Would you expect to buy a new Lexus for $10,000? Or a house on 3 acres with 9,000 square feet of living space in a new section of town for $75,000? How about a gallon of gas for $1.85?
It doesn’t seem like a long time ago that fuel sold for $1.85, but today you couldn’t dream of getting it at that price. Because? There is not enough incentive for the owner of the fuel to give it to you for that price when he has others that would pay much more. It probably cost you over $1.85 to purchase the fuel and refine it! So how much is enough? When you’re about to make an offer to buy a business, the million-dollar (or more) question becomes “Will you guess the right purchase price?”
Many people struggle with this problem. And guess what, it’s not just you fighting. Even the best people in business who buy and sell other businesses try to figure it out. The truth is that value, like beauty, is in the eyes of the beholder. There is no scientific justification for why a company is worth 8 times its annual EBITDA one year and then 5 times a month later.
Yes, market conditions and attitude play a large role in determining the value of a going concern. But how much is it really worth? Nobody really knows. The price of a business is determined solely by what is paid. Under normal circumstances, companies are purchased in an arm’s length transaction. As the definition states, the fair market value of a business is what a seller and a buyer, both in possession of all relevant facts and conditions, and not under duress, agree to as a price.
But since you are the buyer, what price should you offer? We get that question a lot. Be careful here. As a buyer, make sure you have objective advice when and if you want to determine an offer price for a business. Remember, most brokers and dealers are actually Seller’s agents and as such should ethically caution you about asking for price advice from them. They cannot be objective on your behalf.
They can help talk through the issues with you, but in the end it is you and ONLY you who make the final decision on what to offer. Your paid advisors are usually hired to highlight the flaws and risks of a decision you want or need to make. The actual level of risk that you accept and are willing to take is something that you must be aware of. no one will do it for you.
When YOU want to make an offer on a business of your own, YOU are the only one who can take that leap of faith as to how much is enough. That winning PRICE is something that tips the scales in your favor. It’s something that makes the business owner take a break and think about its value to him. In a word, it is a price (and terms) that INCENTIVE them.
A buyer should only make an offer based on the value of a business. But that offer must incentivize the business owner to accept the sale. Unfamiliar with the process they should use to determine the value of a business or determine an offer price, many buyers become confused and make unrealistic offers, both high and low.
An offer price that incentivizes a seller to sell, but is not representative of the value of the business, is a bad offer. Offering a high price to ensure success could be disastrous. The company’s cash flow may not support debt service or provide a competitive return on investment to shareholders. An informed seller may fear that you will not pay the money you owe them and then be forced to take back the business, which they probably don’t want to happen.
Unfortunately, the reverse is also true in many cases. Buyers make offers for everyday businesses that don’t work. Why, because the buyer didn’t offer the business owner enough incentive to sell. This article is not intended to help you price a business, but with that in mind, it will help you understand the psychology of a sale. IN good business that is profitable, has a strong cash flow positive, and has an excellent outlook for continued operations, has definable value. As a buyer, you must determine how to place a value on the business that appeals to you and meets your needs.
You will likely never know exactly what will incentivize the Seller. However, during his discussions with the Seller and other investigative work, he will need to try to determine what would incentivize them. I’ve seen businesses sell for 10% of their value because a salesperson wanted to walk away and just make sure their customers were still being served. But, as you probably guessed, that happens once in 10,000 times.
When determining what price to offer, first determine a price range that makes sense to you. Ask yourself how much you need to earn. What are the chances of increasing cash flow? What are the risks? Find comfort with the range. It’s not unusual to be nervous about that amount, especially at the top end. But, it still has to be workable for you.
Now, try to determine what the Seller would consider reasonable, and it would goad them into giving you the kidneys. Keep the following items in mind when attempting to make this determination:
- What is the multiple of the cash flow? Is it within current industry standards or not? If it is too low, the probability of a better offer from someone else is very high.
- Are the mix or the price and terms reasonable? It makes a big difference when a price actually pays off with loan payments or profit. Remember this formula that a salesperson will consider:
- Price = Cash Now + (Cash in the future * collection risks).
- How long would it take for a homeowner to EARN the money you are paying them? at closing and that there is no risk of collection? If it takes 2-2 1/2 years or LESS, most sellers would rather stay in business, keep what they make in that time, and then just close it. They will not have closing costs, aggravation of a sale, nor will they have to deal with a third party during the transition period.
- If the allocation of your transaction will result in a high tax consequence for the Seller, it may not be profitable for you to sell. Ask your broker or tax accountant the true implications of an assignment for both you and (not directly obvious without considering your personal tax situation) the Seller.
- An offer can be seen as insulting (in dollars or terms) and failing to tell the owner what their efforts have been worth. This could lead to being disqualified from receiving a counter offer or even negotiating a new offer!
- You are not doing the seller a favor by buying their business. They’re likely proud of what they’ve built, and they wouldn’t sell it for a lower price or condition than they would give away a prized painting they own because they’ve had it for too long.
- Offers should be non-emotionally priced. However, that does not mean that in all cases the Seller will evaluate it without emotion. If you, as a buyer, believe that a seller will place too much emphasis on emotion over value, he may be wasting his time. You need to evaluate both the seller and the business to make sure you are using your time, money, and resources effectively.
When you finally get a business owner to agree to an offer price, chances are neither you nor the seller got exactly what you wanted. You’ll think you paid too much, or maybe you made the terms more in the seller’s favor, and they’ll think you got a bargain price and are being too harsh in your terms and payment requirements. That is not to say that there was a disagreement. It’s just the nature of negotiations. No one thinks they really won.
To be prepared! Understand the psychology of what motivates a salesperson. Be careful to only offer what a deal is really worth. Understand that you may have paid more than you wanted, but if you have faith in the business, as well as your experience and skill set, hopefully your investment will pay financial and psychological dividends for years to come.