Published August 2004

Pricing, preparing your business for sales market

One of the effects of today’s economic climate is that more businesses are being bought and sold.

Low interest rates, an improved business outlook, a buildup of cash balances and a scarcity of attractive alternative investments have combined to increase investor interest in smaller businesses. In fact, many businesses that were considered too small for buyers a few years ago are now finding that they have suddenly become more alluring. The experience can be great fun.

Business owners have many reasons why selling their “baby” can be an appealing idea. Certainly, battle fatigue, especially with human resource problems, has to be high on the list. But there are other contributing factors, everything from health considerations and the desire to move somewhere else to simply wanting to pursue some other dream. Maybe you just can’t face opening one more hot oven door and chucking in another large special with extra cheese, anchovies and pineapple.

The increased activity in business sales has given a rebirth to people who offer advice on how a business owner should prepare for these transactions. Some of this advice, of course, is excellent. For example, it will never hurt a business owner to locate key documents and to assemble the recent financial history of the operation.

If an owner is interested in selling a business, though, eventually you run out of the easy advice and have to confront the first of two very tough questions: How much is it worth?

The obvious answer is that it is worth exactly what someone is willing to pay for it, no more and no less — but that answer, while correct, is neither satisfying nor helpful.

Far more helpful is calculating the market value of a business the way the experts do. Valuation specialists generally agree that there are three basic ways to place a value on a business: (1) net worth, or asset value; (2) discounted cash flow; and (3) market comparables — the price that similarly sized businesses in the same industry have sold for. Most of the experts have their own versions and combinations of these basic methods, depending on what has worked best in their experience, but the fundamentals remain the same.

Generally speaking, net worth has been the least used of the methods because, of the three, it usually bears the least resemblance to the market value of a business.

Market comparables are an important part of a business appraisal, but their significance can vary widely, depending on how you plan to address the market for buyers. If you feel your best shot is to put your business on the national market, then comparables are crucial. If you plan to address the market in a different way, by identifying potential merger partners, for example, comparables will probably be far less important than the profile and internal dynamics of your business itself.

There are fads in business pricing methods, but the most durable calculation has been the discounted cash flow. And perhaps it isn’t a coincidence that besides being the most popular, year after year, it is also the simplest. At its most fundamental, it forecasts the cash profit of a business and discounts it based on current interest rates — that is, the sooner the profit the higher the value, the longer you have to wait, the lower the value.

But, whatever business valuation method you use, you will eventually have to confront the second tough question: How far do you go in preparing and reshaping the business to maximize its selling price?

A business prepped for sale is just like a house prepped for sale: It is cleaned up and looking its best, but it can be a bit tough to live in. For a business manager contemplating a sale, sometimes arranging your business to maximize some financial target like cash flow can delay or otherwise distort key decisions. And that isn’t always a good thing. It is important to manage the business — to make the best decisions you can for its short- and long-run success.

Don’t reshape your business too much to fit someone else’s idea of how it should look. Just as with your house, if the buyers want the kitchen done in orange, after the sale they can paint it themselves.

James McCusker, a Bothell economist, educator and small-business consultant, writes “Your Business” in The Herald each Sunday. He can be reached by sending e-mail to otisrep@aol.com.

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