The most common question that I hear from business owners looking to retire or move on:
“How much can I sell this business for?”
And when this question pops up you’ll be tempted to apply the same logic you use when pricing your business’s services. In some cases, this works.
In others, it doesn’t apply at all.
After all, we are talking about selling your entire business.
By the end of this article, you will understand these similarities and differences in pricing logic.
Now there is one core rule to keep in mind throughout the pricing process:
The value of your business, like anything else, is worth what someone is willing and able to pay.
Willing
As a business owner, you keep an eye on your competition’s pricing to benchmark what customers are willing to pay. You know customers shop around so it’s important to understand their other options. The same goes for pricing your business; it needs to be appealing relative to other options in the market for a buyer’s cash.
But when you’re valuing a business it’s not as simple as googling competitors’ pricing to determine the going rate. Your business is unique. Your best bet here is to follow a few “best practices” to assess what business buyers have recently been willing to pay – and translate that information to your situation.
Able
People only have so much cash – it doesn’t matter how life-changing or high quality your product or service – if they aren’t able to afford it they can’t pay you.
The concept of affordability is especially important when it comes to selling your business given the high price tag. However, if a buyer can finance a purchase, they’re suddenly able to pay a much higher price.
With these fundamentals in mind, in this article we’re going to break down:
- The “Market Approach” which is used to assess what a buyer is likely willing to pay
- Common pitfalls when using the “Market Approach” that can lead to unrealistic price expectations or dead-end negotiations with buyers.
- What information banks require from buyers in order to get financed (thus increasing what your potential buyer is able to pay)
In high-stakes scenarios like buying a business your potential buyers are going to shop around.
In the world of buying and selling businesses, the price (value) relative to the annual earnings (profit) is in the spotlight. Count on this and make sure you know what other options your potential buyers have (or may have recently had) as far as similar businesses to purchase.
Now let’s get into the nitty-gritty of how the Market Approach works…
The Market Approach
The market approach to business valuations on its surface is simple: Earnings x Multiple = Valuation
So if your business earns $1M per year you would multiply $1M by a certain amount (your “multiple”) and that’s your valuation. Multiples tend to vary across industries but can also vary to a large degree inside the same industry.
Here’s the catch: Unlike almost anything else money can buy, your business is one-of-a-kind.
You can ask your friends and colleagues what their businesses sold for but even if they’re in the same industry the comparison won’t be “apples to apples”.
And one transaction doesn’t make a market.
The good news:
There are robust databases you can use to see what prices similar businesses have sold for – and their annual earnings.
With these two critical metrics in mind, the info in these databases can be used to get a feel for what your multiple might be.
The problem is access to these databases isn’t cheap. Especially if you’re just looking for a quick peek into the market.
On top of that, business valuations aren’t black and white and since multiples inside the same industry can still vary the information can look like Greek to an untrained eye.
And even though these databases show sales prices relative to earnings of other businesses…
The definition for “earnings” isn’t as straightforward as you may think.
If you’re an owner/operator you don’t want to fork over your livelihood to the Tax Man.
And if you’re an owner looking for tax efficiency you’ll claim expenses like cell phone bills, vehicles, and maybe even a Few Beers here and there to boost company morale.
This is normal. And most buyers aren’t going to take issue with discretionary expenses.
But when it comes time to market your business for sale – and earnings are under scrutiny – you need to be careful that your numbers are defendable. More on this later.
This brings me to one of the most critical terms in selling small businesses: Seller’s Discretionary Earnings or SDE.
SDE can be thought of as the total financial benefit to the buyer if:
- They bought the business with cash so there are no debt payments.
- All expenses are directly related to business operations (nothing personal)
- The buyer steps into the owner’s current role (they’re not adding or subtracting costs for the owner’s time and they will be filling the owner’s current shoes)
Uncovering an accurate value for the business’ SDE (that will hold up under a buyer’s microscope) is the most time-intensive aspect of valuing a small business.
To arrive at an accurate SDE, we do a detailed review of the owners’ financial statements and add back discretionary expenses to earnings.
A discretionary expense is a King Ranch Tricked Out Truck that you drive to the office…
But that you leave in the office parking lot while you drive a company beater to worksites.
In some cases, we identify expenses that don’t exist for you as the current owner but will for an eventual buyer. For example, if your spouse is an accountant and does your books for free, that’s going to be an expense for the next owner – and its impact on SDE must be considered.
Now once you as the owner understand the concept of SDE it can be tempting to get carried away with discretionary add-backs.
Don’t be that owner.
It undermines your credibility when the buyer finds expenses that have been unreasonably added back. It also begs the question: “What else are you not telling me?”
And if you want to make a deal you need the buyer to trust you. Plain and simple.
The temptation to inflate perceived value for the buyer via excessive add-backs isn’t the only mistake we see owners make or unscrupulous brokers encourage…
One of the largest most common mistakes is over-focusing on ONE specific year of earnings. “Earnings” doesn’t refer to one year. And latching onto your business’ best year of earnings to determine its value isn’t the “magic pill” to a higher sales price.
We are looking for average earnings and a one-year lookback isn’t going to cut it. Buyers and banks alike want to see 3 to 5 years. And fluctuations – like pandemics, stimulus checks, and natural disasters – need to be accounted for by looking at a bigger picture of overall earnings.
That being said, if a business has been steadily growing (or declining) we may give more “weight” to recent years earnings. Earnings aren’t a cut-and-dry concept and we don’t want to latch onto the highest year’s earnings just because it will (theoretically) give the highest value.
When you step in front of a buyer you must be able to justify why the selected weighting best reflects the future.
Example
If you own an entertainment venue your worst year was probably 2020 (pandemic) followed by an excellent year in 2021 when customers stampeded through your doors with stimulus checks to burn. But those years were outliers. And the future likely lies somewhere in the middle. We would give more weight to 2022 and 2023 as they better reflect the future.
And just like Earnings leaves room for interpretation, the same goes for finding an appropriate Multiple.
First off, buyers are willing to pay a premium multiple for businesses that require minimal involvement from the owner.
They also prioritize QUALITY of earnings.
- Are the earnings contractually guaranteed?
- What is your customer retention rate?
- Is any of your revenue recurring?
These are the questions that buyers are going to ask – and your answers will determine whether or not they’re willing to pay a higher multiple.
As a buyer if business revenue is recurring – as seen in subscription models – you will worry far less about whether or not the phone will ring to bring work in the door.
This is a massive antidote to a buyer’s anxiety who has less risk if most revenue is recurring.
Thus “Quality of Earnings” will likely be at the top of a serious buyer’s mind when it comes to deciding whether the purchase price of your business is a fair deal.
So if earning quality being higher means a buyer will pay higher multiples… how do you gather this information for other companies and apply it to your situation? The short answer: “Quality of earnings” information for other business is not easy to come by. And your best bet here is getting an M&A professional involved for a cursory look at your accounting records.
A knowledgeable M&A advisor can point you toward a multiple that best reflects your business’ unique circumstances.
And all things considered, if the buyer doesn’t catch egregious add-backs, weighing of earnings or inflated multiples…
The bank will.
Just like buying a home – where an appraiser is required – banks hire an independent expert (CVA) to review the deal and verify the sales price is fair before lending money.
And if things aren’t on the up-and-up your buyer won’t get the loan they need to close the deal.
To be financeable for an acquisition you generally need to have:
- Compliant tax filings (3 to 5 years)
- Accounting records (ideally prepared by CPA)
- A professionally prepared overview of your business
If you don’t have those in order your buyer can’t get a loan.
And if your buyer can’t get a loan their ability to pay is greatly diminished.
Remember to follow the cardinal rule of business:
Make it easy for people to give you money.
Make your business financeable by working with a CPA to keep tax filings in good standing so your future buyer can borrow money.
If you’re looking for someone to help walk you through the process of valuing your business shoot me an email – sean@tws-advisory.com
We provide an opinion of value with no upfront cost; I sell businesses on a commission basis.
You don’t owe me a dime until I’ve sold your business and you’ve been paid.