What it’s Worth: SMB Purchase Price and Value

If you are like most business buyers, at one point or another you’ve struggled with how to determine an initial offer price for a business in the Letter of Intent (LOI).

In this issue I am going to show you one of the easiest ways to determine the fair value of a business so that you can negotiate favorable price and terms to close the deal.

Understanding how to determine a fair price and where the business draws it’s value will allow you to calculate a confident price on your initial offer.

So, how do you pay the right price and maximize your value?

Unfortunately... many buyers get caught up in their emotions, what they can afford, what the seller wants, what the broker thinks, or overall FOMO - losing sight of the real purpose of buying a business as an investment: to get great value through profits.

Here are some of the biggest reasons why buyers struggle to take action by submitting a strategic offer:

• Emotional Attachment: Buyers sometimes develop an emotional attachment to a business, leading them to make decisions based on feelings rather than rational analysis and financial data.
• Overemphasis on Seller’s Asking Price: Focusing too much on the seller’s asking price can distract buyers from conducting their own thorough analysis and negotiations to arrive at a fair valuation.
• Influence of Brokers and External Opinions: Brokers and other advisors may have their own interests, and relying too heavily on their opinions can skew a buyer's perception of the business's true value.
• Fear of Missing Out (FOMO): The pressure to close a deal quickly to avoid losing the opportunity can lead buyers to rush the valuation process and potentially overpay.

But don't worry, I'm here to help you navigate these challenges and ensure you pay the right price and maximize your value. In order to take those actionable steps, let’s take a moment to talk about price and value.

"Price is what you pay. Value is what you get.” - Warren Buffet

Asking Price vs. Offer Price vs. Value

The asking price is what the seller hopes to receive for their years of hard work. Their expectations, emotional attachments, and influence of external opinions can often inflate their interpretation of a fair price.

The offer price is what you, as a buyer, are willing to pay after conducting your initial analysis. A distinction should be made between the initial offer price and potential adjustments to the final offer price depending on addition of accounts receivable or working capital, or decreases in price due to significant findings in due diligence.

(There are times when a blind offer is reasonable, but there’s more potential for price adjustment and mismatched expectations in those cases.)

The true value of the business is determined through careful evaluation of its financial health, tangible assets, market position, and historical performance of past earnings.

Conversely, “blue sky" refers to the intangible value that exceeds the tangible assets and the established earnings potential of the business. It includes elements such as the business's reputation, brand strength, customer loyalty, and potential for future growth.

There are 3 practical steps to take in order to maximize your potential value when offering a fair price:

Step 1: Understanding SDE and Its Importance

SDE (Seller Discretionary Earnings) is a measure of the earnings of a business before taxes, interest, depreciation, amortization (known as EBITDA), and owner's compensation.

While SDE can be a contentious number - it is often a good representation of what the seller’s overall financial benefit of owning the business as it would pertain to a new owner. It is derived from EBITDA and includes additional “add-backs” such as owner’s salary, meals & entertainment, travel, and other “seller benefits”. It represents the total financial benefit that a full-time owner-operator would derive from the business.

There’s a delicate balance of calculating the right items, removing unqualified add-backs, or incorporating appropriate negative add-backs. Items such multiple owners’ salary, large “miscellaneous” items, or overpaid family members can be a point of contention.

Example: Let’s say you’re looking at a business with an SDE of $200,000. This number tells you the annual earnings you can expect before paying yourself and covering certain financial obligations.

Step 2: Researching Industry Multiple Valuation

Among the most popular valuation methods is industry multiple valuation. It stands out for its practical application and relative simplicity, using established financial metrics from comparable companies within the same industry to estimate a company's value.

In order to arrive at a price, simply multiply the calculated SDE by an industry appropriate number.

Example: If the average market multiple for businesses in the same industry is 2.5x, then the fair value of the business with a $200,000 SDE would be approximately $500,000 (200,000 x 2.5).

The industry multiple valuation reflects current industry conditions and investor sentiment. It provides a straightforward benchmark for comparing companies of similar size and operations, making it a widely favored method among analysts and investors.

Note: EBITDA multiples are often used in larger businesses with higher valuations often above the $10M.

Each industry will have a range of SDE or EBITDA multiples that comparable businesses have sold for. Sentiment on this range of values depends on many factors - but I’ll focus here on the buyer’s perspective.

Let’s assume for the moment that you’ve already filtered out any businesses that have “deal breaker” characteristics like highly fluctuating revenue and unresolved legal issues.

Low Multiples Business Characteristics

1. Business heavily reliant on the owner with no strong management team.
2. Little or no tangible assets included in the sale.
3. High customer concentration, where a few customers represent a large portion of revenue.
4. Revenue dependent on one-time sales or projects with no guaranteed future income or recurring revenue.
5. High regulatory risk or significant compliance costs.
6. High employee turnover or difficulties in hiring and retaining talent.
7. Weak customer relationships or poor customer service reputation.
8. Outdated technology and resistance to adopting new advancements.
9. Expiring lease, unfavorable lease terms, or a landlord who does not maintain the facility adequately.
10. Revenues that are highly dependent on certain seasons, leading to cash flow issues during off-peak periods.

High Multiples Business Characteristics

1. Strong, experienced management team in place.
2. Diverse customer base with no significant customer concentration risk.
3. High percentage of recurring revenue from long-term contracts or subscription services.
4. Strong market position with significant competitive advantages.
5. Clear opportunities for growth and expansion in the market.
6. Strong brand recognition and positive reputation in the market.
7. High operational efficiency with optimized processes and cost controls.
8. Stable regulatory environment with low risk of adverse changes.
9. Low employee turnover and a skilled, stable workforce.
10. Strong, long-term customer relationships and high customer satisfaction.
11. Advanced technological infrastructure and adoption of industry innovations.
12. Clean legal history with no significant ongoing or potential lawsuits.
13. Business model that is easily scalable without significant additional investment.

Step 3: Trusting the Process & Adjusting

Lets make sure you don’t have FOMO, leave emotions at the door to offer a good price (use some negotiation tactics), work with the broker to help bridge the gap between seller’s expectations or inflated price assessments, and submit an offer that will secure the deal and begin diligence.

If you’ve followed the previous steps you have a confident and accurate assessment of SDE, you’ve spent time researching market multiples for this industry, and compared to the target business characteristics to determine a fair price if the business has been represented accurately.

Adjustments to the multiple valuation can be made for for many reasons:

• These include unexplained increases in revenue or profits near or after the decision to sell
• a general manager or operator unwilling to stay with the business after sale
• poorly maintained equipment
• loss or expiration of major contracts before the close of sale
• a landlord unwilling to renew the lease with favorable terms
• stock that is out-of-date or unsellable, requiring write-offs and loss of potential revenue
• The seller stops operating the business in a normal and profitable way once under contract, causing irreparable damage to the company and brand prior to closing

Don’t let negative findings make you emotional - know when to adjust the price and when to simply walk away from a deal that can’t be saved.

After all, paying the RIGHT price sets the foundation for a profitable future.

It’s easy to get caught up in trying to “make a deal work” when the numbers don’t align and the risk has gone past your threshold thereby decreasing the overall value - Stick to the process.

Bonus: Other Notable Value Calculations

Discounted Cash Flow (DCF): Projects future cash flows and discounts them to present value based on interest rates and business risk.

Best used in valuations with high-growth potential, predictable cash flows, and a long-term investment view.

Capitalized Earnings Method: Uses the net operating income and divides it by a capitalization rate to estimate value.

Best used in valuations with stable earnings, mature businesses, and simpler calculations.

Assets Approach: Computes the fair market value by adjusting the company’s assets and liabilities, including intangible and off-balance-sheet items.

Best used in valuations with asset-intensive businesses, underperforming businesses, liquidation scenarios.

Real Estate Valuations: Always use market comps and cap rates to evaluate its value separately from the business itself, then combine both valuations for a total price.

Market comps for commercial real estate involve comparing recent sales of similar properties to determine value, while cap rates measure the rate of return on a property based on its net operating income relative to its current market value.

In Conclusion

If you're determined to buy a business but struggle with determining its value, focus on these three priorities:

1. Master the SDE multiples valuation to understand earnings.
2. Recognize the characteristics that influence high or low multiples.
3. Trust the process and adjust your offer based on thorough research and findings.

When you concentrate on these priorities, you'll increase your chances of making a profitable investment. Avoid emotional hang-ups, be able to articulate the true value, and get ready to negotiate for the right price.

Take action today and stay focused. Follow these steps diligently, and you'll be well on your way to making informed, profitable business purchases.

If you want more help with evaluating business valuations, consider booking a call with me. Get a comprehensive business valuation consultation tailored to your needs.

Book a call now and let's secure your profitable future together. Book a Call Now

To your lasting success,

Sage Price

Please note: The information provided in this newsletter is for informational purposes only and does not constitute financial advice.