Over the past several weeks, I’ve talked about the subjective factors that influence the price a business will bring at market and the factors that create the opportunity to achieve a premium price for a business. In today’s post, I’ll give you some practical tools for how to calculate a value for your business.
Unless your business is in a position to qualify for a premium price or is in the category where it will be discounted or not salable, it is highly likely that the ultimate value it can achieve is going to fall in a rather narrow range of value. This value range reflects two overriding values in American business. First, is a general desire to see an investment repay itself within five years. Second is a desire to have a fall back position in the way of liquidation should an acquisition not work out as planned. These can be represented by two rules.
The 3 to 5 Year Payout Rule – An acquisition is generally expected to payback its cost in 3 to 5 years. This will translate into a pricing formula such as 8 to 10 time Income (After Taxes, Fully Taxed) or 4 to 4.5 times Cash Flow (Income Before Interest, Taxes, Depreciation and Amortization).
0% to 50% Risk Rule – This rule affects the amount of cash paid at closing as well as the total price of a transaction. One times the acquired company’s Net Worth represents a 0% risk. This means that if the business were liquidated the day after it was acquired, in theory, the Net Worth would cover the cost of the acquisition. Thus two times Net Worth is a 50% risk, meaning that 50% of the purchase price would be at risk if the acquisition were liquidated. Generally speaking, acquirers will not pay a price representing more than a 50% risk. The higher the risk the more the seller will have to finance even if the price falls within the range of the 3 to 5 year payout rule.
As always, your comments and insight are appreciated in the comments.