Avoid Common Problems When Selling Your Business

Here are 10 common mistakes business owners often make when selling a business. You don’t have to make these mistakes, profit from the experience of others.

How is a business valued?

Probably one of the most common questions business owners ask is “What is my business worth?”.  No question why that’s important, it helps with retirement planning, succession planning, divorce planning, estate planning, etc..  This simple question has no simple answer, however.  You ask for a price and what you get is an “Opinion of Value”.  There is no concrete objective value that one can place on a business.  Pricing a business is a combination of art and science.  The result is a “Most Probable Selling Price”. 

There are three main approaches to determining a most probable selling price:

1)      Market Approach

2)      Income Approach

3)      Asset Approach

 

The market approach is based on the comparison of “similar” businesses that have sold when compared to yours, then projecting a value for your business.  The principle of substitution would suggest that this is a reasonable way to come up with a valuation.  There are several problems, such as comparing businesses in different parts of the country, or even state that might make this comparison inaccurate since local economic conditions vary.  Also, comparing companies of significantly different sizes can skew the results since buyers typically pay higher multiples for larger companies. 

The income approach looks at a view that presumes that a business is a cash generation machine, and you should compare your business to any other investment that generates cash.  The big difference here is that small business is risky, so an accommodation for risk needs to be built in.  A key part of the process is to identify the cash coming from the business through a process known as recasting.  Recasting will take tax returns or financial reports and estimate the cash flow of the business that benefits the owner.  This is often referred to as “Sellers Discretionary Cash Flow” (SDCF) or “Seller’s Discretionary Earnings”, or something similar.  This cash flow number is then multiplied by industry specific ratios to estimate a value.  Other variations on this method include a capitalization rate applied to the SDCF or looking forward and estimating the SDCF for several years and calculating the net present value of that cash flow (what the sum of future benefits is worth today).

Finally, the asset approach depends on the fair market value of the company’s assets.  This is sometimes called the cost approach, since it deals with the physical assets of the business, and doesn’t provide much value for goodwill.  In most businesses, goodwill is the majority of the value of the business.  This approach is most useful for unprofitable businesses or businesses that have a significant investment in equipment or other assets.

 

But wait, there’s more.  The purpose of the valuation also makes a difference, since there is a difference in the value of the business based on factors such as a partial sale or how quickly it needs to be sold.  If there is no interest in a training period or a non-compete agreement, and it has to be disposed of quickly, that will depress the value of the business.  If the seller is willing to allow an average market time of nine months to sell the business, and will provide transition training and a non-compete agreement, you will typically get a higher value. 

 The buyer also makes a difference, since a buyer with industry experience will have a better chance of making the business successful and probably perceive a reasonable amount of risk in the purchase of the business, where someone without that experience would see more risk and want a greater margin of safety, and hence a lower price for the business.  Additionally, if a strategic buyer is available to buy the business they may be able to combine operations and reduce the cost to deliver the same goods and services as the current owner, or perhaps sell different goods and services to the existing customer base.  These would be reasons a buyer might pay more or less for a business.

 The valuation report is usually a combination of the above, to try to accommodate the complexity of the situation.  It will usually take some time with a business broker or valuation professional to collect the information required to do a valuation.  There are software programs that will then do the mechanical computations and generate a report.  Then there needs to be a little experience in the analysis of the results.  Your business broker will then propose a selling price. 

The larger the business for sale, the greater the reason to get a third party valuation.  This provides for a neutral third party to provide their opinion of value, and separates the marketing of the business from the pricing of the business. 

Ultimately, the market determines the price of the business.  Because every business is unique, expect negotiation on the price.  Buyers buy the whole package, it’s not just price, but the perceived risk of the business, the prestige of owning that business, the volatility of earnings, strength of the industry, the local economy and a host of other factors not easily quantified.  The opinion of value is the start of the discussion on what the business will actually sell for.  Get some help when its time to price your business.