How to Value a Business for Purchase
Buying a business can be both an exciting and complicated process. Often, one of the most nerve-racking components is determining the purchase price. Valuing a business for purchase is more of an art than a science and the processes used are inexact at best. Factors that affect a business purchase price include the terms of sale, the motivations of the buyer and seller, the lending environment and the age of the business. There is a basic procedure to follow when pricing a business, but it is not uncommon for two parties to arrive at different outcomes using the same process.
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Instructions
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Determine the business's free cash flow or owner's discretionary cash flow. When buying a business, you're really buying a stream of income. The purchase price of a business should reflect the size and stability of that income stream. The exact procedure for calculating the ODCF can vary from situation to situation. However, buyers should look to the business's earnings before interest, taxes, depreciation, and amortization, or EBITDA, which is a good measure of the economic profit of a business. Most prospective buyers will add the owner's salary, bonus, benefits and company-paid perks to the business's EBITDA.
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Pick a fair multiple. Multiply the ODCF by an earnings multiple. The calculation is quite simple, determining a fair earnings multiple is not. An earnings multiple of one means that the buyer will recoup his investment in one year, an earnings multiple of two equates to two years. The higher the risk in the business, the lower the multiple should be. Most small retail and service businesses typically sell for 1.5 to 2.5 times the ODCF. Larger "middle market" businesses, such as manufacturing and distribution companies, tend to sell for 3 to 4 times the ODCF.
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Run your figures by a CPA who often advises on business transactions. The CPA should be able to review your calculations and help you decide whether they are fair.
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Make an offer below your target value. Once you've arrived at what you feel to be a fair purchase price, make an offer to the seller at 10 percent to 15 percent below that value. The seller will want to negotiate a higher sales price, so starting low gives you the chance to end at a fair value.
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Tips & Warnings
Terms occasionally trump price, so keep in mind when negotiating a business purchase that the speed and terms of the sale will affect the final purchase price.
While a CPA can help determine the economics of the purchase price, an attorney should always be consulted for the terms of the sale and legal aspects of the purchase.
References
- Photo Credit for sale image by dead_account from Fotolia.com
