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How To Value a Business Purchase

Business valuation is a complex affair. There are many different methods of valuing a business, but in the end it simply comes down to a negotiated agreement between you and the seller.

Some businesses have a listing, or asking, price, while others do not state a price. Instead, the owner or broker waits for offers or letters of intent from prospective purchasers.

In either case, the seller may have unrealistic expectations. This is particularly true if they've received advice from advisors, business associates, or even friends who have little to no experience in the marketplace.

Types of Valuation

There are many ways to value a business and they typically fall into one of these categories:

Earnings-Based Valuation

This method determines a multiple, or range of multiples, of the earnings of the business, where an estimate of earnings is determined by looking at historical results.

For smaller businesses, earnings usually refer to the owner's discretionary earnings. Larger businesses typically use a multiple of EBITDA (earnings before interest, taxes, depreciation, and amortization).

Discounted Future Earnings Valuation

Instead of looking at historical earnings, this method tried to predict future earnings or cash flow, and discounts those earnings by a capitalization rate. Smaller businesses, or those that appear to have more future risks and uncertainty, will be discounted using a higher capitalization rate than larger, more stable businesses.

Market Value Valuation

This method is similar to that used by realtors, who look at what comparable homes have sold for. While it may be a reasonable and accurate predictor for homes, it's not as easy for businesses because there may not be a sufficient number of comparable sales for businesses, especially small businesses.

Terms of the Purchase

Another factor to consider when thinking about how to value a business is the terms of the deal. For example, if you want the seller to finance a large portion of the price, the seller may insist on a higher price. On the other hand, an all-cash deal could bring the purchase price down significantly because you have eliminated the risk for the seller.

Other Factors Affecting Business Value

During the course of due diligence, there may be other issues, legal or financial, that can affect the risk involved in the purchase and therefore the final purchase price. You might even find that there are too many risk factors for you to complete the purchase and your best bet might simply be to walk away and pursue another business.

Our Advice: Use Experienced Business Advisors

There is no one objective value for a business. The asking price is merely someone's opinion of value and can vary a great deal, depending on the level of sophistication of the seller and the seller's advisors. Most businesses have a price tag, but this can be a price range and there is always room for negotiation.

It's more important for you to determine how much the business is worth to you, based on your own requirements and with the help of your advisors. If your valuation and the seller's valuation are reasonably close, you can start thinking about taking the next step. Otherwise, you're probably not going to be successful. The seller has certain expectations and, if you're worlds apart, it's unlikely the deal will get done.

How much you offer depends on the value you see in the business as well as what you think the seller will accept. If you sense that the seller would like to get out quickly, you may be able to offer a lower price and agree that the seller can leave immediately and see your offer accepted before a higher one. This, of course, is always a judgment call.

For the best chances of success, consult with experienced professionals:

  • A business broker or M&A advisor. They can provide a good indication of the market value of the business.
  • An experienced accountant. Your accountant can examine the seller's books and records, including previous years' tax returns, and provide valuable advice on the reliability of the financial information.
  • An experienced business lawyer. Your lawyer will undertake due diligence on all agreements and contracts of the seller's business and may also finds some “ghosts in the closet” that you wouldn't have discovered on your own.

If you're in the process of searching for a business to buy, or have decided to pursue a specific business, we can assist you in the purchase process and help protect your interests. Contact us today.

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