How to Fairly Price, Buy, or Sell a Business
Did you know only 30% of all businesses sell? 30%! One of the main reasons businesses don’t sell is the seller is unrealistic as to the overall worth of the business. Industry averages say most small businesses sell between 1.5 to 3.5 times cash flow. Some call it discretionary earnings. Discretionary earnings is the amount of owner benefit in a small business. Owner salary is an owner benefit. Insurance premiums are an owner benefit. Car allowance is an owner benefit. Travel and meals can also be owner benefits. Rental income might be an owner benefit. The idea is to add all the parts of the business that are directly related to owner compensation or earnings. Or, what is the answer to the following question: Will the expense continue after the sale of the business? If yes, then it’s not an owner benefit. If no, it is. Add all owner benefit items together. Then, multiply this amount by the 1.5 to 3.5 multiple. That gives you a range…a BIG RANGE that is frankly not realistic and is why only 30% of businesses sell. Sellers use the high number. Sellers use the low number. The gap is tough to cross.
CAUTION: AS A BUYER YOU SHOULD NOT SIMPLY TRY TO MULTIPLY A BUSINESS BY AN AVERAGE MULTIPLE! Business valuation is as much art as it is science. There are certain industry standards that can be applied but there are many “non-cash” factors that go into determining the true value of a small business.
The reason for this article, however, is to think about a company from the buyer’s perspective. If you are going to buy a small business, what should you pay for it? What makes is valued at 1.5 times. What about 3.5 times? There is a simple way to determine fair value.
First establish an asking price. Then subtract the anticipated down payment of 50%. This will give you the amount financed. Then, subtract annual debt service (amount financed), a reasonable owner salary, capital reinvestment needed annually, and annual taxes from the total SDE (sellers discretionary earnings). This will give you the net cash return. If this number is negative, the seller may be asking to much for the business. If it is zero, it’s considered neutral. If it’s positive, then it can be considered positive for the buyer. Then, add the down payment and working capital required. This will give you the total investment required. Divide the net cash return by the total investment required. Multiply by 100 for the annual return cash on cash for the investment/purchase of the business. Again, if it’s positive, it’s considered good for the buyer. If it’s zero, it’s neutral. If it’s negative, it’s considered good for the seller. But, this calculation is only as good as the numbers you put into it. If the owner salary is unfairly skewed one way of the other, the numbers may be unrealistic.
At the end of the day, 30% of businesses sell. Of the 30%, there are still some within the 30% who really overpaid for the business. The goal is not simply to be one of the 30%. The goal, in my opinion, should be to be one of the 30% AND have the business continue on. The only way everyone wins, and continues on, is if the business is fairly priced.
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Peer Business Group
“Helping our Peer Buy and Sell Businesses”
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