How to value a business you’d like to acquire
You’ve got your eye on a business you would like to buy. You’ll need to consider a few things when looking at its price tag.
Establishing a reasonable value for a company isn’t easy. Access to key information is vital, as is finding a qualified valuator both parties agree on and seeing what figures the bank comes up with.
How do you calculate the price for a business?
The most common method used to determine a fair sale price for a business is calculating a multiple of EBITDA (earnings before interest, taxes, depreciation and amortization), which is a measure of a company’s ability to generate operating earnings.
The multiples vary by industry and could range between three and six times EBITDA for a small to medium-sized business, depending on market conditions. Many other factors can influence which multiple is used, including goodwill, intellectual property and the company’s location.
After arriving at the EBITDA-based figure, a professional business valuator typically seeks to confirm it by applying other valuation approaches—first, calculating the value of the company’s tangible and intangible assets and, second, checking what comparable businesses sold for.
A business may also be more valuable in pieces than as a whole. For example, you may find the target company’s real estate holdings more attractive as an asset than the entire business.
How is a company valued?
Professional valuators typically use a mix of three methods to confirm the value of a business:
- Income-based approach
calculating a multiple of EBITDA - Assets-based approach
calculating the value of tangible and intangible assets - Market-based approach
checking what comparable companies sold for
What happens when you disagree on the price of a business?
Many entrepreneurs have an unrealistic idea of how much their company is worth.
This means, as a potential buyer, you may have a different value in mind than the company’s owner. That can cause conflict and derail a potential acquisition.
Because of the complexity and stakes, it can be very helpful for both sides to hire a professional valuator to set a fair price for the company. (It can also be helpful to consult a tax expert, who can explain how the various valuation options impact your tax liability in the purchase.)
An outside valuation may also help you identify weaknesses in the finances of the acquisition target and show you ways to maximize its value after the transaction goes through.
Finding a good business valuator
When looking for someone to come up with the proper price for a business, seek experience and reputation.
Ask your accountant, lawyer and others in your network to recommend valuators they have worked with. It’s helpful to seek those who have experience with your industry and with whom you have a good fit. You’ll likely be spending a lot of time with this person and have to be able to trust them with sensitive business information.
It’s also a good idea to choose someone who holds the Chartered Business Valuation certification, which is administered by the Canadian Institute of Chartered Business Valuators.
If you’re hiring a valuator as part of a business transfer, it’s good to choose one both parties agree on. This can help you avoid disagreements about the valuation or the risk of duelling valuations.
In some cases, a valuator may not even be needed. For smaller businesses or a sale to family members, an accountant experienced with business valuation may be able to give you an adequate sense of a company’s worth.
If you do choose to work with a valuator, the fee will tend to vary according to the size and complexity of the business being valued.
The bank’s role in valuating a business
A business valuation is more than just a figure that helps in your negotiation; it’s also a crucial part of the bank’s calculation. The bank’s valuators set prices for businesses to see how much financing it will provide for the transaction.
If their valuation is below the proposed purchase price, you may need to find other sources of funds to cover the difference, such as additional buyer.
The bank also reviews the business’s financial strength, existing leverage and other financing sources. The bank’s goal is to ensure the business will be able to service its debt after the transaction.
A bank may be willing to provide you with a rough valuation of your company—for example, if you want to sell but aren’t sure how much your business is worth. A bank’s valuation can also give you ideas on how to improve your company’s value.
The information you’ll need to provide to the bank
The bank typically asks for the following financial documents or details from your business:
- financial statements for the past several years, interim year-to-date results and financial projections
- the prior year’s tax return
- a list of discretionary and non-recurring or one-time expenses
- any significant upcoming changes for the business
- major planned investments
- information on the management team
A bank’s valuation process is similar to that used by business valuators. However, banks tend to include more conservative assumptions in their calculations, placing less weight on factors such as technology, location and market conditions.
Finally, keep in mind that the price you finally settle on may differ from both the bank’s figure and the appraised market valuation. Unexpected factors can influence this, like paying more because the business fits well with your company’s culture or due to competing bids.
Next step
Download the free BDC guide on Business Valuation and discover the methods valuators use to determine the value of a business and how valuation impacts price.