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:
- 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.
- 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.
- 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.
- 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.
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.
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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