We get it...buyers have gotten used to seeing businesses for sale that are wildly overpriced. It’s a real problem in our industry. Admittedly, many businesses on the market today are not priced correctly. It’s probably the main reason why only 25% of businesses listed for sale will actually sell. It’s a combination of some business brokers not knowing how to accurately price businesses for sale, and sellers having an unrealistic valuation of their business’s worth. At Green & Co. we pride ourselves on working hard to price businesses accurately, and that’s one of the reasons that we sell 82% of the businesses we list.
We put a business on the market recently, and it’s a fantastic business, priced very fairly at market value. The feedback we keep getting from potential buyers is that it’s “overpriced.” When we ask them WHY they think the business is “overpriced,” they can’t really give us an answer, and that’s probably because the average buyer doesn’t understand how businesses are valued and priced for sale. They are most likely just assuming, based on what they’ve seen on the market, that all businesses are overpriced.
Furthermore, we’ve found that most potential buyers don’t know how to evaluate whether the asking price is a good return on their investment. Inspired by these buyers, we felt compelled to explain how it all works, so that our buyers can shop for businesses confidently knowing what they are looking at.
How Businesses Are Valued
In the small business sales marketplace, businesses should be valued based on the past 3 years of their owner benefit multiplied by the industry multiple, which is based on actual comparable sales. There are many different ways to value a business or company, and the way that it’s done for small businesses sales is different than the way it’s done for multi-million-dollar companies. The way businesses are valued for tax purposes or mergers is different than the way they are valued for re-sale on the open market. So, it’s no surprise that there is confusion when it comes to pricing businesses for sale. Many business brokers, CPAs, and sellers don’t understand how to properly price a business for sale in our marketplace, and that’s why it’s so important that business buyers and sellers work with professional, experienced, and knowledgeable business brokers.
We've seen many business brokers and sellers just list businesses for sale at a price that seems to have no relation to their owner benefit or the industry multiple. Those are the listings that are obviously overpriced and will have a very difficult time selling. A good business broker who has done a thorough valuation should be able to demonstrate exactly how they came to that specific asking price. The owner benefit for the past three years should be obviously displayed in the Confidential Business Review and when requested, they should be able to show comparable sales that clearly indicate the industry multiple. The owner benefit times the industry multiple brings us to the market value of the business, and the asking price of the business should be in the same range as that market value.
Looking at Return on Investment (ROI)
Another way to determine if a business listing is overpriced is to look at the buyer’s return on investment or ROI. When we perform a business valuation at Green & Co. we have a worksheet called, “Buyer Investment Analysis” which lets us know at a certain purchase price, what the return on investment is. It takes into account whether the buyer is paying in cash or using a loan, and it calculates ROI, taking out expenses and the owner’s salary as well. It tells us, at that particular purchase price, how many years it will take for the buyer to be repaid for their initial investment.
The target, which would be an average return on investment is 3-4 years. In 3-4 years, the buyer should expect to get their initial investment back. This is after paying business expenses, paying themselves a salary, because that’s essential for the buyer to live, and debt coverage (if applicable). If the ROI is less than 3 years, anywhere in the 1-2 year range, then the buyer is getting a GREAT deal on the business. If a seller is particularly motivated and wants to make their business more attractive to buyers, then pricing it with a buyer ROI of 2-3 years is a good strategy. In contrast, a buyer ROI that is longer than 4 years is a much more difficult sell, and generally, an ROI of 5 years or longer is not a desirable investment for a buyer.
Do Your Research & Get Expert Help
If you are buying a business, then working with a business broker who understands how to find the market value of a business will be important. If you are looking at a business listing that you feel is overpriced, you need to be able to prove WHY it’s overpriced. The only real way that can be done is with market data. You have the owner benefit numbers, but do you have the comparable sales, in order to have an accurate industry multiple? Business brokers have access to sold business data, so you will need to ask them for comparable sales and the industry multiple if you are trying to figure out if a listing is in-fact overpriced. Having research and data in-hand is essential if you want to make the argument that the business is overpriced. If you think it’s overpriced, you’ve got to make a calculated case as to why. Working with a good business broker will be essential to helping you get the business you want at the right price.