Two of the most difficult parts of buying a business are learning to evaluate the asking price and proposing a fair offer. In this article, you'll learn:
- How sellers, brokers, and valuation specialists select an asking price
- The importance of that price for lending
- The methods you can take to determine a fair value
- The considerations you should keep in mind before firming up your final offer price
How is an asking price determined?
Many sellers work with a broker to market, valuate, and assist with the sale of a business. Part of the broker’s role is to help the seller set a suitable asking price that’s likely to attract buyers and result in a favorable, fast-closing sale.
The price is often based on the broker’s opinion of value (BOV). Brokers depend on their experiences with the industry, their knowledge of economic factors, and their familiarity with specific markets to form the BOV and help the seller set a reasonable sales price.
In most cases, the BOV is a good estimate of what a business should sell for in the current market. But, sometimes, other factors can come into play. Here are two common ones:
- A broker may inflate the business’s value to secure the listing from a seller.
- A broker might inflate the price to attain a higher commission on the sale.
Because of these factors, it’s important to create your own estimates of value or have a professional valuation specialist provide an opinion.
What is a fair price?
You'll need to work through a few steps to make an offer that's fair and reasonable.
Start the process by requesting the business’s financial records for the last three to five years. You'll likely need to sign a non-disclosure agreement (NDA) before you can access this information, but once you receive it, you use a proven valuation strategy to find a fair price range.
|If you aren't comfortable doing this step on your own, work with a valuation specialist or an accountant who specializes in business valuations. The service, which may cost $3,000-$5,000, is often worth the cost.|
If you’d like to connect with a valuation specialist, click the button below to get started:
There are two methods that you or the professional you hire might use to valuate the business:
The EBITDA multiple is a popular way to valuate a business because it provides a good estimate of the return you’ll earn on dollars invested. Most use this approach to price a business that’s profitable or has a positive earnings forecast.
Using the business’s income statement, you’ll locate its earnings before interest, taxes, depreciation, and amortization (EBITDA). Then, you’ll assign a multiple (often between 1 and 4) based on the size of the business and the industry in which it operates.
The following graphic provides some common multiple ranges:
Generally, larger and more profitable businesses are assigned EBITDA multiples in the high end of their industry range, and less established businesses use multiples at the lower end of the range.
Here is an example of how this works:
In a labor-intensive business, such as an independent restaurant or auto repair shop, many brokers recommend a multiplier between 1.5 and 2.5, depending on the size and success of the business. A small, moderately successful business in this category that nets $100,000 a year may use a multiple of 1.5 and be priced at $150,000, while a more established business that nets $500,000 a year may be priced with the high-end multiple of 2.5, resulting in an asking price of $1.25 million..
A second approach is asset valuation, which is most often used when a buyer is interested in purchasing a business’s assets rather than its brand, operations, or customer lists. It can also be used to valuate capital-intensive businesses that aren’t yet profitable.
For this valuation, you will simply calculate the fair market value of the business’s assets, which should include inventory, equipment, real estate, and intellectual property. To do this, you could estimate the value of the assets by seeing what they're selling for through informal channels. However, most experts recommend attaining a professional appraisal for any item that’s high in value, including real estate, vehicles, and essential equipment.
Should any factors influence my offer price?
If you're purchasing a business rather than its assets, be sure that your offer that accounts for the business’s past and present financial wellbeing. Use the following list of questions to assess its status. Then, raise or lower your offer price accordingly:
- Does the business tend to have a surplus of cash, or has it had a history of shortages?
- Has the business used financing to cover shortages in cash flow? How often does this occur?
- Is the business’s cash flow predictable? Does it swing wildly month-to-month or adhere to patterns throughout the year?
- Does the business have enough cash on hand to purchase surplus inventory or hire people to meet spikes in demand?
- What is the status of the business’s accounts receivable? How many are collected within 30 days, 60 days, or 90 days
- What percent of business is uncollectable?
- Are there any outstanding loan balances? Has the business kept current on repayments?
Other factors should weigh into your offer, too. Here are two important factors to consider:
- How the economy is fairing and how its strengthening or weakening may affect the future profitability of the business
- The seller’s motivation for exiting the business and how that motivation affects their willingness to sell at a discount
This list is not comprehensive, but it’s a good representation of the kinds of questions you should ask as you assess the price of a business. You can work with an accountant or valuation specialist to identify the questions you should ask for the specific business you’re examining.
We have a few favorite accounting firms we like to recommend. Check them out here (and be sure to click the logo to learn more about them):
Is there anything else to keep in mind?
Yes. There are a few more essentials you should know when evaluating the price of a business:
Price matters to lenders.
The price you and the seller agree to must seem reasonable to third-party lenders who will be involved in funding the transaction. Lenders will want to reconcile the offer price with business, market, and industry data to protect their short-term investment in the venture.
Risk has a price.
Your offer price should account for changes to macroeconomic trends, competitive factors, legal exposures, reliance on vendors, customer concentrations, and customers’ connections to the present owner that could harm the business's long- or short-term success.
Goodwill may be inflated.
Many sellers overestimate the value their brand adds to the price of the business. You should assess how much the brand likely contributes to the business’s cash flow before finalizing your offer price.
The owner’s discretionary income is important.
The owner’s discretionary income is the amount that the owner takes home each year. You’ll need to decide whether that amount is sizable enough to take on the risks of owning the business. You can also assess whether it would allow you to pay another person a fair rate to manage the business while continuing to provide you with income.
Credit is key.
Details are everything when it comes to assessing a business and ensuring its financial health. When you conduct a thorough assessment, you can present a well-researched offer to the owner that accounts for unforeseen risks, discrepancies in value, or differences of opinion in forecasts and projections.
The offer you make will be sent to the owner as a letter of intent (LOI). An attorney can draft the LOI, or you can create one using a template from an online legal site, such as Law Depot. In most cases, your LOI won’t be a binding offer. Your final binding offer will occur later, after you complete a thorough due diligence review of the business.
For more information on the LOI and sales agreement, check out the following articles:
Log into your owner’s portal for articles and advice as you work through the due diligence process, negotiations, and other critical steps of your acquisition.