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How Much Should You Pay for a Business?

08/02/2010


Purchasing a business is a big decision that requires a large investment of your time and money. There are many factors to consider when deciding whether or not to acquire a new business; perhaps one of the most critical factors being the price you pay for the business.

How do you determine a fair purchase price for a business?

The ultimate goal is to pay a price that will result in a reasonable return on your investment in the business. Four variables need to be taken into consideration when determining an appropriate price:

1. Cash Flow
Cash is king when evaluating a business. The profitability of the business and its ability to generate cash flow is one of the most important factors when assessing the value of the business. A major part of the analysis is focused on normalizing the accounting profitability, so that the key indicators of performance for the business and their potential for growth can be measured.

2. Business Risks
An assessment of the risk of a business affects the price you may be willing to pay as you would apply a lower multiple to the cash flows discussed previously. The higher the level of risk, the lower multiple of cash flows and consequently, the lower the price.

The risks associated with a purchase may include the following:

  • No long-term contracts in place
  • The vendor has customer relationships that may not remain with a new owner
  • Poor accounting or information systems
  • Conducting inadequate due diligence
  • Pending lawsuits
  • Increased competition

3. Value of Assets
The value of the tangible assets such as land, building, property and equipment included in the transaction also affects the level of risk. In general, the higher the value of tangible assets included in the transaction relative to goodwill, the lower the risk. It is important to obtain a listing from the vendor of the assets and liabilities they will include in the transaction. If necessary, hire a professional appraiser to determine the value of those assets if they make up a significant portion of the purchase price.

4. Market Sentiment
The market sentiment (such as the activity & price movement of securities, national & world events, etc.) should also factor into the price you are willing to pay for a business. In 2009, due to concerns about a downturn in the global economy, there was increased difficulty in obtaining financing to acquire a business and consequently, fewer purchasers. With fewer buyers in the marketplace, prices of businesses in general have dropped from their peak.

What if you pay too much for a business?

There can be several implications if more is paid for a business than it is worth. Pitfalls in each transaction are unique and the seriousness depends on how large the overpayment is and how the business performs after the purchase. Ultimately, if the business only performs marginally, the owners will have to make significant operational changes in an effort to run more efficiently. If this doesn’t help the owners achieve critical economic goals, then appropriate steps need to be taken to close the business.

Ultimately the amount paid for a business has a major impact on its health and profitability. One of the most important steps you can take when you consider purchasing a new enterprise is to determine a value for the business that makes sense.

For more information please contact Chris Perret, CBV, AACI.