Pricing a Business to Sell: Part 2
Last week in Pricing a Business to Sell: Part 1, I wrote about some of the issues a professional business broker – or business owner – should consider when establishing the price of a business; at least if you’re pricing a business to sell. Unfortunately, some brokers act like real estate agents – they just ask the seller what he wants and list the business at that price. (Come to think of it, the business owners that list their business with realtors are not, by default, listing or pricing their business “to sell”.)
But most professional business brokers will employ several commonly-used methods to establish a Broker’s Opinion of Value or a Most Probable Selling Price for the business they are asked to value and hope to list. Such methods include multiples of revenue, multiples of discretionary earnings, historical sales of similar businesses, etc. This is known as the Direct Market Data Method (DMDM).
This approach is perfectly adequate, especially for Main Street businesses and even for businesses in the lower Middle Market; businesses with revenue of up to about $2 million or so. But for larger businesses, another key method of establishing value is doing a return on investment (ROI) analysis. Many professional business brokers that focus on businesses with revenue north of $5 million use this tool and they enjoy three significant benefits by doing so.
- First, it provides strong and substantial evidence supporting their conclusion. This is important from the standpoint of establishing a valuation at which the business will have the best chance of selling, possibly eliminating months of wasted time trying to sell something that, if more thoroughly analyzed, would be shown to be over-priced.
- Second, it is almost impossible for any potential buyer to argue with the conclusions in the broker’s Offering Memorandum – the ultimate selling tool.
- Third, it confers enormous credibility on the broker. The seller is unlikely to have even considered approaching the valuation from this standpoint.
This is an issue we go over in our course, The Basic “How-To” of Becoming a Business Broker and it is important that any broker that works or intends to work in the Middle Market have a grasp of this concept. It is another tool that will make your job easier.
Our course, The Basic “How-To” of Becoming a Business Broker”, teaches how to become a professional business broker.
Become a Professional Business Broker…
Buying a business, especially one in the Middle Market, should be considered an investment opportunity for a buyer. Otherwise, the buyer is simply buying a job. When you invest in something – when you “buy” an investment – you want a return on that investment.
This is basically an extension of several of my earlier posts about how a business must provide The Three Essentials. If it doesn’t, the best that can be said is that the seller is selling a job.
Identify the Cash Return
The last of The Three Essentials is that the buyer – the new owner – must realize a return on his investment. That return must be in addition to the salary he or she pays him- or herself. The owner’s pay is in exchange for the owner’s time running the company. This means that, once the discretionary earnings are established, what the owner is paid to run the company – or, more accurately, what the owner would have to pay a manager hired to run the company – must be deducted from the discretionary earnings. The result is the buyer’s ROI expressed as cash.
Some people use a very simple – but not nearly accurate enough – way to calculate a return on investment. They start with the buyer’s cash investment, apply a certain interest rate to it and calculate it out over the anticipated holding period. As an example, if the buyer buys a business for $3 million and puts $750,000 (25%) of his own cash into the deal, we could look at current interest rates that that money would earn in the market and apply that interest rate over the holding period as if the buyer was making a loan.
In this example, if the buyer could borrow at 6%, one might think that a slight premium – say 2% – would be appropriate and apply an interest rate of 8% to the buyer’s invested capital. The math would look like this:
- Cash Invested: $750,000
- Interest Rate: 8%
- Annual return: $60,000
Using this simple but inadequate method suggests that the annual ROI is 8%. But buying a business is far riskier than lending money at a couple of points above what a conventional lender would want. This approach does not consider risk. And risk raises the required rate of return or ROI.
The Quick Analysis
Calculating the ROI can be done by using a simple formula: ROI=(Discretionary Earnings – Manager’s Salary)/Price where Manager’s Salary is what the owner pays himself or, more accurately, what he would have to pay a manager to run the business. But this is useful only in hindsight. The formula assumes that we know the price.
But if we’re trying to establish the price – as in a valuation – we need to know what kind of ROI the market (buyers) is likely to require. The formula then becomes Price=(Discretionary Earnings – Manager’s Salary)/ROI. The difficulty is trying to establish an appropriate ROI.
One way to approach this is to use the “capitalization rate” method that is common in commercial real estate. Using this method, we “capitalize” the adjusted discretionary earnings – that is, discretionary earnings minus a manager’s salary – of the business by a rate that represents the risk of the investment. More specifically, the capitalization rate for a particular flow of income is a function of the rate of interest on Treasury bills (the risk-free rate) and the risk associated with the flow of that income. A riskier investment has a higher capitalization rate (ROI) and a higher cap rate means a lower value.
A cap rate is what an investor will demand as a return on an investment – expressed as a percentage – to make that investment. If there is little risk, the investor will require a lower percentage return. Once a business’ discretionary earnings are determined, that is the cash return. The percentage – or rate of return – that cash represents is determined by the price paid for the investment. A lower return (ROI) means a higher price.
For example, if a business has discretionary earnings (DE) of $500,000 and hiring a manager would cost $100,000, the adjusted DE is $400,000. If the ROI required by the buyer is 25%, the price he is willing to pay is $1.6 million because $400,000 represents 25% of that figure. But if the buyer believes that the business has significant risk and requires at higher ROI – say, 35% – to compensate for that risk, the price he would be willing to pay would be only $1.143 million (approximately). Conversely, if the buyer believes there is little risk to the business’ cash flow, the ROI required by a buyer may be only 15% (an extreme example) which suggests that the price he would be willing to pay would be $2.667 million. Price=(DE-Manager’s Salary)/ROI.
The Bottom Line
Determining the ROI that should be applied to a business when trying to arrive at a value is more art than science. Assessing risk is a subjective exercise and accuracy – never assured to begin with – improves over time.
In the past, we’ve used the “ROI=(Discretionary Earnings – Manager’s Salary)/Price” after establishing value using the Direct Market Data Method (DMDM) to see what the ROI would be at the price suggested by the DMDM as one way to determine if we want to take the engagement. As a rule, if the ROI falls somewhere in the area of 25% or north, we feel reasonably comfortable with our numbers and that we can sell the business. On the other hand, if the ROI is south of 25%, we take another look at everything – particularly risk – to see of we made any errors. And to see if we even want to take the assignment.
Next week, I’ll tackle the elusive aspect of pricing a business to sell – risk.
If you have any questions, comments or feedback on this topic – or any topic related to business – I want to hear from you. Put them in the Comments box below. Start the conversation and I’ll get back to you with answers or my own comments. If I get enough on one topic, I’ll address them in a future post or podcast.
I’ll be back with you again next Monday. In the meantime, I hope you have a profitable week!
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