The Number One Thing That Determines the Sale Price of Your Business

Chart showing the U.S. All Grades All Formulations Retail Gasoline Prices, 1994-present, with the Oct. 2014 price highlighted. U.S. Energy Information Administration

In the past year, our company, Acceleration Partners, has been evaluating several potential acquisitions as part of our partnership with a private equity firm. Unfortunately, as we’ve connected with several first-time sellers in this process, it’s become clear that many founders don’t have an accurate sense of what their company is worth to a buyer.

Understanding Your Business’ Worth is Not Intuitive

Not knowing the accurate worth of a company is the position I found myself in many years ago before seeking advice from experienced owners who had been through the process. But, unfortunately, understanding your business’ worth is not intuitive.

Many founders, unfortunately, end up emphasizing the wrong metrics, turning off prospective buyers’ interest, and losing focus on the business itself.

The Number One Thing That Determines the Sale Price of Your Business

If you are serious about selling your business, one metric matters above all others: the market-clearing prices for similar businesses in your industry.

It’s easy for entrepreneurs to overestimate their business’ worth, but financial and strategic acquirers rarely share that rosy viewpoint, as they have a broader perspective. So at the end of the day, you need to know what kind of prices actually get paid for companies similar to yours—in transactions that close.

If you enter the acquisition market with an unrealistic sense of your business’ worth, you’re not going to get very far.

Here’s how you can best estimate the right price for your business and avoid passing up on the offer you’ve been waiting for.

Know Your Stripes

While no two businesses are exactly the same, a business’ value generally depends on three things: its industry, its size, and its business/pricing model.

Level of Profitability

For example, almost all professional services businesses are valued based on their level of profitability; they typically don’t have proprietary assets or intellectual property and earn money from their people, who are never guaranteed to stay.

How to Calculate

An acquirer will often calculate the offer for a services business by multiplying the company’s EBITDA, or Earnings Before Interest, Taxes, Depreciation, and Amortization, from the past 12 months.

In valuation shorthand, this is referred to as TTM EBITDA, or trailing-twelve-months EBITDA. This is a proxy for the annual cash flow a business generates before debt service. Businesses with higher levels of TTM EBITDA get higher multiples, especially as EBITDA surpasses $5/$10/$20 million thresholds.

Within services businesses, there is another key distinction: project-based businesses and recurring-revenue businesses.

Project-based businesses: must replenish their revenue stream each year, consistently bringing in new clients or projects, so revenue is less certain from year to year and requires more sales and marketing effort.

Recurring-revenue businesses: have much more long-term predictability and don’t have to constantly acquire new customers and projects to maintain revenue and profitability.

Here’s an illustration of how this distinction appears in the real world

Company A

For a marketing agency, a project or campaign-based services business with $1 million in TTM EBITDA and $15 million in annual revenue would likely be valued at 3X to 5X EBITDA, or $5 million at the high end.

Company B

On the other hand, Company is a tech-enabled services business with long-term contracts resulting in 90 percent recurring revenue and $5M in EBITDA. Company B also has the same $15 million in annual revenue and might be valued at 10X EBIDTA, or $50M.

This business has much better margins and a recurring revenue model that provides much more certainty on future revenue and profit.

If the founder of Company A walks into the market believing they will be valued the same way as their friend who founded Company B is — they will be very disappointed.

Company A does not have enough scale, enough profitability, or the right business model to command the premium 10X multiple of Company B; and it’s much riskier for a buyer.

When selling your business, remember the potential buyer is often a larger, more established company within your vertical

When selling your business, you may be selling to private equity or an investor that has seen what works and doesn’t work in your industry.

In short, a savvy buyer will look at your business’ core offering and finances and know exactly how you measure up to other acquisitions in your field. To attract these buyers, you have to know what constitutes value in your industry and understand how your company’s size and pricing model look to scrutinizing eyes.

Just as an animal knows their kind by matching their stripes, you need to make sure you are comparing your business to the right companies.

Understand Your True Financial Picture

Many business owners don’t understand how a potential buyer will interpret their financial picture, especially when it comes to profit. As a result, in some cases, they may fail to account for certain expenses and end up drastically overestimating how a buyer will measure their profit.

For example, a founder might show a business with $500,000 in annual profit to investors, only for the buyers to discover later that the founder only takes a $50,000 salary and gets most of their income from profit distribution.

This calculation and shown incorrectly to a buyer or the investors can be a big problem

If the founder’s role has a market salary of $200,000, and they or their replacement needs to continue earning that income when the deal is closed, the new owners will have to increase the cost structure by $150,000 to pay the leader’s salary.

While this company showed $500,000 in profit on its income statement, its real profit, or adjusted net profit, is $350,000. When you factor in a 5X multiplier, that’s a $750,000 valuation difference.

The Common Occurrence of an Entrepreneurs Salary

The following is a common occurrence — 51 percent of entrepreneurs don’t take a salary when launching their businesses.

When the entrepreneur business owner is not taking a salary — this type of financial misrepresentation can derail a promising deal.

Before you share financials with a prospective buyer, work with your accountant or transaction advisor to develop a clear adjusted net profit that gives an accurate first impression to buyers.

Also, consider taking a market-based salary for your role, rather than offsetting a low salary with profit, as this will save you headaches and give you a more accurate picture of your business.

Reference Actual Market Clearing Prices and Be Aware of Deal Terms

Two other common factors cause owners to overvalue their businesses and inflate their expectations.

In some cases, founders get caught up in the rumor mill of deals in their industry without knowing the full context of those acquisitions.

Most press and available data are related to much larger transactions. In other instances, an owner uses another deal’s price as a baseline — even though the referenced transaction never actually closed.

Think: Rumor—Until Verified

Just as your social media feed will only show you the best five percent of others’ lives, the rumors and tall tales you hear about pricing often give a distorted view. In some cases, people simply embellish the truth; in other instances, they’ll share the total enterprise value of the deal and not the deal specifics.

For example, there is a big difference between a company that sells for $10 million in cash and one that sells for the same $10 million price tag, but with $5 million in cash upfront and a five-year earn-out.

In the latter case, only the initial $5 million is guaranteed; the rest is paid out of future earnings and may require you to be employed for that duration or to grow the business to a specified earnings level to achieve it, effectively implying a lower valuation multiple.

In a long-term earnout, you are also essentially paying yourself for the business out of future profits, not the acquirer’s money

It’s also misguided to assume that a proposed deal represents true market value. For example, Harvard Business Review found that between 60 and 80 percent of proposed acquisitions fail to close.

A huge percentage of proposed acquisitions fail to close because many acquirers, unfortunately, make a practice of presenting artificially inflated offers to get a business under the agreement.

The business may then plan to “retrade” the seller before close or change the material conditions of the deal after a long due diligence process

At that point, you must either agree to the new terms or walk away with nothing — after investing so much time and effort. You want your business deal to close, and this is the best reason to present your financial picture fairly, as any deviation gives the acquirer ammunition to “retrade” the deal.

Focus on Market-Clearing Prices

Again, this is why it’s best to focus on market-clearing prices. Next, look for verification — which is the realized value of the deals that have actually closed. Otherwise, you’ll be basing your expectations on stories that often don’t match reality.

At the end of the day, if you want to sell your business, you should go to market with the right expectations and assumptions

With accurate expectations and assumptions, you’ll have your financials in order and an understanding of the actual market clearing prices and terms for businesses in your industry and at your size.

What is the most important issue to you?

The price might also not be the most important aspect of the deal, depending on what you want to do next and how much freedom you seek.

Conclusion—Consult Your Values

And last but not least, make sure to consult your values to ensure the acquisition you’re getting is the outcome you want, and you are partnering with the right team. To paraphrase Warren Buffett, you can’t do a good deal with the wrong person and a bad deal with the right one.

By Robert Glazer