One of the most challenging aspects of running a business is deciding on the pricing. If the price is set too high, then customers will not buy the product, and revenue will be lost. The company is not making the most money if the price is set too low. We help you choose the best option for the value of your company.
If you are preparing for an exit, understanding how to sell your business effectively starts with setting the right price.
Moreover, we will help you know how to price a business for sale in this guide.
The Basics of Business Valuation
The first step in pricing is business valuation. Valuation is not something that can be completed through a set formula. It is a more subjective process that requires you to have a good understanding of your business and its story. Incorporating your value, net assets, goodwill, and going concern value are all important factors to consider in the story of your business.
A common myth is that the owner of the business determines the value of the business. Buyers will provide value according to their own financial goals and then compute the value of the business according to their financial goals. This means that the seller’s personal financial goals will not set the price of the business. Customers will determine the value based on the financial return that will be obtained from the value of the business.
Key Financial Terms You Must Know
When determining the sale price of a business, the seller must understand key business terms to ensure a common understanding throughout the transaction.
Seller’s Discretionary Earnings (SDE)
When it comes to small businesses, SDE is a critical metric. It reflects the entire economic value captured by a business’s sole owner/manager over a given year. SDE is calculated by starting with the net profit of the business and adding certain expenses back.
Included in the calculation of SDE are:
- Owner’s salary
- Company-funded personal perks (auto, health insurance, etc.)
- One-time expenses of an unusual nature
- Interest on loans
- Taxes
- Amortization and depreciation
Buyers see SDE as the total financial inflow available to an owner/operator of the business.
Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA)
With more considerable companies, EBITDA is more common. It is comparable to SDE, except it does not add back an owner’s salary. EBITDA is utilized when a business is substantial enough to require an employed manager (not an owner). It indicates how much a business makes in terms of operating profit while excluding other operating losses and non-cash expenses.
It is common for buyers to take an SDE/EBITDA and apply a multiple to it as a form of initial valuation.
Three Main Methods to Price a Business For Sale
No single method can be used for business valuation. For most deals, a mix is used to provide an adequate price. Here, we will describe the three primary methods used to price a business.
1. The Asset-Based Approach
With this approach, the worth of a business is determined by the value of the business’s total assets minus its total liabilities. An example of this is, ‘What would it cost to recreate this business from the ground up?’ This valuation approach is usually used for businesses that are not making a profit or businesses that are closing. This approach is also appropriate for valuing companies that are rich in valuable physical assets, like manufacturing and construction companies.
There are 2 ways to evaluate asset value:
- Going Concern Value: This is the operable business assumption, which means the business is going to continue to operate. Here, the value of the assets is determined by their capacity to produce an income.
- Liquidation Value: Here, it is assumed that the business is going to be closing down and its assets will be sold. This value is generally less.
An asset-based valuation sets the minimum for your business price. Your business ought to be worth at least the value of the net assets.
2. The Market-Based Approach
This type of analysis involves comparing the sales of similar businesses. Like how real estate agents price a house by looking at comps. It’s probably the most common and most reliable way to assess the price of a business for sale.
To analyze this type, you will need to find information about comparable sales. Business brokers and valuation professionals have access to databases with this information. They screen businesses by industry, size, and geography. Then they compare the various multiples of SDE or EBITDA to determine what the market will pay for the business. This method is the most appropriate for assessing the worth of a business at the time of evaluation.
3. The Income-Based Approach
In contrast to the market-based approach, the income-based approach looks at the potential income of a business for years to come. The buyer is acquiring a future stream of cash flow. This method attempts to locate an amount of cash flow to be generated in the future and assign a current value to it.
The Discounted Cash Flow (DCF) methodology is the most widely used version. This would involve estimating the company’s cash flows over several years and then discounting these future cash flows to present value. This is based on the principle that a dollar received tomorrow is worth less than a dollar received today. However, this method is convoluted and involves many variables.
Many buyers also evaluate long-term returns using metrics like the Internal Rate of Return to justify the price they are willing to pay.
Factors That Increase Your Business Value
An example is how two firms with identical SDE might be valued and sold quite differently. The valuation multiple is not constant. However, several variables can improve the multiple factors a potential buyer may consider.
- Stable and Recurring Revenue: A business will be considered more valuable if it has revenue generated from long-term contracts or a subscription model.
- A Strong Management Team: A business is more valuable if it can run without the owner.
- Clean Financial Records: Organized and complete financial documentation inspires trust.
- A Diverse Customer Base: Having one or two dominant clients is considered a high-risk scenario. Having a large and diverse set of customers improves the stability of the business.
- Growth Potential: If a business has growth potential, it is visually and realistically better to demonstrate that potential to prospective buyers.
- Good Systems and Processes: Documented systems and processes ease a management transition for a new owner and are a compelling selling feature.
Improving these factors can help increase your business’s sale price. Knowing how to price a business for sale is essential to get the best business value.
Frequently Asked Questions
1. How can I get my small business valued?
One answer might be to look at Seller’s Discretionary Earnings, often called SDE. In other words, a small business might be worth two to four times its SDE.
2. I need to set a multiple for my industry. How do I do that?
It’s difficult to set a multiple because they can be quite different, depending on industry, location, and size. Business brokers often appear to have the best multiples because they have access to private sales.
3. How does debt influence a business’s worth?
While the debt itself may not be directly included in the business’s valuation, it does impact the business’s value. In most small business sales, the seller retains the debt and pays it off with the sales proceeds, so the total sale price must cover the business’s debt.
4. How much does a business valuation cost?
The complexity of the business being valued affects the price. A broker’s opinion of value can cost a few thousand dollars, while a more complicated valuation and a certified appraisal can cost over $10,000.
