In Part 2 of our Purchasing a Business Blog, we will deal with:
1. Determining the value of a business
2. Conducting negotiations
1. Determining the value of a business
One of the most difficult and often subjective parts of purchasing a business is determining a value for the business. There can be some wildly different views on what a business is worth. Frequently, what the vendor believes their business is worth can vary markedly to the value that a potential purchaser or their representatives place on the business. And it’s no surprise that many business sale negotiations break-down due to the parties not being able to reach an agreement on the value of the business and the subsequent price to be paid. However, over the last two decades there has been a robust body of work completed around the valuation of small to medium businesses which assists greatly in removing “the guess work” and “hunches” from valuing a business. To assist in determining the value, we’ll briefly discuss 3 common methods being used for valuing a business.
Capitalisation of Future Maintainable Earnings
The Capitalisation of Future Maintainable Earnings Method is a reliable method to employ for small to medium businesses that have a degree of continuity and maturity. This method calculates the future maintainable earnings of the business, applies a capitalisation rate (a multiplier) to those earnings and values any assets surplus to the core business. This method is commonly used in the valuation of small to medium enterprises and is appropriate where it is reasonable to expect that the value of the business is likely to exceed the underlying value of the net assets.
Industry Market Method
The Industry Market Method may be used in industry sectors where there are a relatively large number of participants, sale of these businesses occur on a frequent basis and where the determination of the sale price is known to the broader public. In these sectors current market prices can be established for similar businesses. By way of example, it is quite common for small to medium sized real estate businesses to be valued using the Industry Market method.
Net Tangible Asset Method
The Net Tangible Assets Method is an appropriate method to use where a business is asset heavy and where goodwill is not a major component of the underlying value of the business. This method assumes that the value of the business rests in its underlying assets which are often independently valued by expert valuers to determine a value.
Of course, when trying to determine a value of a business, it’s always a good idea to ask your professional advisers for assistance.
2. Conducting Negotiations
Now that you’re ready to begin negotiations over purchasing the business, there are a few tips that may help you during the process.
- Decide on the maximum price you are prepared to pay and stick with it.
- If you do not feel comfortable negotiating, then ask a professional adviser to conduct negotiations on your behalf.
- Never agree to the first price the vendor offers.
- Aside from price, other critical matters will need to be discussed. Ensure you have developed a full list of “must have” items that you will need the vendor to agree to.
- Always begin negotiations at the lowest point reasonably possible and be prepared to work your way up from there.
- Aim to keep negotiations professional, courteous and focussed on the business that is being purchased.
- Don’t allow yourself to be rushed during negotiations. Purchasing a business is a life changing decision, so slow down and take your time.
- Don’t discuss the reasons you are interested in purchasing the business. It may provide the vendor with valuable information that could increase the price the vendor demands
- If you are not comfortable with how the negotiations are progressing, be prepared to walk away.
Following the basic steps outlined in our Blog will hopefully assist you in purchasing a viable business. In one of our future business Blogs, we’ll aim to discuss some of the most common business structures. As always, if you require further information or advice, please call or email your regular DRB Group contact.
References: The Valuation of Businesses, Shares and other Equity, Wayne Lonergan, Allen and Unwin, 4th edition, 2003.
A Practical Guide to Business Valuations for SMEs, Greg Hayes, CCH, 2009