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Buying a Business: Vital Factors in Pricing
Profitability is a crucial element of looking at whether to purchase a business. But the Profit that the Seller says he/she is reporting on his/her tax forms is unquestionably not the entire picture. There are any number of adjustments that can and should legitimately be made in most businesses, that add to the bottom line from the Buyer’s perspective. These are things that we need to examine, prior to rendering any kind of a decision on estimating the Price.
Every Buyer seems to want a “quick and dirty” pricing estimate. Frequently, even some of the more amateurish Brokers will lean on multiples of Profit or Cash Flow. (That is to say, multiplying a rather arbitrary number by the stated Profit, in order to determine the Sale Price.) This might be fine for casual discussion, but it is an approach that quickly and frequently breaks down, providing misleading results for many, many businesses. One of the big problems is that the multiples change from industry to industry. Another is the nature of the relationship that the business has with its clientele, which can increase or decrease the multiples utilized, even within a given industry.
Moreover, even if one insists on solely utilizing some sort of multiple, there are a huge number of additional, less tangible factors that come into play. The following is a list of only some, emphasize S-O-M-E of these intangibles:
- The number of years that the business has been open is a mammoth consideration. The SBA will frequently not even entertain thoughts of financing an acquisition unless there are three (3) years of tax returns filed on behalf of the business. The reason for this is that many businesses go through a “honeymoon” phase, where the operation can be doing extremely well for the first 18 months, and then sales fall appreciably, thereafter. With less than three years of experience, the Price can frequently be lower, compared to other businesses of similar size, but with greater maturity. And in some industries, the longer the business has been operational and Profitable, the higher the Price expectation may be, even past the three-year threshold. E-commerce is an example of one such type of business.
- Consistent performance and growth is a huge factor. When a business goes down even marginally, we will often hear the Sellers say that it was a “blip”, or temporary decline that will be quickly overcome. Frankly, the Buyer and the bank do not want to hear that – nor should they! They want to see proof. That “blip” may be just what the Seller says it is. But the Buyer and bank take the perspective that for all they know, that “blip” may be just the start of a long-term erosion in Revenue and Profit, which could well bury the business. Wise Buyers want to buy a consistent, if not growing business entity. They certainly do not want to buy a company that is in its death throes, or at least struggling. And if they do – such as those people looking for a “turnaround” opportunity – they are absolutely not paying top dollar for such an acquisition. More typically, Buyers should want to know that they are purchasing a company that is not only growing by itself, but is part of an overall industry that is expanding and growing. This is part of what the smart Buyer will examine, in developing a complete Business Plan. (See our other posts, on this subject.)
- Customer loyalty is something that Buyers could or should be looking for. This is often evidenced by repeat purchases or customer referrals. The more professional Sellers keep a tracking mechanism of some sort, any Buyer should ask about this.
- There is no such thing as a “recession proof” business. But Buyers will want to see proof that the business has few, negative influences caused by outside factors. As an example, an e-commerce business needs to demonstrate that it did not suffer broadly if and when Google updates occurred.
- One of the most critical issues to any Buyer or lender is the involvement of the current Owner, and the confidence that the business can continue to operate once that Owner has departed. Businesses where the Owner makes all the decisions and is “the face of the business”, carry a tremendous amount of liability with them, and their pricing suffers as a result.
- The Seller should be able to demonstrate what, if any growth opportunities lie ahead and briefly, how they might be captured. Frequently, the intelligent Buyer wants to make sure that he/she is buying a long-term investment, rather than just a job.
- Excellent relationships with suppliers can be important. Written contracts with such suppliers are also preferred.
- Depending upon the business, written contracts with customers, maintenance agreements and similar instruments that can work toward guaranteeing a certain amount of income will absolutely increase the Price.
- Profit margins, compared to the industry standard or other competitors can and should be examined. We are dealing with one business right now that, for the purpose of generating market share, has a 20% lower Profit margin than the industry, as a whole. Anyone that is studying the business sector as part of the due diligence process understands this, and has consistently stayed away from making offers at the level the Owner has arbitrarily set as a threshold.
As a Business Buyer, these of some of the things to which you need to be extremely sensitive. These are the kinds of things that will add to or detract from the kind of offer you will ultimately make.
(Receive in-depth, personal consulting online, with The BAF Group’s principal at https://clarity.fm/donaldbarrick .
The BAF Group LLC is a full service Business Brokerage, with a history of more than a decade of service. Its Principal Broker possesses 25+ years of Business Sales and Divestiture. Although most of our work is involved in the Mid-Atlantic States, we have represented Sellers and Buyers throughout the Continental USA, and a number of overseas Buyers, as well. Some of our listings and additional information about us can be viewed at www.bafgroup.com. Thank you for your interest.)