Buyers of Businesses Should Pay Fair Price
Prior to making an offer for a business, a buyer should carefully determine whether the proposed purchase price reflects a fair valuation of the business. For some buyers experienced in purchasing and operating businesses, this will come fairly easily. Buyers such as experienced competitors in the industry often intuitively understand what they are buying, how much cash flow they can expect to receive from operating the business, and what ‘multiple of cash flow’ businesses typically receive in their industry. Other buyers may have a difficult time in understanding the fair price to pay for businesses they wish to purchase.
Key Factors for Buyers to Establish Fair Price
With preparation and hard work, even inexperienced buyers can properly determine the valuation of a business. In general, buyers may ascertain the fair value of a business by viewing similar business listings online in order to get a sense of the ‘businesses for sale’ marketplace, analyzing ‘comparable sales’ of closely related businesses, and properly conducting formal due diligence which enables the true ‘owner benefit’ of the business. to be understood. Moreover, buyers must understand what their role in the business will be compared to the seller’s role in the business, and how this may affect the ultimate valuation. In valuing offered businesses for sale, buyers may consult a professional business broker, but the final decision remains with the buyer.
View Similar Business Listings
A potential buyer of a business may go online to view businesses for sale that fit their criteria. The most common venue for an online search is bizbuysell.com. Here, buyers may view the ‘blind ads’ of hundreds of businesses for sale in Palm Beach County. The ‘blind ads’ do not disclose the identity of the business (and are hence confidential or blind ads), but will disclose their asking price, revenue, and annual cash flow (or Seller’s Discretionary Earnings). By carefully viewing all available business listings within their price range and industry, a buyer may learn about the attributes of available businesses, and the general valuation ranges of businesses within a particular industry. A buyer must qualify themselves by completing a Non-Disclosure Agreement (NDA) in order to receive confidential listing information about a particular business listing.
Example of Viewing Similar Business Listings
- Barry the buyer is currently working a corporate job that he is thinking of leaving in order to pursue his passion of auto repair.
- Barry determines that he would like to buy an auto repair business in Palm Beach County.
- Barry’s available liquid funds to buy an auto repair shop is $500k.
- Barry goes to bizbuysell.com and enters his search parameters of all available auto repair shops in Palm Beach County with an asking price of $500K or less.
- Barry sees 10-20 active auto repair-related business listings in Palm Beach County.
- Although the listings are displayed as ‘blind ads’ without the identity of the business, the listings still enable Barry to get a good sense of what sort of auto shops are available for what price.
- This allows Barry to tailor his expectations of what is a fair price based on the reality of the marketplace.
- Eventually, Barry may zero in on one or more auto shop for which he will sign an NDA and receive a confidential listing package from the broker.
- This should contain a comprehensive write-up about the auto shop, an equipment list, pictures, and historical financials.
Analyze ‘Comparable Sales’
A ‘comparable sale’ valuation method compares the ‘price to owner benefit ratio’ of recently sold similar businesses with the ‘price to owner benefit ratio’ of a business being offered for sale. The price refers to the final purchase price (not the asking price) of a recently sold similar business compared to the asking price of the business being offered for sale. The owner benefit refers to the actual economic profit of a business derived by its owner. Others may use the terms cash flow or Seller’s Discretionary Earnings as a way to measure the true profitability of a business. Buyers may go to bizbuysell.com and view recently sold businesses (with the purchase price and owner benefit) in a specific geographic area in order to compare what was sold with what is being offered for sale.
Calculate ‘Adjusted Owner Benefit’
The adjusted owner benefit of a business is calculated by first obtaining the annual EBITDA (Earnings Before interest, Taxes, Depreciation, and Amortization) from the most recent financial statement such as a tax return. Then one ‘adds-back’ the owner’s salary, personal expenses of the owner that flowed through the financial statement, unrecorded sales (if proven), and any other adjustments necessary to derive the normalized annual owner benefit. Crucially, the role of the owner must be fully understood in order to properly calculate the adjusted owner benefit. Absentee-owned businesses command premium valuations while businesses with working owners who have personal relationships with key customers have lower valuations. It can be risky and costly for a buyer to replace a working owner, especially if the working owner has special skills and relationships.
Properly Conduct Formal Due Diligence
After an agreed upon Letter of Intent or purchase agreement along with a refundable deposit are in place, buyers may engage in the formal due diligence process. The carrying out of formal due diligence to the buyer’s satisfaction is typically a contingency to close, and is the process by which a buyer fully investigates every possible aspect of the business. This includes more sensitive financial and company records such as banks statements, payroll records, insurance certificates, and accounting ledger reports.
Formal Due Diligence May Change Valuation
A buyer must take full advantage of the opportunity to conduct formal due diligence, and should prepare a thorough list of due diligence request items for the seller. In many cases, the buyer’s estimate of the seller’s adjusted owner benefit will significantly increase or decrease after reviewing the seller’s more sensitive financial records. Moreover, the buyer may significantly increase or decrease their estimate of what they themselves will earn from the business as a result of formal due diligence. If, for example, the buyer discovers through formal due diligence that the owner’s role in the business is more important than initially portrayed, then the buyer will be less confident about their own future profits from the business.
A well prepared buyer is far likelier to pay a fair price for a business. When buying a business, many buyers will benefit from reviewing available online listings of relevant businesses for sale, comparing the valuation of recently sold businesses with the business being offered for sale, and properly conducting formal due diligence.
Give Martin at Five Star Business Brokers of Palm Beach County a call today at 561-827-1181 for a FREE evaluation of your business.