Recently an entrepreneur I know contacted me to help her figure out what many would call a “high class problem.”  She had a potential buyer for her business, and the buyer was asking her the price at which she would be willing to sell her business.  Not surprisingly, valuing her business to sell was not something that she had been spending any particular time working on – she was too busy growing her business – but even if she had taken the time she admitted she really had no place to begin.  Over the next few days we had series of conversations about how to value her business -- the overall themes of which I thought would be of use to other entrepreneurs.  So, with that, here are some thoughts on how you deal with the issue of “what’s your business worth” when an unsolicited buyer comes along.

A business, for a buyer, represents a number of potential positive attributes – reaching new customers, acquiring important technology and adding to cash flow are some of the reasons to purchase an existing business.  In determining whether a business purchase is a good deal to pursue, the buyer will balance the price to pay for the benefits to be obtained, against the cost to the buyer of acquiring those benefits.  If the benefits outweigh the costs – the buyer will move forward.  The costs might include things like how expensive is the capital needed for the buyer to pursue the business: is he using equity (very expensive), debt (less expensive) or cash (the least expensive)?  Are there hidden costs – integration, operational distraction or other matters which will cause the buyer to incur other expenses?  There are many other potential costs, but the point is that the matter of the buyer’s cost is not likely to ever be truly visible to the seller.

The only thing that is visible to the seller is the price that is offered by the buyer.  And, that price gives a few pieces of very important data.  The first is that the seller knows that at the price offered, the buyer believes that benefits of the deal outweigh the costs.  Buyers won’t overpay for businesses – they pay what they believe is necessary to achieve their hoped for benefits.  A seller won’t necessarily know what the buyer’s true value analysis is for her business, because the seller cannot know the weight that a buyer places on the various reasons for pursuing a purchase.  The second, and more important piece of information a buyer gives when communicating a price is possibly more significant – you can learn a great deal about their likelihood of closing and their integrity by the price they offer.  If they offer a fair price, the likelihood of closing is much higher.  This might be the most important piece of data.  How can you determine a fair price?

Business valuations do not exist in a vacuum. While there will be specific reasons how a buyer will value a particular business, there are generally external examples of what other buyers paid for similar businesses. In our economy there is a general sense in business that buyers and sellers will complete a purchase when a deal is “fair” and the deal terms are consistent with “market terms.”  The implicit assumption is that if a buyer does not offer “market” terms, then eventually someone else will.  This assumption drives business sales throughout the economy, and keeps a large number of investment bankers and business valuation experts busy.  Therefore, an informed buyer and seller both have the ability to research and determine how the market has valued similar business sales.

There are two main methods for valuing businesses – discounted cash flow and comparable valuation.  I am not going to spend much time on the mechanics of each in this blog entry although a short summary would be helpful.  Discounted cash flow basically takes the positive cash to be obtained from a business over an investment horizon (say five years) and measures that against the cost of obtaining the capital to purchase the business.  If the outcome is positive, then the business is worth pursuing.  The amount of the “positivity” becomes the maximum amount that a buyer can pay for the seller’s business.

The other method, comparable valuation, looks at the prices paid for similar businesses.  It then takes that price and applies some ratios – purchase price to revenues or purchase price to net income – as a way to see how to value businesses.  This method is very prevalent in the business acquisition market, because a potential buyer (and seller) can quickly determine the ratio of revenues to purchase price for the last ten similar deals (for example) – this gives some external predictability to business pricing.  Of course, the challenge and art form of comparable valuation is in selecting the correct comparable companies, and having access to pricing data for similar deals.  

Of the two methods, comparable valuation is much more prevalent and important, because it doesn’t depend upon any particular business’ cost of capital or internal allocations of other costs.  Both potential buyers and sellers can look at external market data and determine a “fair” price.

From the seller’s perspective, the determination of the correct price also depends upon balancing benefits and costs.  For the seller, the benefits can be things like cashing out and minimizing risk.  Additionally, for situations where the purchase allows the seller to capture upside (say through an earn-out) accessing a larger balance sheet or reaching new customers can be a significant benefit. Costs can include: giving up future profits, losing autonomy and costs of liquidation (if the business is purchased in part). As is the case for the buyer, the seller’s internal calculations of her business’ worth are not available to the buyer.

You should see, therefore, that in the absence of clear visibility into the respective calculations of the buyer and seller into the view of a business’ valuation, both sides and their advisers rapidly fall to comparable analysis to determine if a deal is possible. In other words, if a deal price isn’t externally “fair” then a deal is likely to fail. 

Therefore, the most important thing for a seller to do when asked by a buyer for her business’ worth is to:(i) force the buyer to declare what the business is worth to him and (ii) immediately get as smart as possible about external valuations of comparable businesses.  A potential seller who was not publicly marketing to sell her business should never give first indication of her belief in valuation.  It is up to the buyer to provide that indication.  This is advisable for a number of reasons:

• You will learn how serious the buyer is by how the price relates to the price that would apply in a comparable deal.  The closer to the “market” the more serious the buyer is.  Offers that are significantly off market, either way, should be treated more carefully.
  
• Reflecting on a buyer’s offer gives the seller some time to catch up.  Inevitably, a buyer who comes to call on a seller has had time to consider why a deal makes sense to the buyer.  A seller needs time to consider what her business is worth to her.
  
• If the price indication is deemed by the seller to be reasonable, the seller can then engage in a sale process – exchange of confidential information, negotiation of deal terms and deal completion – with a stake in the ground (the purchase price) controlling the process going forward.
  
• A seller should never, ever give up much confidential information to an unsolicited buyer until a price indication satisfies the seller that the deal is real.