When it comes time to sell your business, there are only three potential scenarios for agreeing on a final price:
- The buyer is better informed than the seller and buys the company cheaply
- The seller is better informed than the buyer and is able to extract a juicy premium above the true market value
- Both sides are equally matched and a fair price for both parties is negotiated
In my experience, it’s usually one of the first two scenarios that play out and seldom is the third one achieved. If a small business is being acquired by a large company then it’s almost a given that the seller will be out-negotiated. Unlike large corporations that can afford to buy the best advice from investment bankers and specialist law firms, many small business transactions are handled directly by the principles, who in some cases may be aided by an accountant or a lawyer that isn’t experienced in acquisitions.
It’s just not the same thing.
Experienced advisors and negotiators have information on recent transactions and deal terms beyond the blurb that might be printed in a local newspaper. After years of negotiating sales, they know the hidden risks, unrecognized opportunities and the “devil in the details” that gives them the advantage. Small-business owners need to be prepared and go into a price negotiation with as much information and understanding of how the process works as possible. One area that requires special attention is the methodology that buyers use to price your company.
The Multiples Method
This is a simple industry standard for determining what the rough price of a company should be, based on its sales or earnings. If you research acquisitions within a given industry you will see a pattern between the sales price and revenues or earnings. It’s best to use recent transactions to develop a multiple, as these tend to shift over time. The most common multiples are revenue multiples and normalized earnings before interest and taxes (EBIT). Normalized earnings are adjusted for non-recurring events, like costs associated with the disposition of a long-term asset or restructuring charges.
New York University’s famous finance professor Aswath Damodaran maintains a database of recent acquisitions and multiples by industry, which you can review for free. Keep in mind that for private company transactions, the multiples may be lower given the greater risk associated with owning a smaller company.
Discounted Cash Flow Method
This is the most traditional (and intensive) method, which anyone who studies business in college must learn. This method requires the development of a financial model that projects the free cash flow that your company can expect to generate from now until forever. This projected cash flow is then adjusted to take into account certain factors including the cost of capital, the time value of money and the riskiness of the project to arrive at the net present value of the company.
This isn’t a traditional acquisition method but it is becoming quite common these days, especially as large technology companies seek out talented engineers and executives. Innovative startups tend to attract talented individuals. Large companies know this and they also know that wooing these executives to work for them isn’t easy, particularly if they enjoy what they are doing and have an equity stake in the startup. For companies like Google and Facebook the preferred method of acquiring this talent is to simply acquire the startup.
Don’t Limit Yourself to One Methodology
As a seller, you should develop a price metric that includes the estimated value of your company using all of the methodologies described above. This will give you a good idea of the range of values that your company may have in the hands of the buyer. It can also provide insight into which method the buyer may be using, which in turn can help you determine what he or she really wants: your customers, your assets, intellectual property or maybe you.
Have you gone through a sales process? Did you develop a methodology for estimating your price?
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