Buying or selling a business will probably be the largest financial transaction you ever take on.
Settling on the right price is crucial for both sides of the transaction. As the seller, you will have worked hard over years, maybe even decades, and will want to maximize the amount you receive. As the buyer, you will want to ensure you’re receiving maximum value for your dollar, and feel reasonably secure in the eventual profitability of the transaction.
To accomplish those goals, both parties need to be able to effectively arrive at a realistic valuation for the business in question. This guide is designed to give you the basic guidelines and powerful tips to help you do just that, no matter what unique circumstances are involved.
When and why a business sells
Most advisors recommend formulating an exit strategy before you even start a business.
The exit strategy is a strategic plan for how you will eventually cash out, or otherwise devolve yourself of ownership, since no one person can expect to own and run a business forever. Understandably, selling it when you have achieved your objectives — financial or otherwise — is the most common strategy entrepreneurs pursue.
While planning when and how you’ll sell your business years in advance is ideal, even a successful business may wind up unexpectedly for sale due to other factors like personal problems (sickness, divorce, or needing to relocate) or disagreements among business partners. You could potentially receive an unsolicited offer from another company, often a competitor. Or, you might realize that the current economic climate is good for a seller and decide to take advantage of it.
Of course, some business opportunities are sold because the owner feels they are unsuccessful or are likely to become so in the future — but that doesn't mean their businesses are worthless. Certainly, even during difficult economic times, entrepreneurs with cash are in the market to buy. That’s because, in most cases, businesses have some form of assets, real or otherwise, that will represent value to the right buyer.
Understanding the valuation process is important for sellers because it will allow you to understand the mindset of that optimal business buyer. It will also help you to maximize the value of the business by learning and applying what you need to do to prepare your unique business for sale.
Likewise, understanding business valuation is vital for buyers because it can help you determine if a seller is being fair and realistic in their asking price. And, if that’s not the case, this knowledge provides powerful leverage during negotiations. It also serves as a key means of identifying great buys and prioritizing potential purchases over time.
So, let’s dive into exactly what business valuation is, how it’s accomplished, and what you, as a prospective buyer or seller, should be doing to get the most out of this valuable skill.
What is business valuation?
Put simply, business valuation is a broad umbrella term that covers numerous methods buyers and sellers can use to place a dollar figure on the total quantifiable and unquantifiable value of a company. Since both tangible and intangible assets and liabilities are often included in the transaction, business valuation is far from a simple, straightforward equation. In fact, calculating figures is only a small part of the total process.
Many experts claim business valuation is more of an art than a science. What they mean is that valuation involves a lot of educated guesswork and creative thinking.
There is truly no right answer, because the same exact business could be worth half as much to one buyer as another. So, valuations are often presented as reasonably wide ranges with qualifying factors included. This provides the best negotiating tool for buyers and sellers alike, although in most cases, buyers and sellers will arrive at different overall ranges and may still need to settle outside of them. (This is a challenge known as “the valuation gap,” which is discussed in more detail in the next section.)
Due to all the factors involved, and the highly unpredictable human side of the equation, business valuation is a specialized skill that smart business owners and buyers will outsource to experts with plenty of experience. These can include business brokers, experienced attorneys, or accountants that specialize in business sales transactions.
To accommodate these varied factors, there are numerous models you can consider using to estimate the right price for a business. Some are more appropriate to particular sectors or company types, but there’s no “best” approach for any one business.
This is part 1 of our ultimate guide. You can read Part 2 here