How Buyers Put a Price on Your Business
A funny thing happened when I was first approached by someone who wanted to buy my marketing agency: I forgot everything I knew about sales.
Instead of listening to the customer and understanding his or her needs, I went into negotiations with potential buyers focused on my needs. I wanted to get a certain multiple for my business but failed to put myself in the shoes of a buyer to figure out what he or she would be willing to pay.
It was a rookie mistake on my part. Any first-year salesperson knows the first step in selling is figuring out what the customer needs. I should have asked about buyers' goals in wanting to acquire us. In particular, I should have tried to understand what kind of return they were looking for on their investment in an acquisition.
The price buyers are willing to pay for your business depends on a lot of factors, but one of the most important is the return they expect to get and the risk associated with achieving that return.
Assuming your revenue is flat or growing modestly, the higher the return on investment the buyers are looking to achieve, the lower the multiple they will be willing to pay for your business.
At the risk of oversimplifying a complex equation, if the buyers are looking for a 22 percent return on their investment in your company, then they will derive the multiple they are willing to pay as follows:
100 ÷ 22 = 4.5 times EBITDA
Provided you're not the next Google and you don't have the cure for cancer, the buyers would be willing to pay around 4.5 times EBITDA to buy your business.
If, however, their expectations for a return are higher, let's say 30 percent, they will be willing to pay less for your business:
100 ÷ 30 = 3.3 times EBITDA
So what drives up buyers' expectations for return on investment while at the same time driving down the price they are willing to pay for your business? In a word, risk. The riskier your business looks to buyers, the higher their expectation for a return will be.
Likewise, with your own investments, you are willing to settle for a lower return when you buy relatively safe assets, like a government bond. But when you buy that risky small-cap fund, you expect a higher rate of return in exchange for putting your capital in harm's way.
So how do you de-risk your business in the eyes of an acquirer? Ted Davidson, a valuation consultant with SPARDATA, an independent business valuation firm, says you should consider factors like:
- Client risk—do you rely on just one or two key clients for most of your business?
- Supplier risk—will you be in trouble if one of your suppliers goes under?
- Depth of management—what happens if a key employee disappears?
- Contracts—do you have legal agreements in place, or do you rely on handshakes?
Ask yourself these questions to judge how risky your revenue stream is. 'Investors want to know that things won't fall apart if something unexpected happens,' says Davidson. 'Show them safety in your pattern of earnings, and you can expect a higher offer."
When you sit down with people interested in buying your business, try to find out what their expectations for return on investment are. That will tell you a lot about what their offer will look like and how risky they view your business. From there, you can do the math and anticipate their offer price and decide whether or not you want to keep talking.
JOHN WARRILLOW | Columnist | Sellability
John Warrillow’s new book, The Automatic Customer: Creating a Subscription Business In Any Industry will be released on February 5, 2015. John is also the author of Built to Sell: Creating a Business That Can Thrive Without You and the founder of The Sellability Score, a company dedicated to helping business owners improve the value of their company.