Buyer and Seller: Different
Determining the value of a business
is the part of the buy-sell transaction most fraught with potential for
differences of opinion. Buyers and sellers usually do not share the same
perspective. Each has a distinct rationale, and that rationale may be based
on logic or emotion.
The buyer may believe that the purchase will create
or an economy of scale
because of the way the business will be operated under new ownership. The
buyer may also see the business as an especially good lifestyle fit. These
factors are likely to increase the amount of money a buyer is willing to pay
for a business. The seller may have a greater than normal desire to sell due
to financial difficulties or the death or illness of the owner or a member
of the owner's family.
For the transaction to come to conclusion, both parties must be satisfied
with the price and be able to understand how it was determined.
Factors That Determine Value
The topic of business evaluation is so complex that any explanation short of
an entire book does not do it justice. The process takes into account many,
many variables and requires that a number of assumptions be made. Shannon
Pratt, a noted business valuation expert, names six of the most important
The rule for using rule-of-thumb formulas for pricing a business is don't
use them. The problem with rule-of thumb formulas is that they address few
of the factors that impact a business's value. They rely on a "one size fits
all" approach when, in fact, no two businesses are identical.
Rule-of-thumb formulas do, however, provide a quick means of establishing
whether a price for a certain business is "in the ballpark." Formulas exist
for many businesses. They are normally calculated as a percentage of either
sales or asset values, or a combination of both.
Using comparable sales as a means of valuing a business has the same
inherent flaw as rule-of-thumb formulas. Rarely if ever are two businesses
truly comparable. However, businesses in the same industry do have some
characteristics in common, and a careful contrasting may allow a conclusion
to be drawn about a range of value.
Balance Sheet Methods of Valuation
This approach calls for the assets of the business to be valued. It is most
often used when the business being valued generates earnings primarily from
its assets rather than the contributions of its employees or when the cost
of starting a business and getting revenues past the break-even point
doesn't greatly exceed the value of the business's assets.
There are a number of
methods of valuation including book value, adjusted book value, and
Income Statement Methods of
sheet formula is sometimes the most accurate means to value a business,
it is more common to use an income statement method. Income statement
methods are most concerned with the profits or
produced by the business's assets. One of the more frequently used methods
is the discounted future cash flow method. This method calls for the future
cash flows (before taxes and before debt service) of the business to be
calculated using the 4-step formula...