What’s The Right Selling Price For Your Business?
In the end, the selling price is determine by the market — the price agreed to by a willing buyer and seller, neither being under any compulsion to engage in the transaction. There are two major ways to figure the price of a small to mid-sized business:
- The company’s ability to generate sales, cash flow and/or profits.
- Value the company based on its assets.
Which method is used depends on the condition of the business and the industry it is in.
Most companies today don’t have substantial physical assets, so we’ll spend this time focusing on a company’s ability to generate sales and cash flow.
Value based on sales. In some industries, the norm is to determine value by using a multiplier of the firm’s annual sales. Examples: Consulting firms, radio stations, temp agencies, PR or ad agencies, professional practices, retailers and insurance brokers are often valued using a multiplier of annual sales.
The multiplier depends on the exact type of business, the predictability of sales from year to year and many other factors. Generally, the industry multiplier is the starting point and is then adjusted based on specifics of the company. For example, the industry’s multiplier may be two times sales, but if the firm has experienced strong, consistent growth in the past three years, that may boost the multiplier to 2.5 or higher. On the other hand, if the firm has one client that makes up one-half of its billings, the higher perceived risk may drive the multiplier down to 1.5 or lower. If your business has low fixed costs, few assets and little retained earnings, the sales multiplier technique may be appropriate.
Value using cash flow or profits. The price can also be based on the company’s ability to generate a stream of profit (which can be defined in different ways) or cash flow (sales less expenses). The seller projects this stream of cash over a number of years to calculate the worth of the business. Often, discounted future earnings are used which takes into account the time value of money – where cash expected to be received in future years is discounted based on some assumed interest rate. In this method, disagreements can occur regarding calculation of cash flow and estimated sales projections. Many projections of cash flow and EBITA (earnings before interest, taxes and amortization) use “recast” numbers to reflect the effect on profits of perks that a business owner takes from the business.
What factors affect the multiplier? There is plenty of room for judgment, but by and large, a profitable, reasonably healthy, small business will sell in the 2.0 to 6.0 times EBIT range, with most of those in the 2.5 to 4.5 range. So, if annual cash flow (sales less expenses) is $200,000, the selling price will likely be between $500,000 and $900,000. But there are many factors that affect the multiplier.
Examples of positive factors (that raise the multiplier) include:
- Proprietary products, with strong brand and/or patent or trademark
- Diversified customer base – no one customer more than 10% of sales Strong management team with few key personnel
- Weak competitors and a healthy market share for your company
- Products that are early in the Product Life Cycle
- Diversified products – no one product more than 15-20% of sales
- Ability of the company to meet some growth with current plant and equipment
- No pending legal or government action
- Financial ratios that are near or above industry averages
Examples of negative factors (that lower the multiplier) include:
- “Me-too” products that are just like those of competitors
- One or a few customers make up more than 25-30% of sales
- Strong competitors and a weak or declining market share for your company
- Products that are near the end of the Product Life Cycle
- One product makes up more than 20% of sales
- Major investment needed soon in plant and equipment
- Pending legal or government action
- Financial ratios that are below industry averages
Next: Things You Should Do To Maintain A High Value For Your Company