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Simple Reality Check For Price Of A Business

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When it comes time to value and sell a business, it is only human nature that most business owners have an inflated opinion about the value of their business. Unfortunately, overpricing a business and not relying on an objective, independent business valuation can lead to many problems and end up costing just as much as an undervalued business. This article is intended to provide a couple simple steps a seller or buyer can take with a little help from their business broker or advisor to do a reality check on the price of a business.

 

The key business valuation word that is used all the time but just as often misunderstood is the principle of “fair market value.” Fair market value has a very definitive meaning to business appraisers such as myself. Fair market value is defined by the International Glossary of Business Valuation Terms as, “the price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arms length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.” Unfortunately, on the real market the concept of fair market value is very elusive and controversial any time it involves a buyer and seller.

 

The problem with overpricing a business is that worst case, it may never sell and best case, it will extend the sale time dramatically and potentially chase away some of the best buyers for the business. Arguably, either of these scenarios could be worse than just pricing a business below but close to fair market value from the very beginning.  I recently gave a presentation to a group of business brokers where I suggested some fairly easy steps to do a reality check on business pricing so as to avoid substantially under-pricing or over-pricing a business.

 

While there are several approaches and methods for valuing a business, without question, the most common method used by business brokers and M&A advisors is a market-based method which relies on the data from past sales of similar businesses to arrive at a value based on the earnings of a business multiplied by a valuation multiple. The earnings of a business is generally unique to each business but the valuation multiple is a statistical average or median derived from many actual business transactions of comparable companies. It is the business valuation multiple which can provide a meaningful benchmark and reality test for the price of any business. The following steps outline a simple but effective means to do a reality check of the price of a business.

 

Step 1 – Business broker or M&A advisor should obtain comparable sales data from a highly reputable business transaction database such as Pratt’s Stats, Bizcomps or the Institute of Business Appraisers transaction database.

 

Step 2 – Estimate the median business valuation multiple for the sale of businesses comparable to the subject business. The median valuation multiple is the value at which 50% of businesses sale for more and 50% sale for less.

 

Step 3 – Compare key performance metrics of the subject business such as profit margin, gross profit margin, annual sales growth, diversity of customer base, etc. against industry averages to see if the subject company compares better, worse or on average with the industry as a whole.

 

Step 4 – Based on the findings of step 3, determine if the subject company appears to be in top 25%, bottom 25% or somewhere close to the industry averages.

 

Step 5 – Based on conclusion of step 4, determine if subject business warrants a business valuation multiple above, below or approximately equal to the median, industry valuation multiple.