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Buyers want Businesses that Make Money
The typical buyer of a small business is looking to “buy a job” that will support his family, pay off his debt, and provide a return on his investment. Most buyers are considered "Financial Buyers," because they are chiefly concerned with profitability. Less common are the "Strategic Buyers," who find synergies with their other business interests. Regardless of type, none of these buyers wants to pay more than fair market value for a business.
Recasting Financials to calculate Seller's Discretionary Earnings
The financial statements must be "recast" to determine the Seller's Discretionary Earnings (SDE), which is how much a full-time owner/manager would earn from the business each year. Proper recasting shows buyers the true earnings of the business, and results in higher selling prices. In recasting, certain business expenses—such as owner’s wages and benefits, interest and depreciation—are "added back" to the net income to calculate the SDE. Smart buyers strongly consider SDE in determining how much they will pay for a business.
Estimating Value from Seller's Discretionary Earnings
The value of a business can be estimated by multiplying the Seller's Discretionary Earnings by an “SDE Multiple,” then adding the cost of the inventory. These SDE Multiples usually fall between 1 and 3. The value can also be estimated by multiplying the Annual Sales by a “Sales Multiple,” and again adding the cost of the inventory. Sales Multiples usually fall between 10% and 100%. The business type, size and other characteristics influence where the multiples fall within these ranges. For example, most restaurants sell for 2 times SDE or 35% of annual sales, plus the cost of the inventory.
Higher Price and Interest from Seller Financing
Such estimates of value are based upon the Seller offering reasonable terms, such as seller financing. Consequently, a lack of seller financing reduces the selling price by 15%, on average. This is because most buyers want to "leverage" their cash to buy larger and more profitable businesses. Sellers are often the buyers' only financing option, because most banks see small businesses as risky investments, and obtaining Small Business Administration loans can be very difficult and time-consuming. On the other hand, sellers who provide financing get higher prices, along with interest income from the loan payments.
Reasonable Asking Price and Terms
The asking price should ideally be set 10% or so above the estimated market value of the business. This gives the Seller the best chance of getting full value, by attracting the most buyers, while allowing a "cushion" for negotiation. Remember that the asking price merely establishes a starting point for marketing and negotiations. In the end, the selling price and true value of the business will be determined and agreed by the Buyer and Seller.