One of the critical elements involved when selling a business is determining a price. Coming up with the right price when selling your business is a crucial step, one that could make or break a deal. The seller won’t generate the best return if the price is too low. On the other hand, businesses priced too high will languish on the market. So, just what steps can a business owner take to ensure the price they settle on will result in an equitable sale?

Most sellers have owned their business for years, and they have a rough idea of what it’s worth. However, how did they arrive at that value? In many cases, the initial price considered is based more on emotions than anything else. That’s not a good way to establish an asking price for any property, and it’s unlikely to reflect the actual value of the business. Here are a few strategies commonly used to determine the value of a business.

Work with an Expert

When you’re considering selling a business and need to determine its value, the first step will always be to consult an expert. A business broker has the education and expertise to help clients work their way through the entire business sales process. That doesn’t mean the broker will always evaluate a business to determine its value without input from others.

Your broker will, however, know how to create a discounted cash flow analysis and which databases are reliable for comparable sales when pricing a business. They generally have access to other professionals, including appraisers, accountants, and attorneys who work with business owners during the sales process. Of course, your lawyer and accountant may play important roles in the process, which will help the value of the business. The important thing here is to rely on data and other valid evidence, rather than emotions, when setting a price.

Compare Your Business to Other, Similar Businesses for Sale

One valid way to establish a selling price for your business is to look at similar businesses for sale. A similar business that sells should determine a starting point when setting a price for yours. However, there are some caveats to consider here.

First, the business must be similar. In other words, the price can’t be used without some modifications if the business is larger or smaller. The comparable business must also be in the same market niche for the price comparison to be valid.

Next, is real property included in the sale? Business brokers will want to split out the value of your real estate from the value of your business.  A business can be similar, but adjustments must sometimes be made for each individual business. The amount of inventory, any patents, and raw materials on hand must also be considered. The point is to ensure you’re comparing apples to apples.

Base the Value on Income

Appraisers frequently use the income approach to establish a selling price. What is the total income generated by the business? Usually, businesses will be worth a multiple of their current income stream. Different categories of businesses use different multipliers, but most experts put the value somewhere between two and three times your annual seller’s discretionary earnings (SDE) for smaller businesses or three to five times your annual adjusted EBITDA (earnings before interest, taxes, depreciation, and amortization) for larger businesses.  Aside from the simple ‘multiple’ method, a business broker may build a discounted cash flow model, as well for this approach.

This approach assumes the future income stream to remain stable or increase. If that doesn’t happen, the buyer may be frustrated. Income can be different under different management even when all other factors remain the same, so use this approach with caution.

Use the Cost Approach to Determine Value

Another common approach to determining the value of a business is the cost approach. This strategy adds the replacement costs of real estate, equipment, inventory, and other assets to establish a value. Again, this approach has pros and cons, as “value” can be subjective. Appraisers must use reliable industry sources when estimating values.

The value of any business may vary from one month to the next, which means the valuation at the time of a valuation won’t always be valid a few months later. A bank will want the valuation to have been completed within the last three months or it will need an update.

Equipment values are also somewhat fluid depending on the industry, the age of the equipment, and the maintenance provided. Older equipment must be depreciated to reflect its age even when maintenance has been adequate. Newer equipment that includes state-of-art features will have a higher value and be more attractive to buyers.

Weigh the Validity of All Approaches When Determining Value

For years, valuation experts used multiple approaches when determining the value of a business to deal with changing conditions and other factors. Rather than relying on one valuation strategy, the valuation expert will (to some degree) average the values from each strategy to determine a final value.

However, conditions will vary from one business to another, which means more emphasis may be placed on one valuation technique than the others when conditions demand it. For example, if earnings are expected to increase dramatically, the valuation expert will consider that factor when arriving at a value. In addition, the expert will explain the rationale for the valuation to the client. Coming up with the right price when selling your business considers many factors.

Consider Other Factors

While the three approaches to value described here are well-established, they should not be the only factors to consider. Remember the three approaches rely on current data and don’t always consider trends that may also impact the value of your business.

One good example is a retail business located in a good area that’s expected to experience significant growth in the future. That location has a value today that may not reflect the future potential. Even the most effective calculations by an appraiser may fail to reflect how growth will impact the business in coming years.

Plan Now for a Future Sale

If you’re considering selling anytime in the next few years, now is the time to discuss your plans with a business broker, your accountant, and an attorney. To maximize the price of your business, specific steps will be required. Those steps often take time to complete, which means the sooner you begin planning for the sale the better off you’ll be.

Your business broker, accountant, and attorney will all provide input in how to position yourself for the eventual sale of the business. Get started today by contacting a business broker for additional advice. Coming up with the right price when selling your business is a crucial first step!