Buying a Business for the Best Price
What is the "best price" when buying a business? Is it the lowest price? Or is it the best price given the agreed conditions? How does a buyer work out those conditions?
When buying a business most people think it is all about how hard you can negotiate to get the price as low as possible. Ironically the vendor is also looking to find ways to get the highest price.
So at some point there needs to be compromise, and this often introduces other conditions that become part of the deal.
The best price to buy a business will take into account all the motivating factors for the buyer and vendor, of which price is only one factor.
Buying a business (and this applies to selling a business as well) is all about understanding the motivating factors and risks, and how these influence selection of the options on the BATNA (Best Alternative To a Negotiated Agreement) continuum.
Working out the "best price" (or more accurately the best offer) will be based on the following key areas:
The BATNA continuum.
The price continuum.
The BATNA continuum is based on the range of alternatives available between walking away and reaching complete agreement.
The best way to think about the BATNA continuum is to think of the worst alternative at one end (walking away with no deal) and complete agreement at the other end. In between these two options is a range of other alternatives, some better than others.
The alternatives that sit between the “worst” and “best” cases will reflect all the conditions that are likely to be negotiated in a terms sheet. The buyer should list out these conditions under such headings as:
Absolute requirements without which no agreement can be reached (such as no competition by owner, transfer of all key employers and key customers, release of intellectual property etc).
Key performance indicators that are determine potential payout amounts.
Negotiation and due diligence periods.
Preferred arrangements such as inclusion of certain non-core assets, office locations, handover periods and post-sale support.
Method of the transaction – outright purchase of enterprise or entity or a staged purchase.
In order to select the best alternative we need to document and understand each of the conditions that influence the "best price".
The Price Continuum
The final agreed price is going to sit between two values on a price continuum:
The lowest price the vendor will sell for (their walk-away price).
The highest price you can pay and still make a commercial return.
Most vendors are after some sort of premium over the market value of their business.
Owners of a business will always have an optimistic view of business value (this is known as the endowment effect). But they will also have a price, below which they will walk away and not consider any offers at all.
If there is going to be agreement between a buyer and a vendor the price will need to be above this point.
The lowest price the owner will accept is sometimes close to the market value - what everyone else is likely to pay.
The highest price a buyer can pay and still make a return will take into account:
Increased revenue opportunities.
Expected cost reductions that a new owner can implement.
The standard of value that takes these factors into account is called strategic value. This value is often based on market value and adjusted for the new opportunities specific to the buyer.
Another way of determining the highest price is to consider a number of optimistic business growth scenarios where profits significantly exceed current levels. Whilst these profits will be optimistic, they should also be based on realistic achievable assumptions.
The value of these cash flow scenarios are then assessed using a higher cost of capital than would otherwise be selected in a market valuation. This cost of capital takes into account the higher level of risk associated with the optimistic scenarios.
The result is the maximum that should be paid, maintaining some confidence that business will still generate a commercial return.
A buyer is willing to pay more than market value for a business based on the opportunities the specific buyer can realistically implement.
The opportunities most buyers want to consider are those that will ultimately increase the value of the business.
The opportunities to increase the value of the business:
Increase cash flow.
Increase the attractiveness.
Reduce the invested capital.
Opportunities will include:
New revenue opportunities from existing and new products and services.
Cost reductions or improvements in productivity and efficiency.
Improved use of technology and application of more efficient and automated processes.
Reduction in working capital.
Improved market share and competitive position.
Reduced reliance on key staff or owners.
Development and application of existing or new intellectual property.
A buyer should document all the opportunities and provide estimates on the impact on cash flow and working capital.
The extent to which new opportunities can increase cash flow and reduce working capital will determine the quantum of the premium that can be offered over market value.
The risk of a financial asset is defined as the uncertainty in future cash flows.
In business terms it is the degree of uncertainty in the projected cash flows associated with a particular valuation. The more risk, the more uncertainty associated with the cash flows.
Risk is related to the cost of capital – the lower the risk the lower the cost of capital. The cost of capital is the rate of return that capital could be expected to earn in an investment of similar risk.
For SME’s the risk measure most often used is the EBITDA multiple:
An EBITDA multiple of 2.0x implies a capitalisation rate of 50%.
An EBITDA multiple of 3.0x implies a capitalisation rate of 33%.
A higher risk implies a lower multiple and a higher capitalisation rate.
The risk inherent in a privately held business will typically be divided into two categories:
Internal risk – how reliable has the business generated positive cash flow in the past?
External risk – how much uncertainty from external factors is the business exposed and how are these factors likely to impact cash flow?
In order to achieve the best price, a buyer should document each of the key risks and estimate to what extent these risks will influence the likelihood of generating profits and returns at the expected levels.
The higher the risk or uncertainty of generating the expected cash flows the more the price should be discounted to reflect this risk.
Once a buyer has documented and assessed all of these issues the conditions that give rise to the best offer can be determined. In many cases working out the offer price (and the range within which to make an offer) is relatively easy.
The complexity arises in ranking each of the alternatives that combine to reach an agreement. The ranking process considers all the alternatives and whether they are deal breakers, preferred outcomes or icing on the cake.
The final offer will always be a price (or a price range) – but the devil in a deal is always in the detail.
The value of a business is the single most important metric when considering how that investment has performed and what decisions you make on its future.
The value of a business incorporates profitability, capital investment and risk into a single measure that will reflect the and decisions changes that you make in a business.
A valuation is critical when you are:
Buying a business or selling a business.
Buying or selling to other owners or shareholders.
Making a capital investment decision.
Restructuring the business.
Bringing in new investors.
Managing tax issues.
Resolving commercial disputes.
Settling a divorce that involves a business.
Without a clear assessment of the value of a business you are running blind when making critical strategic and management decisions.
Whether you are developing an exit strategy, improving your business or needing to meet compliance requirements, a business valuation will guide your to make better decisions.
Maxell Consulting has completed hundreds of business valuations and helped many businesses make value decisions that impact the future of their business.
Find out what your business is worth today.