How to agree to a business sale price

You’ve finally found a business that you want to buy. Now it’s time to agree on a purchase price. Here’s how to calculate a company valuation so you can negotiate with confidence.

Determining a company’s valuation and agreeing on a sale price can sometimes be more art than science. There are many factors that can determine the answer, and at least some of them are difficult to quantify. For example, what will the future hold? Will future business performance be consistent with the past? Will it be made more difficult by emerging challenges? Or will it be accelerated by new trends?

As someone who wants to buy a business, your job is to conduct a valuation that you feel comfortable with, and engage in a dialogue with the seller. The seller may have already indicated their asking price, and you might have already given them a Letter of Intent to start the negotiation with an offer price. Ideally, you can each present your quantitative and qualitative assessments of the business and continue the dialogue until you reach an agreement. 

Conduct a business valuation

If you have indicated to a seller that you are interested in buying their business, what typically follows is a due diligence period. During this period, you should be granted access to the inner workings of the business, from tallying up its inventory and reviewing its payroll, to analyzing its finances and reviewing its customer lists. The purpose of this process is for you to make sure that you know exactly what you’re buying. It’s also your chance to conduct a business valuation and decide what you think the business is worth.

There are a few different methods that you might use to conduct a business valuation. In the end, you might use more than one approach plus a dose of your own gut instinct, coupled with your vision of how you would transform the business as its new owner. Keep in mind, a buying a business can be a like buying a “fixer-upper” house. Perhaps it will surge in value once you take over, but it’s probably going to need an injection of time, money, and capital. You should take that into account when you develop your valuation.

Income-based approach

One way to value a business is to look at its income. There are two main numbers to consider in this instance, and it’s extremely important not to confuse them.

The first number is revenue. This is the amount of money that rings the cash register or comes in from billing clients. In many industries, there is a rule of thumb for how to value a business based on revenue. For example, you might find that coffee shops in your area tend to sell for two times their annual revenue. The problem with this calculation is it does not tell you if the business is profitable. What if the coffee shop is paying all of its revenue in rent, wages, and supplies?

In many cases, a better income number to look at is earnings. This is often expressed as earnings before interest, taxes, depreciation, and amortization (EBITDA). This gives you a much clearer picture of whether the business is making money or not. You might find that coffee shops in your area usually sell for 10 times EBITDA. At that multiple, the selling price would be the equivalent to 10 years of the business’s current earnings.

Assets-based approach

The assets that a business owns are often at the foundation of what the business is worth. Essentially, you add up the value of everything the business owns, including all equipment and inventory, then subtract any debts or liabilities. Assets are typically significant for businesses that rely on tangible property (like trucking companies and factories) and minimal for those that deliver services (like chiropractors and advertising agencies). Although non-tangible property, like patents, can also be treated like assets.

If a business does not have any earnings, you might base its entire valuation on its assets. If it does have earnings, the value of those earnings times an appropriate multiple, may be added to the value of the assets to determine the overall business valuation.

Market-based approach

Sometimes it is difficult to capture the fair market value of a business just by studying its earnings and assets. For example, let’s say there is a trendy fitness boutique for sale in a quickly gentrifying part of town. The assets of the business include a modest amount of fitness equipment, and the earnings of the business are not terribly significant, but growing rapidly.

The seller, in this case, might not agree to a price based on the assets and earnings as they stand today. They might point to comparable sales of other trendy fitness boutiques to demonstrate that they deserve a higher valuation given the positive trends surrounding their business.

As a buyer, it makes sense to pay attention to market-based realities, but it is also wise to recognize the risks involved. When you are paying real money for something other than proven assets or earnings, there is always the possibility that market sentiment will change or trends will prove unsustainable. So buyer beware.

How to negotiate the sale price

The due diligence process is your opportunity to research the revenue, earnings, assets, and liabilities of the business for sale. It is also a good time to gather information about any recent sales of similar businesses. Armed with all of this information, you can arrive at the negotiation with a sound point of view on what the business is worth.

If your business valuation does not match the seller’s valuation, do not panic. This is a common situation. Many sellers are proud of their businesses and lean towards higher valuations initially. But if you are able to maintain a patient and respectful dialogue, backed by careful valuation research of your own, you should be able to shake hands on a price eventually. Good luck!

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