As a small business owner moves towards retirement, or they find that their company is “stuck” at a certain size, an owner may choose to sell their firm. Most entrepreneurs will only own one, possibly two businesses over the course of their life. When sales are decades apart, it’s difficult to know if the rules from the last sale will apply to the next one. It is especially difficult to know if the rules for determining the sale price still apply. If you have never sold a business, arriving at a sales price can be a mysterious and difficult process. Today, we will demystify the process, and give practical tips on how to know the selling price of your business.
It is difficult to say exactly what any specific business is worth at any given time. The same business will have a different value at different points in time, even when the revenues are unchanged. A business that could sell for a million dollars today, might be worth fall less tomorrow if: the economy takes a downturn, the stock market crashes, the rate of interest rises, your biggest customer declares bankruptcy, or some global issues occurs. Even when your revenue is not directly impacted.
Big businesses, which are often publicly traded and have their financial data reported on the news or in businesses publications. Small businesses rarely make their financial data known, including the price their firms are sold for. The Small Business Administration (SBA), is the main Federal agency with jurisdiction over small businesses. However, the SBA doesn’t even have a specific count of the number of small businesses in America. The best data the SBA has is that there are between 23 and 25 million small businesses in operation in the US. Beyond that, information gets pretty spotty.
The best source of information for a quick idea of what your business is worth, and to find out if the market is going up or down is a private service called, BizBuySell.com. Their quarterly report provides financial information for businesses sold on their site. BizBuySell is probably the biggest and best run site for the sale of small businesses. While the numbers on BizBuySell appear similar to deals that I have seen, their numbers may not be completely the same as deals consummated elsewhere.
For example, almost all of the postings on BisBuySell are placed by business brokers rather than by the business owners. BizBuySell is a digital marketplace, and that might mean that when small business owners do choose this site, they are younger entrepreneurs that are more comfortable with technology. Even so, the quarterly reports by BisBuySell are as good or better than any other data source for small business sales by geography and by industry. Your local chamber of commerce may be able to provide you with additional information on the value of your business and market trends.
If you look at this type of data, you will see that there are some general rules, or at least guidelines about the value of a business. In order to arrive at a reasonable asking price, you need to understand Revenue and EBITDA (or cashflow, or profit). Revenue is the easiest to understand. How much money did your firm make? For most industries, this number is the total amount of money that goes through your firm. For others, it is only the fees that you charge, and not the entire pass-through amount. For example, a payroll company may issue checks for $100 million, but it is not a $100 million company. Instead, the revenues might be just $2 million, based on a 1%-2% processing charge.
In general, most small businesses have a cash flow (or EBITDA or profit) of 5%-25% of their revenue. Of course, there are huge differences in cash flow, but most companies fall somewhere in this range. Asking price, the price that the seller wants for their business, is usually between 2.5 and 3.5 times cash flow. Here too there are businesses that command far more (or far less) than this multiple, but this is how most of the small businesses in will be priced.
Is that it? Do these few numbers sum up the value of years of work and dedication? No, not quite. Many factors increase or decrease the price for your business. Some factors are industry specific, but quite a few operate across all or most businesses. If you speak with your trade association or industry group, they may be able to provide you with nuances on these factors, but these are the details you should keep in mind:
Industry: Looking at BizBuySell’s data by industry, you can see that most asking prices fall between 2.5 to 3.5 times cash flow, but some go as high as 6.3 (warehousing) or as low as 1.2 (internet domain services). If you order these industries by cash flow ratio, highest to lowest, you will see a pattern. Businesses with the highest cash flow ratios have tangible assets. Property, truck and car fleets, equipment, intellectual property (patents, etc.), inventory, etc. Consider a tiny antique or jewelry store. The value of the store comes down to the list of customers and the inventory… which could be worth millions of dollars. Once you remove physical assets, the ratio moves a lot clos
er to the average. In the early 20th Century, most businesses were asset based. Farms had land, a general store had the assets of the store and possible the property the store was located on, and factories had machinery and/or property. In the 21st Century, a small business is likely to be a service with little or no physical assets (a consulting company, pool cleaning service, a beauty salon). On BizBuySell, 38% of the businesses sold are service firms.
Size: Usually, a larger business is valued higher relative to gross revenues, because a larger business should benefit from the economies of scale. That should yield greater profitability, and a higher cash flow. Being big and profitable should also make you attractive to more buyers. Especially if you are showing an upwards trend in revenue. What I mean by that is that a firm that made $1 million in 2012, $2 million in 2013 and $3 million in 2014 is likely to be valued more highly than a firm that had higher revenues and “fell” to $3 million, or where revenues are unchanged after several years. Ongoing improvement total revenue, number of accounts, number of employees, products sold, etc. all show a positive trend that usually leads to a higher valuation.
Location: If we return to BizBuySell‘s market report, we see cash flow ratios varying based on geography. New Orleans ratio is 4.08, while in Bridgeport Connecticut it is just 2.40. Are businesses worth more in New Orleans? Possibly, but it could easily be due to other factors, such as New Orleans having larger than average businesses, or the Big Easy might have more profitable businesses. While location, location, location is the mantra of real estate, and retail businesses, the same is not true for business to business services. Some towns grew into big cities because of one firm, and other similar businesses followed. Microsoft and Redmond is a good example. Or Silicon Valley in California, where many big technology firms grew and others moved in. There was a time when having a Silicon Valley address added considerably to your value. In more ordinary examples, restaurants, hotels, and other retail businesses set the price of their services based on their neighborhoods.
Customers: If you have a business to business… business, then the number of customers you have will change the value of your firm. It may not matter if you have ten customers or one hundred, but it probably will matter if you only have one customer. One customer is a big risk! Your contact at that one customer could go away, or your customer could go out of business. Without several customers to benchmark the value of your products and services, your profits may not be scalable. Better than average profitability may be due to just one overly generous contract. Maybe that contact manager is your brother-in-law. Whatever the case, financial data based on just one customer doesn’t reveal a lot about the potential of your business, and that will be reflected in the buyer’s offer.
Interest Rate: There are many reasons for an acquisition. Some buyers base their offer on the cost to add the equivalent amount of new business. Part of that equation is the cost of money. If I use a million dollars to buy a company, that is a million dollars that I cannot use for other improvements to the business. Than money has a financial cost, but when interest rates are low that cost is low. The rate of interest has been extraordinarily low for years, which reduces the cost of buying a business. With interest rates at historical lows, this buying new business remains a particularly favorable way of growing a business.
Payment Agreement: One last thing to consider. Except for the smallest of small businesses, very few sales are single payment and all in cash. It is much more common that your deal will involve 2 or 3 payments, over a year or more. In part, this is to ensure the seller ia active in transitioning the business to the buyer, and is as active as possible in ensuring the success of the transaction. Some deals will include bonuses if the acquired firm exceeds financial goals and penalties if it fall below minimum revenues. When the seller management stays with the firm, and there is a big difference between the seller’s and buyer’s financial projections, bonuses and penalties may be the way to go. In order to bridge the gap in expectations, you can agree on a middle value, and agree to adjust the payment (up or down) through the subsequent payments.
Every deal is different, and there is no formula that will get you to the exact number for your business. Still, there are some rules… like those we discussed today… that will get you to a basic understanding of the price of a small business. Beyond the general numbers, there are individual issues about how the acquisition (and the staff) will fit into the new company, and questions about how well individuals will work together. There are many reasons to buy and sell and small business, and many ways to consummate the deal. How do you make the deal work? You start by talking to some buyers! Yes, it’s pretty simple but that’s my Niccolls worth for today, and I’m sticking with it!