Free Advice

The Pricing of Small Businesses

A while back a prospective client said to me that he was willing to take a lower rate of return (than normal) on his investment in a business (he said 15%). His equating the current interest rate on his money market account to the return he was willing to take on his investment led him to this erroneous decision. 

Small businesses should not be valued or priced based on these type of factors. They should be valued based on the inherent risk of ownership. The chances that current profits will remain. The chances that profits will increase. The odds of something causing sales and/or earning to decline.

History & Research

This issue came up again last month. I spoke to two business appraisers and found some articles on pricing "multiples" and how they are technically calculated. 

Both appraisers were adamant that interest rates and similar factors should not affect the pricing of small businesses. The discount rate used should remain in the 25-40% range for most firms with the cap rate (the inverse of the multiplier) slightly lower. The risks of owning and buying a small business are just too great to justify paying a higher multiple they both stated.

One also told me about numerous statistical sources including the Institute of Business Appraisers and the International Business Brokers Association. Both state that the pricing levels within an industry remain at pretty consistent multiple of earnings whether it is good times or bad. Profits may change, but the ratios don't.

The caveat is that supply and demand is also a factor. Over the last six months or so I've noticed that every profitable business listed by a business broker generates multiple offers at or above the asking price. Too many buyers chasing too few businesses creates this situation. The bottom line, it's easy to pay too much for a company when the buyer gets "buyer fever." 

You shouldn't be in the position where any hiccup can destroy cash reserves. Too many businesses are undercapitalized the way it is. If the seller is absolutely convinced the company has that bright a future, an earn-out (the buyer pays more as the business does better) is a great option. In fact, at a recent meeting of the Association for Corporate Growth (ACG), the panel on mergers and acquisitions stated that an earnout is almost universal these days for middle market deals.

The deal must work

When an owner asks what the price range of a business should be, I tell my clients to say that most buyers are looking for a return on investment of 20-35% which means they will pay 3-5 times profit (after reasonable owner compensation). Where the price falls within this range, or if it even makes it into this range, depends on the non-financial factors like the employees, management team, customer base, lease, etc.

There's a reason why the price of a small business needs to be in this range (and not at almost seven times which is what the person mentioned above was willing to accept). It has to do with the "hiccup" I mentioned. And every business experiences hiccups, especially after a transition.

Unless a buyer has so much money that is doesn't matter (and most don't), cash flow is important to them. A buyer paying seven times profit is skating on thin ice. The loss of a major customer, or even the delay of orders from a major customer, will hurt cash flow so much that it will take personal funds to make payments on the acquisition debt. 

The buyer who paid a fair price for the business will be affected but will have the necessary cushion. Buyers should be very careful about committing more that 50% of profits to debt service. The remainder must be there to cover taxes, working and growth capital, emergencies and to take advantage of opportunities that come up.

Don't Compare

You can't compare a small business and its selling price to the Price-Earnings ratio of a large public company. Don't listen to what your buddy said he sold his firm for. Never base the price on a multiple of revenues as it's the bottom line and only the bottom line that matters. And don't pay for potential that you will create.

The most loaded question someone can ask is "What multiple of profits should I pay?" Ask how are profits defined? If you add back depreciation to profits and the company anticipates high capital expenditures your cash flow will be tight as you purchase equipment. If the company recently invested in a lot of equipment and no capital expenditures are anticipated, there truly is "free" cash flow. And don't include owners salary in profits. It's a legitimate business expense. If the owner wasn't there, someone would have to be paid for the work he or she does.

A major consideration is all of the non-financial factors, so you don't blow yourself up post-deal. A recent valuation assignment featured a firm with a month-to-month lease, the high probability of having to move and the cost of the move, tenant improvements, new equipment and disruption was estimated to be about one year's profits. The result was a much lower estimate of value versus if they had a long-term lease.

In closing, many people think that now is a good time to buy a business. Just be careful that you or anyone you know doesn't get "buyer fever" and pay based on what the future may hold. At the ACG meeting I mentioned, the panel also agreed that (in middle market deals) projected earnings mean nothing these days (which is why earnouts are so popular).

© Copyright John Martinka 2003. All rights reserved.