How to Determine Selling Price When Selling a Business
Selling a business can be a challenging undertaking. For most people, they have not been through the business sales process before and are surprised to learn how different it is when compared to a typical real estate transaction.
The entire process of selling a business is usually much more involved and can be much more complicated. For instance, finding an appropriate business buyer, qualifying leads, maintaining business confidentiality, tax issues, asset sale vs share sale, due diligence, VTB financing, transitions, employee issues, liabilities, working capital… and so on.
Besides all of these issues though, probably the most confusing issue for many owners when selling a business is determining an appropriate selling price. For most people, determining a selling price (or business valuation) is a mystery. It is one of the most important decisions a business seller can make though. Setting the selling price too high will discourage potential buyers from inquiring about the listing. If the price is set too high and it stays on the market too long it may lead to red flags (buyers may think there is a problem with the business if it is listed for too long). Conversely, setting a selling price that is too low is not good in that a business owner is not realizing the fullest value for their business.
There are some common useful methodologies that can be used to assist in determining the listing price of a company when selling a business and help arrive at a fair number.
Discretionary Earnings Multiple Method
This method is a common way that small businesses are valued. It is a (relatively) easy method to determine a business’s listing price and is quite intuitive. Essentially, the concept is to determine a business’s ‘discretionary earnings’ that it delivers to the owner and then applying it to a multiple to determine the value of the business. A simple example – if the discretionary earnings of a business is $150,000 and it is determined that the earnings multiple is 2.2x then a valuation of approximately $330,000 would be appropriate ($150k x 2.2).
It is important to properly calculate ‘discretionary earnings’. A qualified business broker or business appraiser can assist you with the calculations but the concept is to calculate the earnings available to an owner as a result of running the business. It usually involves taking pre-tax income and adding back some discretionary items like owner’s salary, personal items and so on.
The next step is to determine the right multiple. Multiples vary by industry, geography and time so it is important to get a supportable multiple that is in line with the market reality. Again, a qualified business broker or business appraiser can assist you. If you are selling a business please work with a professional to help you determine a selling price.
Discounted Cashflow Method
A much more sophisticated method to determine the selling price of a business is the discounted cashlow methodology. Essentially, the concept is to forecast the cashflow that the business will generate into the future and then discount the stream of future cashlfow that has been estimated back to the present by applying a cost of capital. Confused yet??
The principle is that a business is worth the ‘present value’ of the future earnings it will generate; adjusted for time (a dollar earned in the future is worth less than having a dollar now). So, when a business buyer buys a business, he or she are really buying a stream of future cashflow. The earnings that the business will generate in the distant future are worth less than the earnings it will generate in the near future so time-based adjustments need to be calculated.
Please bear in mind that this methodology is generally not used for small businesses. If you are selling a business that is mid-sized or more complicated you may encounter this methodology.
Asset Based Business Valuation – use caution
Please use extreme caution if you want to value your business based on the value of the physical or tangible assets. Often, business sellers believe that the only way to value their business is by adding up the market worth of their physical goods. This is could lead to a costly underestimation of the business’s value. This approach does not factor in the intangible value that is inherent in the business (example – goodwill).
For instance, suppose an owner of a very profitable service based company with very little ‘hard assets’ were selling and he or she decided to value the company based on the market value of these hard assets. The owner would be grossly underestimating the business’s true value by neglecting to take into account the company’s goodwill and any other intangible assets.