If you are considering buying a small business or offering yours up for sale, the central questions are:
- What can the business sell for?
- How should I structure the price and terms of the deal?
Valuing a business to estimate its selling price
Not surprisingly, the business selling price is related to its value. Measuring the value of the business is what business valuation is about. One of the key reasons for a business valuation is to determine the market value of the business.
Company valuation using comparable business sales
Since your goal is to estimate the likely business selling price, an excellent choice of a business valuation method is to study the comparable sales of similar businesses. The actual business selling prices can be related to a number of business’ financial performance factors.
Business valuation multiples
This gives you the so-called valuation multiples. The multiples help you establish the business market value in relation to its revenues, profits, cash flow, assets or owners’ equity.
You can apply these valuation multiples to calculate what your business is worth. For example, you can take the Price to Gross Revenues valuation multiple and multiply it by your business’ gross revenues. The result is the estimate of what your business is worth – and its potential selling price.
So far, so good. If you have enough business sale comparables, you can develop a good idea of the fair market value of your business. However, every business is unique. So it is possible that your business is worth more or less than the average.
How to evaluate a business based on its earning power
Enter the income-based business valuation methods. Instead of comparing your company to others, you can determine the business value directly based on its earning capacity and risk profile.
The classical methods to do income-based valuation are the Multiple of Discretionary Earnings and Discounted Cash Flow. Both focus on your specific business and give you the business value result that is as unique as your business itself.
Business goodwill valuation
If your business has been around for a while, chances are it has developed considerable business goodwill. You can calculate this important part of your business value by using the Capitalized Excess Earnings valuation method. Known as the Treasury Method, this well-known appraisal technique helps you determine the value of business goodwill and total business value.
Putting the business sale together: price and terms
Now that you know what the business value is, the next objective is to put together the terms of the business acquisition that make sense to you. Business selling price is but one element of a successful business purchase. In fact, the business sale terms often make or break the deal.
From the buyer’s perspective, the deal terms must ensure:
- Down payment amount acceptable to the buyer.
- Generous financing terms for the balance of the purchase price.
- A living wage for the new business owners.
- Sufficient debt service coverage.
- Cash required for capital investments to keep the business running. This includes equipment purchases and working capital.
- Return on and of the buyer’s down payment, called payback.
Business cash flow must be sufficient to cover all these requirements – or the deal cannot be made. Depending on the buyer’s specific needs, the deal terms can lead to the offer price that may be well below the business value!
A strategic choice for business buyers and sellers
If you are selling your business, picking the right buyer is often the most strategic choice you can make. If you are buying a business, choosing your target carefully is well worth your while.