Negotiating and determining the selling price of a small business
(Self-Employment in South Africa)
There are no rules cast in stone when you wish to determine the correct selling price of a business. It is thus necessary to make use of factual assumptions rather than using undefined or emotional price decisions.
Sellers might fail in being realistic as to what the financial status of the business can offer to a purchaser. In some instances, sellers price their business to high in an emotional last attempt to profit from their hard work during their period of ownership. These businesses stay on the market for lengthy periods and, in time, earn a reputation as non sellers. When, at some stage, the prices are corrected these businesses are still hard to sell because of previous over exposure at non-realistic prices.
Sellers should actually be able to make a complete mind shift and try to think like a purchaser when determining the price of their businesses. This will result into factual arguments when negotiations take place.
Purchasers tend to over bargain when negotiating a deal with a seller. Purchasers often upset sellers in placing emphasis on the weaknesses of the business as a bargaining attempt. This may result into emotional arguing which has no benefit to concluding the transaction.
In an attempt to help them make a decision, purchasers often seek advice from friends or other non-experts in the field. Many a purchaser has decided not to buy a good business, or has burnt his fingers by listening to the so called “good advice” from an inexperienced friend.
As a starting point in bargaining, a purchaser should ask a seller a question that he must qualify like one of the following;
· Tell me how you got to the price for your business.
· Can you tell me why you think my offer is not realistic?
· I base my offer on the following. …………… ………….. I am of the opinion that it is a very good offer. On what grounds do you differ from me?
In making statements like these and by asking the right questions, the negotiations are forced away from emotions and rather focused on facts.
The experienced business agent / broker will always direct negotiations to facts. He should be able to avoid emotional traps. When the parties, to the negotiations, fall into these emotional traps, the agent / broker must be able to guide them back to facts with as little as possible emotional scars to the negotiation process.
Let’s look at the cost of money and time
The transaction involves money that changes hand. The purchaser expects maximum profits from his investment, but often fails to make a proper analysis as to what the expected price-earnings ratio of his newly acquired business is. He might have been better off by investing his money elsewhere and stay at home, rather than to sell his personal time to the business the moment he took ownership of it.
The first factor that needs to be evaluated is the cost of money (capital) employed.
· Borrowed money will always cost you money because it is incurring interest, say for instance @ 15%
· A purchaser’s own money, invested in a business, will always cost him the interest that he could have earned when the money was invested elsewhere.
-Passive investments in blue chip share funds on the JSE returned in the region of 30% p.a. during the past 10 years.
-Investments in real estate averaged more than 20% during the past 5 years.
-Passive investments in financing large property development companies offer 22%, some with guarantees, though some with more risk than others. Bear in mind that investing in any business, even your own, has a risk factor attached to it.
· Whether money is thus borrowed or owned, it has an interest cost value when employed into any investment, like for instance your own business.
The second factor that needs to be valued when buying a business is the purchasers own time involved.
· If a purchaser takes up 100% employment in his newly acquired business, the business will have to be able to pay 100% of his salary.
The two factors mentioned above, could be illustrated as follows when investing the total amount of R800 000.00 in acquiring a business.
The cost of capital employed (Interest on R800 000.00 @ 15%) = R120 000.00
The salary of the purchaser @ R23 000.00 per month (X 12) = R276 000.00
To cover the above, the business needs to return p.a. = R396 000.00
This example results in a price earnings ratio of 2.02, (which is still acceptable).
(Price Earnings Ratio or PE = Capital employed divided by the yearly profit earned)
The earnings could also be expressed as a return of 49.5% on investment.
(Return on Investment or ROI = 396 000 divided by 800 000 X 100 = 49.5%)
Remember, in the example above, the business has only covered the basic costs for its owner. No provision has been made for capital repayments and year end surpluses (profits) will be non existent.
Businesses transactions at a PE of higher than 2.5 (ROI of less than 40%) and which are dependant of full time owner involvement, could be viewed as getting risky.
What is sold and what is bought
It is important to know what is actually sold and what is actually bought when a business is sold as a going concern. It is further necessary for the parties to the transaction to be in full agreement of this.
Although the business, as a going concern, is sold as a unit or “package”, this package could be broken down to a few saleable assets.
· Goodwill often represents a large part of the purchase price. Sellers always place a high value on goodwill, purchasers does not want to pay goodwill and financial institutions will seldom if ever view goodwill as surety for borrowed capital. Goodwill is often overvalued by sellers and misunderstood by purchasers.
Goodwill can be viewed as the clientele of the business. Other factors that add to goodwill may be the location in relation to its markets, the trade period (time established), an actual prime premise, a favourable lease agreement, the history of profitability, Special skills of the staff and trained staff, trade contracts, registered brand names and more.
Although the value of goodwill is a grey area to calculate, it is a definite asset that adds value to the business. A business without goodwill still has to become a business.
· Inventory of trade assets like shop fitting, signage, equipment, etc, are easier to value, because it represents tangible items. The question is what the correct criteria to determine its value are.
The replacement value might be used if all the assets are fairly new. If the book value is used, it might be under valued because of tax write offs in the past. Although the most difficult to determine, it may be the best to value the inventory at an approximate auction value.
Refinancing of trade assets like late model vehicles, could form part of the payment for the business. The down payments thereof should then however been noted as an expense against the profits of the business when the PE value of the business is calculated from such profits.
· Stock is normally included in the sale, but paid separately for, because of the fluctuations in its levels. Businesses like rental companies differ from retailers in the sense that stock levels are more stable. In such businesses the stock price could be integrated in the selling price.
· It is best to exclude creditors from the sale, which means that the seller will be liable to settle his debt with all creditors.
· Debtors, like stock, might be included in the sale, but excluded from the purchase price. Payment of the debtors’ book to the seller might be postponed until monies have been collected. The sum of the debtors book might also completely be excluded from the sale. It could then be collected by the seller, or it could be collected by the purchaser on behalf of the seller at a percentage fee.
Putting it all into practice
Net profit, after VAT has been paid, before income tax has been calculated, is a fairly uniform criterion to use in determining the selling price for a business. Such net profit may include the business profits plus the owners’ earnings and benefits.
Gross profit or turnover is not that uniform. Take away businesses has a far lower turnover and a far higher gross than wholesalers and general retailers.
Everything comes back to PE as being the uniform basis to be used when calculating the correct selling price.
Although stock is calculated separate from the purchase price, it is a necessity for the purchaser to have. He has to pay for it and he might have to provide operating funds for additional stock or debtors. If it is a franchised business, a listing fee to the franchisor might be applicable. It is essential to include everything that the purchaser has to pay or provide for, when calculating the PE.
The following example can be used in calculating the value of a business:
Per Month Per Annum
Net profit after VAT, before income tax: = R 33 000 R 396 000
Capital outlay of the purchaser:
Franchise Listing: = R 50 000
Stock: = R 80 000
Business as a going concern,
Including Goodwill & Inventory = R616 400
Agents commission @ 8 % = R 53 600
(Commission is payable by the seller from the funds generated by the sale)
Total outlay: = R800 000
This example results in a price earnings ratio of 2.02.
(Price Earnings Ratio or PE = Capital employed divided by the yearly profit earned)
The earnings could also be expressed as a return of 49.5% on investment.
(Return on Investment or ROI = 396 000 divided by 800 000 X 100 = 49.5%)
Although not cast in stone, the table below may serve as part of a more factual approach in deciding what the total capital outlay should be in relation to the profit when a business is sold.
(Self-Employment in South Africa)
There are no rules cast in stone when you wish to determine the correct selling price of a business. It is thus necessary to make use of factual assumptions rather than using undefined or emotional price decisions.
Sellers might fail in being realistic as to what the financial status of the business can offer to a purchaser. In some instances, sellers price their business to high in an emotional last attempt to profit from their hard work during their period of ownership. These businesses stay on the market for lengthy periods and, in time, earn a reputation as non sellers. When, at some stage, the prices are corrected these businesses are still hard to sell because of previous over exposure at non-realistic prices.
Sellers should actually be able to make a complete mind shift and try to think like a purchaser when determining the price of their businesses. This will result into factual arguments when negotiations take place.
Purchasers tend to over bargain when negotiating a deal with a seller. Purchasers often upset sellers in placing emphasis on the weaknesses of the business as a bargaining attempt. This may result into emotional arguing which has no benefit to concluding the transaction.
In an attempt to help them make a decision, purchasers often seek advice from friends or other non-experts in the field. Many a purchaser has decided not to buy a good business, or has burnt his fingers by listening to the so called “good advice” from an inexperienced friend.
As a starting point in bargaining, a purchaser should ask a seller a question that he must qualify like one of the following;
· Tell me how you got to the price for your business.
· Can you tell me why you think my offer is not realistic?
· I base my offer on the following. …………… ………….. I am of the opinion that it is a very good offer. On what grounds do you differ from me?
In making statements like these and by asking the right questions, the negotiations are forced away from emotions and rather focused on facts.
The experienced business agent / broker will always direct negotiations to facts. He should be able to avoid emotional traps. When the parties, to the negotiations, fall into these emotional traps, the agent / broker must be able to guide them back to facts with as little as possible emotional scars to the negotiation process.
Let’s look at the cost of money and time
The transaction involves money that changes hand. The purchaser expects maximum profits from his investment, but often fails to make a proper analysis as to what the expected price-earnings ratio of his newly acquired business is. He might have been better off by investing his money elsewhere and stay at home, rather than to sell his personal time to the business the moment he took ownership of it.
The first factor that needs to be evaluated is the cost of money (capital) employed.
· Borrowed money will always cost you money because it is incurring interest, say for instance @ 15%
· A purchaser’s own money, invested in a business, will always cost him the interest that he could have earned when the money was invested elsewhere.
-Passive investments in blue chip share funds on the JSE returned in the region of 30% p.a. during the past 10 years.
-Investments in real estate averaged more than 20% during the past 5 years.
-Passive investments in financing large property development companies offer 22%, some with guarantees, though some with more risk than others. Bear in mind that investing in any business, even your own, has a risk factor attached to it.
· Whether money is thus borrowed or owned, it has an interest cost value when employed into any investment, like for instance your own business.
The second factor that needs to be valued when buying a business is the purchasers own time involved.
· If a purchaser takes up 100% employment in his newly acquired business, the business will have to be able to pay 100% of his salary.
The two factors mentioned above, could be illustrated as follows when investing the total amount of R800 000.00 in acquiring a business.
The cost of capital employed (Interest on R800 000.00 @ 15%) = R120 000.00
The salary of the purchaser @ R23 000.00 per month (X 12) = R276 000.00
To cover the above, the business needs to return p.a. = R396 000.00
This example results in a price earnings ratio of 2.02, (which is still acceptable).
(Price Earnings Ratio or PE = Capital employed divided by the yearly profit earned)
The earnings could also be expressed as a return of 49.5% on investment.
(Return on Investment or ROI = 396 000 divided by 800 000 X 100 = 49.5%)
Remember, in the example above, the business has only covered the basic costs for its owner. No provision has been made for capital repayments and year end surpluses (profits) will be non existent.
Businesses transactions at a PE of higher than 2.5 (ROI of less than 40%) and which are dependant of full time owner involvement, could be viewed as getting risky.
What is sold and what is bought
It is important to know what is actually sold and what is actually bought when a business is sold as a going concern. It is further necessary for the parties to the transaction to be in full agreement of this.
Although the business, as a going concern, is sold as a unit or “package”, this package could be broken down to a few saleable assets.
· Goodwill often represents a large part of the purchase price. Sellers always place a high value on goodwill, purchasers does not want to pay goodwill and financial institutions will seldom if ever view goodwill as surety for borrowed capital. Goodwill is often overvalued by sellers and misunderstood by purchasers.
Goodwill can be viewed as the clientele of the business. Other factors that add to goodwill may be the location in relation to its markets, the trade period (time established), an actual prime premise, a favourable lease agreement, the history of profitability, Special skills of the staff and trained staff, trade contracts, registered brand names and more.
Although the value of goodwill is a grey area to calculate, it is a definite asset that adds value to the business. A business without goodwill still has to become a business.
· Inventory of trade assets like shop fitting, signage, equipment, etc, are easier to value, because it represents tangible items. The question is what the correct criteria to determine its value are.
The replacement value might be used if all the assets are fairly new. If the book value is used, it might be under valued because of tax write offs in the past. Although the most difficult to determine, it may be the best to value the inventory at an approximate auction value.
Refinancing of trade assets like late model vehicles, could form part of the payment for the business. The down payments thereof should then however been noted as an expense against the profits of the business when the PE value of the business is calculated from such profits.
· Stock is normally included in the sale, but paid separately for, because of the fluctuations in its levels. Businesses like rental companies differ from retailers in the sense that stock levels are more stable. In such businesses the stock price could be integrated in the selling price.
· It is best to exclude creditors from the sale, which means that the seller will be liable to settle his debt with all creditors.
· Debtors, like stock, might be included in the sale, but excluded from the purchase price. Payment of the debtors’ book to the seller might be postponed until monies have been collected. The sum of the debtors book might also completely be excluded from the sale. It could then be collected by the seller, or it could be collected by the purchaser on behalf of the seller at a percentage fee.
Putting it all into practice
Net profit, after VAT has been paid, before income tax has been calculated, is a fairly uniform criterion to use in determining the selling price for a business. Such net profit may include the business profits plus the owners’ earnings and benefits.
Gross profit or turnover is not that uniform. Take away businesses has a far lower turnover and a far higher gross than wholesalers and general retailers.
Everything comes back to PE as being the uniform basis to be used when calculating the correct selling price.
Although stock is calculated separate from the purchase price, it is a necessity for the purchaser to have. He has to pay for it and he might have to provide operating funds for additional stock or debtors. If it is a franchised business, a listing fee to the franchisor might be applicable. It is essential to include everything that the purchaser has to pay or provide for, when calculating the PE.
The following example can be used in calculating the value of a business:
Per Month Per Annum
Net profit after VAT, before income tax: = R 33 000 R 396 000
Capital outlay of the purchaser:
Franchise Listing: = R 50 000
Stock: = R 80 000
Business as a going concern,
Including Goodwill & Inventory = R616 400
Agents commission @ 8 % = R 53 600
(Commission is payable by the seller from the funds generated by the sale)
Total outlay: = R800 000
This example results in a price earnings ratio of 2.02.
(Price Earnings Ratio or PE = Capital employed divided by the yearly profit earned)
The earnings could also be expressed as a return of 49.5% on investment.
(Return on Investment or ROI = 396 000 divided by 800 000 X 100 = 49.5%)
Although not cast in stone, the table below may serve as part of a more factual approach in deciding what the total capital outlay should be in relation to the profit when a business is sold.
Author: Cobus van der Merwe, Principal Agent of InCommercial Property Services based in Paarl, Western Cape, South Africa. Cobus is a certified estate agent, who is specialising as a Business Agent (Broker). He owned several businesses, most of which he started himself and sold after being brought to profiting status. He gained knowledge in the field of small businesses by extensive reading and experience through self-employment since 1990.
The copyright of this article subsists in the author
The copyright of this article subsists in the author