Category Archives: selling your business

Pricing your Business

Most business owners carry two numbers in their head – the monthly sales necessary for break-even and the selling price for their business. Both numbers may be wrong.

Break-even is more complicated than simply covering monthly operating costs and the selling price is not your ego-inflated idea of a selling price, but the value that a dispassionate investor or strategic buyer would put on it.

(Note: My approach to break-even and feasibility analysis is presented in “The Complete Do-It-Yourself Guide to Business Plans” and this article is extracted from “Don’t-Do-It the Hard Way”.)

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The principles of valuation are well known and the math is quite simple. But the real price is established only when a particular buyer and seller actually agree on a price and terms suitable to their current circumstances and their objectives. If you are managing as an owner-entrepreneur, then you should always be focused on maximizing the value of your business. That means understanding what determines the price.

In establishing the value of your business, some basic principles must be recognized:

  1. The value to the owner is unique to that individual. Ego may artificially inflate the price, but more importantly the value is often very dependent on the current roles and relationships established by the owner and may change drastically with his or her departure, thereby reducing the price offered by a new prospective owner.
  2. Value is always determined by an evaluation of the future income and the uncertainty or risk associated with achieving it.

Regardless of the valuation method, the forecast future income stream has to be credible and the potential risks have to be reduced to get the best possible valuation.

  1. Current owners tolerate more risk, uncertainty and fuzzy circumstances than new owners or investors. You may be OK with the fact that you are dependent on one key supplier because he is an old buddy from high school; or that you have no signed lease because the landlord is your favourite uncle; or that your best sales rep is also your daughter and she wants to be president.

Prospective buyers will be much less enthusiastic about these issues, unless they are all resolved to their satisfaction in advance of any offer to purchase or invest.

  1. Different buyers will accept different prices, terms and conditions.

Those usually range from the passive investor looking for a reasonable return with reasonable risk; to the active investor who sees the potential to do better than your forecast under his management; to the strategic investor who sees even greater opportunity in buying a competitor, supplier or customer and merging it with his existing business to increase revenues, reduce overhead and substantially increase profits.

The selling price will depend on the perceived value seen by each of these buyers.

Several valuation methodologies may be used and it is often a good idea to test different approaches to see what values they yield and then select a selling price that can be reasonably supported by any method of valuation.

P/E Multiple

The price-to-earnings multiple is a well-recognized valuation method and is widely reported for public companies. Current price per share divided by annual earnings per share is a simple concept and easily calculated. Unfortunately, it is not always very relevant, since the selling price today is more likely based on the expectation of future earnings, not last years’ earnings. The same may apply to a valuation of your business.

For example, Google’s share price on January 15th, 2014 was $1150 which yields a P/E multiple of 26X based on 2013 earnings of $44.19 per share.  But, if we use the analysts’ consensus earnings estimate for 2016 of $71.74 per share then the P/E multiple is a more “reasonable” 16X.  Still high compared to the less exciting Royal Bank of Canada priced at $70.90 per share with a P/E multiple of only 10.3X earnings estimated for 2016.

What is the P/E multiple for your company?

Typically, small owner-managed businesses can support a P/E multiple ranging from 3X to 5X. It will be higher if future earnings are very secure and not dependent on the current owner and lower if future earnings are risky and very dependent on the current owner.

The buyer will usually look at operating income or EBITDA (Earnings before Interest, Taxes, Depreciation and Amortization) to determine profitability of the business, before considering financing, taxes and capital costs.  For example, that will yield a price of $300,000 on your $100,000 per year operating income, if you can agree on a P/E multiple of 3X and a price of $500,000 if you can persuade the buyer that a multiple of 5X is appropriate.

Payback Period

Some buyers will insist on looking only at net cash flow and the payback period to arrive at a price. They will consider their net investment, after allowing for financing, taxes and payment terms to determine how long before they get their investment back and start earning positive cash flow. They will likely have a minimum payback period, depending on risk, ranging from 3 to 5 years (which yields essentially the same price as a 3X to 5X multiple of EBITDA).

Discounted Cash Flow

Other investors will take the financial analyst’s approach of calculating discounted Net Present Value (NPV) or the Return on Investment (ROI). Again the future net cash flows must be forecast to arrive at a valuation. The buyer will then discount future cash flow at the required rate of return on the investment, typically 15% to 20%, or calculate the expected ROI and then compare it to the required rate of return. For example, a $100,000 per year annual cash flow on a $500,000 investment provides a 20% annual Return on Investment. (And a 5X P/E multiple.)

Using these same methods will give you a range of valuations depending on various buyer/seller scenarios to establish your own best estimate of a fair selling price.  Now you have a methodology for determining the value of your business over time. It will be useful for getting initial investors and will also help in any shareholder buy-sell agreement or future succession plan.

Knowing the value of your business is a key performance measure that you should be tracking regularly. The day you need to know it should not be the first time you calculate it. Don’t wait until your exit is an urgent necessity; always have a price and a plan.

As I concluded my presentation and watched the e2eForum members taking notes, I waited for the next question which usually followed. Stan was the first to look up and ask it.

“I just did a quick calculation and I don’t like the answer. So how do I improve on the price for my business?”

“You are all probably doing the first two things that enhance business value; growing sustainable, profitable revenue and reducing business risk. The next important priority is management transition. How do you evolve from employee to owner to exit? It is very hard to get a new owner to buy your business if that buyer cannot replace you and your value as manager in the business. If you can transition yourself from active manager to passive investor or ‘absentee owner’, it will then be much easier to transfer ownership.”

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Do you have the right price on your business?  Are you working to improve on it?  The sooner the better.

Your Uncle Ralph, Del Chatterson

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Three challenging steps to selling your business

 If you’re thinking of selling your business someday, remember it’s a long, complicated process that you should start well in advance. The recent sale of a client’s manufacturing business, reminded me once again that a successful sale requires considerable time and effort – before, during and after the deal is made. Rigorous planning and preparing for the sale, working hard to get the price and terms you want, then closing the deal and managing the transition to new ownership.

This deal began about five years ago with the casual comment, “I’m thinking it’s time to sell. What do you think my business is worth?” Always a challenging question, loaded with high expectations and a lot of ego. I did the analysis and presented my estimated range of potential values based on standard valuation techniques. As usual, the owner was disappointed that the number, but was eventually persuaded that the rationale was reasonable.

It helps to ask, “How much would you pay to buy this business if you were not already the owner?” And it also helps to remember that every investment is justified on the expected rate of return and any sale, including the equity in your business, only happens when the buyer values it more than the seller. Never when it’s the opposite.

Pride and ego can persuade the owner to price the business much higher than any rationale buyer can see or be willing to pay.  We could look for a crazy person with lots of money, but the two are not often found together.

So, once the decision is made, what are the three steps required to sell your business?

First Step: Packaging for Sale

If we have agreed that the current valuation is not sufficient, then we have to work on short-term action to improve on the value and make the business more presentable to prospective buyers.

The value is always increased if the business can improve on net income and reduce the risk associated with sustaining it. The immediate requirements to stabilize revenue, reduce costs and clean-up the balance sheet are usually obvious, if looked at from the perspective of an outside investor. But often the most difficult and important issue to be resolved in order to enhance the value of the business is to reduce its dependency on current ownership. That may mean introducing a stronger management team and removing the owners from an active role. You cannot sell and exit the business, if it will fail immediately after you leave. (Seems obvious, I know.)

Ideally, the business should already be managed to make it as valuable as possible by continually addressing the key issues of sustaining growth, reducing risk and building a strong management team.  When those issues are all reasonably resolved and the tough questions can be answered, then you are ready to start presenting your business for sale.

Second Step: Presenting for Sale

Preparing for sale requires some strategic planning. We need to know how to present the business for sale and to which potential buyers.

Strategic buyers will always pay the best price because they will have access to synergies in reduced overhead or expanded sales that will add to their return on the investment and consequently to their perceived value. Who are they and where do we find them? Would you consider selling to a competitor? What if they plan to buy your business to close it?

Are you willing to consider passive investors who are seeking low risk returns and will probably offer the lowest price? Would a new owner-management team be a better scenario for continuity of the business and a smooth management transition?

What are your preferred terms to maximize the after-tax cash value and to accelerate the payout? What is negotiable and what is not?

When these strategic questions are answered you can prepare a marketing pitch and Offer for Sale to attract interested and qualified buyers. The package should have enough information to appeal to an investor without disclosing too much confidential or competitive information. You may even wish to remain anonymous and have the initial package presented by an agent or business broker. After the prospective interested buyer sold!has been qualified and signed a non-disclosure agreement, then a more detailed package should be available to provide the company background and financial history and support the valuation and asking price.

As proposals are exchanged and alternatives are considered, negotiations can begin. There may be several prospects that do not lead to an accepted offer, but eventually a deal gets made. Unfortunately, you’re still not done.

Third Step: Closing the Sale

The third step is closing the sale, completing the transaction and making the business transition to new management.

This final step can be a grinding process with all the conflicting, complicated and costly input of your accountants, lawyers and bankers. (Of course, they should all have had some prior warning and the chance for input before the deal is signed, but now it gets more serious.) You need the professional expertise to properly document and process the negotiated Buy/Sell Agreement to avoid any subsequent liabilities, minimize the tax consequences and maximize the cash payout. You will get conflicting advice, especially from the buyers’ advisors, as the best terms and conditions for you may not be in their best interest. More negotiating and compromises will be required.

Then, once the deal is properly documented and the closing gets done as planned, the parties can all work together on the transition to new management and ensure that the business stays on track for continued profitable growth any balance of sale gets fully paid.

Now you can make your graceful exit and focus on managing, or spending, all that cash.

Have you decided to sell? Then it’s time for you to get started on the first step.

Your Uncle Ralph, Del Chatterson

Read more at: Learning Entrepreneurship Blogs. 

 Join our mailing list for more ideas, information and inspiration for entrepreneurs.

Click Here to check out Uncle Ralph’s books, “Don’t Do It the Hard Way” and “The Complete Do-It-Yourself Guide to Business Plans” Both are available online or at your favourite bookstore in hard cover, paperback or e-book.