Negotiating the Price of a Small Business: Part 1

Part 1: Agreeing on valuation techniques, assumptions and inputs

 

As discussed in our Value versus Price post, conducting a business valuation doesn’t necessarily yield the final price a company or asset is bought or sold for. Far from it – a valuation is usually just the starting point for a more involved (and subjective) price negotiation.

 

Over a series of blog posts, we’re going to share a comprehensive overview of the factors that typically influence these price negotiations. To keep focused, and hopefully be as useful as possible to you, we’ll use the example of buying/selling a small business to illustrate these various factors.

 

Our goal here isn’t to teach negotiation. Instead, we hope that by unpacking some of the technicalities, and sharing some of our valuation and transaction experience, you can be more informed and better prepared to negotiate. You can also be more reasonable in seeking out a fair middle-ground on price, which enables more good deals to close – benefitting everyone.

 

With this in mind, let’s start with the first factor that is often (and sometimes unknowingly) negotiated before even looking at the underlying target company: the valuation methods, assumptions and inputs used to frame value for a small business in the first place.

 

Using different business valuation methods

 

The first point of contention in many transactions is that different parties may use different business valuation methods to value the same underlying company. For whatever reasons, any party can justifiably use one (or a combination) of the three broadly accepted business valuation methodologies, including: 

 

  1. an income-based approach (of which the discounted cash flow (DCF) method that EquityMaven primarily uses is the most commonly accepted)
  2. a market-comparable approach
  3. an asset-based approach

 

There are other more asset or situation-specific methods out there too, like the venture capital method for startups, or the capitalization approach for real estate. Clearly, if buyers and sellers go about determining the value of a small business using different valuation methods, their initial views on a fair price for the company could be far apart.

 

Using the same methods, but different inputs or assumptions

 

Next, even if the parties agree on a business valuation method, they can rightfully disagree on the inputs and assumptions to use in their calculations. This happens all the time. For example, a buyer and seller could agree to use a market-comparable approach, using the conventional EV/EBITDA multiple method, but then disagree on the multiple, or even the definition of EBITDA itself.

 

A buyer might argue to use a trailing 3-year average measure of EBITDA (usually lower in a growth company), whereas a seller might contend that the most recent trailing 12-months, or even the current month multiplied by 12, is the best indication of EBITDA going forward (usually a higher version of EBITDA).

 

Also, time-frames aside, buyers and sellers can (and often do) argue over other factors that influence EBITDA, like cyclicality/seasonality, inclusion/exclusion of certain one-time revenues or expenses, and/or other owner-specific accounting practices. In short – because there are some many variables in any company valuation, even if using the “same” valuation methods, parties can come to dramatically different answers.

 

As an aside, this is part of the benefit of using EquityMaven to value a small business – it offers an objective “locked-box” valuation tool that generates consistent and unmodifiable answers that parties can trust (and, perhaps argue over less!). It can give any party a theoretically robust and defensible valuation – or, put differently, a formal view on value – to begin the negotiation, or “price finding” process.

 

In Part 2 of our blog series on Negotiating the Price of a Small Business, we shift our discussion of negotiation factors from valuation specifics, to the characteristics of the underlying company. A complete version of this content is available to EquityMaven’s subscribers in e-book format.