiplier—a
figure which will be computed, along with the cash flow, to
calculate a rough value. The validity of the multiple is that it
reflects behavior in the market. There is no need to theorize
about a proper multiplier. It's calculated by determining what
people actually pay for small businesses in California.
The experience with low risk businesses is that their high
market demand is reflected in a fairly strong multiple. A lot of
buyers want, for example, a well-established franchise, or a
grocery store with a long lease in a densely populated area and
little direct competition. Its multiple might be in the range of
two to three times annual adjusted net income.
A one or two multiple, on the other hand, would be associated
with an enterprise in which the buyer is assuming greater risk.
An example is a retail store near a large shopping area, which
leaves the buyer of the smaller business vulnerable to the
competitive marketing activities of much larger companies. The
lower multiple is a consequence of lower market demand. Fewer
people want that kind of business.
Since profitable distributorships and manufacturing companies
are much sought after, it's not unusual to see them command a
price upwards of four times annual adjusted net profit. The
company in this category providing adjusted net profit of
$200,000 might realize a selling price in the range of $800,000,
assuming a favorable deal structure (more about that shortly).
Also warranting a high multiple are businesses loaded with
assets—equipment, trade fixtures and inventory. But
remember that a seller must be able to establish the company's
"history of earnings" with financial reports and tax returns,
before the higher price will be offered.
More commonly available businesses, such as restaurants, are
priced with a lower multiple - in the one to two range - to
reflect the abundance of this kind of business available for
sale at any one time. In this case it's purely a matter of
supply and demand.
And a company in any industry that is difficult to finance, will
be hard to sell. I'm familiar with a retail business in Northern
California that is not generating enough adjusted net income to
support its $1.5 million asking price. Because a new owner would
have a difficult time paying off a loan that was hefty enough to
swing a purchase of this company, there are no lenders willing
to provide the money. That severely affects marketability. In
fact, the company is probably unsalable as presented.
Importance of Deal Structure/Terms
And the final factor thrown into this equation is particularly
useful in determining the value of businesses offered for sale.
It recognizes that the terms of a transaction--in other words,
how a price is paid--are critical in calculating that price.
When sellers demand all cash for their businesses, for example,
the market tells us that they can expect to receive about 60% to
80% of the sum they would have gotten by taking a down payment
and financing the balance.
It's easy to understand why deal structure is such a vital
component in the valuation process. For a business to be
affordable, the cash flow needs to be substantial enough to
support the price at the multiple being used. A deal that
requires a lot of cash up front, in relation to the expected
amount of adjusted cash flow, will place a greater burden on the
buyer. That principle, translated into the language of the
marketplace, means the business will only be appealing at a low
price. If, on the other hand, the level of adjusted net income
supports the buyer's ability to make payments to the seller in
order to purchase the business—this opportunity will
interest more potential buyers and the result is a higher
achievable sales price.
Other ways an attractive deal structure can be used to build
market appeal include a delay of a few months--after close of
escrow-- before monthly payments on the seller's financing are
due to begin, a low interest rate, and interest only payments
for awhile, until a new owner is able to build the business to
more easily meet the loan obligation. Creative deal structures
always help sell a business and will usually command a higher
market price for the business (remember it has to make sense)!
Pricing a business is as much or more of an art than a science.
Sellers who take a look at the big picture - looking at both
deal structure and price are usually the ones who are successful
in selling their business!