How to Determine Whether a Business is Priced Fairly

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The type of business for which you've been waiting has just come up for sale. You'd like to make an offer, but are you certain that the asking price resembles its actual value? Just as some parents overestimate the talents of their offspring, the emotional attachment of an owner to his organization can lead him to value it more highly than reality warrants.  If you're planning to buy a business, how can you know whether this is the case?

Vetting the Selling Price
Pricing a business differs greatly from pricing a residence and is much more complicated. This fact has given rise to various methods of valuation, each of which has its pluses and minuses.  However, when buying a business, many consider the income multiple method superior to the others.   There is no one exact formula for determining the price of a business; we would advise seeking the help of a professional business broker.

Valuing a Business by the Income Multiple Method
This method multiplies a business' historical net income against a carefully determined factor to arrive at an accurate selling price.  The inherent beauty of this strategy lies in the fact that unlike some of the others, it sidesteps any attempt to predict future revenue.

The procedure begins with a calculation of the seller's discretionary cash flow. Some refer to this as the SDCF or owner's benefit, and the following formula will assist in arriving at that figure:

1. Start with the business' pre-tax profits.
2.  Add the owner's salary and additional perks.
3.  Subtract all capital expenditure allocations.
4.  Add back depreciation. Since an asset's loss of value from one year to the next reduces the company's tax burden, it counts as a gain.
5. Add back interest. When the seller pays off his business loans at closing, the interest that is no longer payable will amount to a plus for the bottom line.
6. Consider any future capital requirements and debt-service expenses. If equipment will require frequent replacement, deduct the predicted costs.
Apply the Appropriate Multiplier

Once you have calculated the owner's net benefit, you must apply the applicable multiplier to arrive at the final fair selling price. Based on certain facts about the business, the factor will normally range between 1 and 3 for most small businesses, with a ceiling of 5 for larger corporations.

In general:

- If the owner and the business are one and the same, multiply the owner's net benefit by 1. The clients of that one-man business are liable to follow him right out the door when he leaves.

- If the business for sale generates an owner benefit of less than $200,000, multiply by 2.

- If the enterprise generates an owner benefit of $200,000, has operated successfully for at least three years and appears poised to enjoy continued growth, multiply by 3.

- When appraising the worth of a larger concern or one that generates an owner benefit of $500,000 to $1 million or more, multiply by 4 or 5.

Caveats

To determine the appropriate selling price of any business for sale, it is important to:

- Learn to read a balance sheet.
- Ascertain whether any depreciation or interest is actually a necessary expense that requires subtraction.
- Include the business' strengths and weaknesses in any determination of the proper multiplier.
- Consider a comfortable investment level.
- Decide on an appropriate ROI.

Perform a Sanity Check

Anyone planning to buy a business should compare his final figures to the results returned by other valuation methods. Some of the most common are:

- Asset Valuation: This strategy bases a fair selling price on the aggregate value of the business' assets.

- Liquidation Value: If the business is failing, it is worth no more than the value of its assets at clearance.

- Income Capitalization: Most accurately applied to large organizations, this rather arbitrary procedure determines a selling price by combining historical data with projected future income.

- Rule of Thumb: Although a consideration of the selling price of similar concerns will establish a point of reference, the approach is too broad to be useful for anything beyond that. No two businesses are exactly alike.

As you can see, valuing a business is no easy matter and has many, many variables.  It is for this reason, that we advise the majority of sellers to consult with a professional before listing their business for sale.   A professional business broker can help you prepare your business for sale as well as help you determine its fair market value.   It is also advisable to seek a business broker who has solid experience and knowledge of the industry your particular business is in.   For example, if you own a restaurant, it is highly advisable to work with a business broker who specializes in restaurants and food related businesses.   Likewise, if you own a manufacturing business, find a broker who has brokered deals in the industrial and manufacturing sector.    To find a business broker near you, please visit BusinessBroker.net’s Business Broker directory.
  • Author: Matt Maxwell
  • Date: November 14, 2013
  • Category: Buying a Franchise or Business
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