25 November 2024: Selling a Business:
What’s The right Price? Pt 1
Selling a business successfully requires paying close attention to any number of important factors and price is certainly in the top five in importance.
There are dozens of reasons businesses don’t sell. We’ve posted on many of those reasons here. Not surprisingly, the price established by the business owner – and too often blindingly accepted by the (mostly) inexperienced broker or, worse, the real estate agent – is the reason. The price is very often arbitrarily established and bears little resemblance to what the business is worth.
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But when selling a business, how can you determine what the “right” price is?
Over the past two decades advising business sellers and buyers, we’ve found that a large percentage of business owners have an exaggerated opinion of the value of their business – or they simply don’t care what their business is worth; they want what they want, market value be damned.
But if a business owner wants any realistic chance of their business selling, the price asked must be considered in the light of more than just “…well, this is what the seller wants.” Establishing a defensible/justifiable price is critical and doing so is a process with several steps.
The Prerequisite
During our first meeting with a potential client – a business owner considering selling – we ask that , if they have a price in mind, they not share it with us yet. But that rarely dissuades owners. They’ll blurt it out, often before we even get a chance to sit down.
But with just a brief look at the financials, we often see that the owner’s number is woefully out of sync with the business’ value. At this point, it’s not unusual for us to ask the question, “Would you buy this business for what you expect to get for it?”
All too often, this question results in the proverbial pregnant pause.
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Putting aside for the moment our recent business valuation posts, when selling a business there is an easy question to ask – a test, if you will – to give us an idea as to, 1) whether the business has value and, 2) if that value is significant enough to warrant our involvement. It’s a question we pose to the business owner, as well, and it it this:
“Will this business fulfill the three critical needs of its owner?”
The 3 Critical Needs
A business must do three things for its owner – and by “owner”, we mean “buyer”.
- It must earn enough net income (adjusted) to pay its owner a market level salary; enough to support his or her family.
- It must earn enough net income (adjusted) to pay off the note used to acquire the business.
- It must earn enough net income (adjusted) to provide a reasonable return on the buyer’s invested cash.
Here’s a simple example. And while we go through it, remember that, when swelling a business, the field of potential buyers includes investors – buyers that would buy the business but install a manager – as well as owner/operators.
A business owner wants $1 million for his business. A little research reveals that general managers for the type, size and location of the business in question earn a salary of between $135,000 and $170,000. In this case, let’s estimate a salary of $150,000.
We do this exercise because even a buyer who will manage the business full time must get paid for his or here time.
Next, let’s assume that the buyer will put down 30% of the purchase price – $300,000 – in cash and finance the balance. A buyer borrowing $700,000 at 7% interest for a 15-year term faces an annual debt service expense of $75,500. Add that to the $150,000 salary and we’re at $225,000. But that buyer also has to get a reasonable return on their $300,000 invested cash. So, we have to determine that next.
But what’s reasonable?
From the stock and bond markets and money market funds, to real estate, angel investing and crypto, the buyer can put their $300,000 into any number of investments and the returns expected vary based on perceived risk. But as risky as small businesses (those valued at less than, say $3 million) may be, most buyers look for a return more in line with mortgage or the low end of car loan rates. In this example, we’ll use 7%. Annual interest on an investment of $300,000 is $21,000.
This admittedly basic, thumbnail analysis tells us that the business has to generate at least $246,500 to meet these simple requirements. If the business is spinning off $170,000 in Discretionary Earnings, it fails this most elemental test.
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It’s important to note that this approach is not supported by any valuation work. Even if the business is throwing off something close to the necessary $246,500, it may not be worth $1 million that the owner wants.
But what does this have to do with “the right price?
Not much, actually, but it does illustrate to us and, more importantly, the business owner whether the number they’re looking for can be justified, even remotely. So, how do we get to the “right” price?
The Bottom Line
Successfully selling a business requires understanding how to establish the right price before bringing that business to the market. Pricing a business correctly is sometimes as much art as science. The example above is helpful only to determine if the business generates the minimum amount of Discretionary Earnings to meet an owner’s minimum requirements. And that determination is useful only to he extent that it educates the seller and, hopefully, begins to bring their thinking closer to reality.
Next week, in Part 2, we’ll discuss what “right price” means and how we arrive it.
I’d like to hear from you. What topics would you like me to cover? How can we tailor these posts to be more useful to you and your business. Let me know in the comments box, below, or email me at
jo*@Wo*******************.com
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If you have any questions or comments on this topic – or any topic related to business – I’d like to hear from you. Put them in the comments box below. Start the conversation and I’ll get back to you with answers or my own comments. If I get enough on one topic, I’ll address them in a future post or podcast.
I’ll be back with you again next Monday. In the meantime, I hope you have a safe and profitable week.
Joe
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The author is the founder, in 2001, of Worldwide Business Brokers and holds a certification from the International Business Brokers Association (IBBA) as a Certified Business Intermediary (CBI) of which there are fewer than 600 in the world. He can be reached at
jo*@Wo*******************.com