An Explanation: Pricing a business

Why is there not a single asking price that includes everything?

The short answer is to protect both the buyer and seller from reasonable misunderstandings that crop up after the close.

Most business sale transactions will end up as the net of:Pricing a business

  • The negotiated price for the business,
  • Plus the value of the current assets (inventory, supplier deposits, receivables, etc),
  • Minus any debt still on the books at the close of the transaction.

Current assets and debt change daily as business happens. Receivables and payables due down the road continuously accumulate and retire.

Business brokers think the value of the business is simply what is negotiated. Accountants and bankers then figure out the net of the current assets and the debt.

Any business is worth the rewards of ownership times some comfort multiple that those rewards will survive a change of control.

In pricing a business, the firm is mostly worth it’s history of success with minor (unless there is inventory) adjustments for it’s day to day changes of cash and near cash items.

That history of success is expressed as earnings for Revenue Canada and normalized cash flow for bankers and business buyers.

The difference is in how certain expenses are treated. This is explained on our page discussing normalized cash flow.

The prices shown in business brokerage are the asking price for the firm’s continuing normalized cash flow including all the operating assets the seller uses to capture that cash flow.

Most often you’ll find the seller of an owner-operated business is asking three times normalized cash flow. This is because pricing too low leaves money on the table while pricing too high scares off buyers.

The difference between the three times NCF asking price and the actual selling price is finalized through negotiation.

It is thought of as if assigning a ‘comfort’ multiple to the cash flow figure on the basis of the buyer’s comfort that the cash flow will continue through a change of control.

This final selling price buys all the ‘stuff’ owned by the business operation and used to produce the cash flow such as equipment, goodwill, customer lists, web sites, etc. Non-operational assets are not included and will be removed by the seller.

It does not include items carried on the balance sheet as ‘current assets’. The largest example may be inventory, but may also exclude cash in the bank, receivables, landlord deposits and other ‘near cash’ items.

The negotiated sale price also does not include any debt. The price shown is for a debt free business.

This accepted methodology when pricing a business is not based on anything other than grade nine algebra. Forget any theory of what should be included where.

What we are doing is solving for Transaction Price (TP) by removing the ‘knowns’ (All debt and the Current Assets) leaving only the unknowns (X) to be discovered through negotiation.

This number is expressed using the normalized cash flow multiple for owner operated businesses (or a higher EBITDA comfort multiple for firms with the ongoing and continuing skill set of arms-length management).

Caution: EBITDA presumes continuing  skill set so it is worth more than normalized cash flow.  I have seen folks price on EBITDA multiples when there is no accompanying comfort from skills that will continue through the transition.

Run like mad when when you see this. Somebody either doesn’t understand EBITDA or, in the worst case, is hoping you do not understand.

This does not mean that there will be no adjustments to the current balance. Buyers will insist it be purged of aged receivables and inventory. And buyer’s usually don’t want to borrow money to pay for cash left on the books to escape taxes by the seller.

But except for firms with inventory, the adjustments to the current balance are seldom material to the total final price.

Upon closing, all outstanding debt will be subtracted from the negotiated selling price. This usually only happens in cases where there are debts that incur a penalty for early payment.

Then the value of current assets will be added to the negotiated price.

Pricing what is called the ‘current assets’ by the accountants is pretty straightforward with little need for negotiation on value other than for old inventory or receivables.

Some of this is year end stuff and its exact value on the last year end is readily available. There will be another year end deemed at the ‘change of control’ so its exact value will again be known.

To ease negotiation worries that there may be a surprise value to the current balance, the seller can certainly give estimates of where it is today or agree to lock in a value that it will not exceed.

Removing the current assets from the price also affords fairer pricing since it prevents gaming. There is no incentive for a seller to change the way he conducts his day-to-day operations during the sale process.

Again, run if you hear ‘the final price includes inventory’. This clause gives a seller the incentive to run down inventory levels prior to the close by offering mark downs to customers.

This may lead to a situation that, when the new buyer takes control, he’s faced with a customer base that has used these markdowns to make larger than normal purchases. The upshot is that it may be a while before customers have a need to re-purchase.

Trying to stop that by stating a value for the inventory (or any current balance item) into the purchase agreement is arithmetically the same as saying the inventory is not included since all that does is subtract a known value from one side of the equation and adding it to unknown side. Your grade six math teacher would have shuttered since it complicates the math while the total price does not change.

But a more subtle reason is that cash flow is cash flow and a dollar is worth a dollar.

To include inventory, as a prime example, would mean that the value of a dollar flowing from a firm distributing products would be different for a firm providing a service.

That is ridiculous. Profit is profit and that’s what the buyer is buying.

Doesn’t this mean that if one firm’s final price is going to be twice as much as another, then certainly that drops the relative value flowing from that dollar?

Yes. And one place where this most common and which we are all aware of it is our RRSP’s. The value of a dividend producing share or TD inside our RRSP’s is worth much more than in a margin account. This is because in the RRSP, the cash flow compounds tax free. But the price of the share is the same since the value of a dollar is a dollar.

The most common way to adjust for this is to build a pro forma statement.

This is what you do when deciding how to balance your RRSP’s and your margin account.

A business purchase pro forma adjusts the normalized cash flow statement to reflect the realities of the new buyer.

A pro forma adjustment to account for inventory adjusts the cash flow downwards by inserting a carrying cost (interest) on the inventory.

This gives a more realistic adjustment than including the current balance or any portion of it into the value of the cash flow.

But remember a pro forma simply gives a better reflection of value for the circumstances of the prospective buyer. It results in the same difference on the price of a business as the difference in price between the same share in a margin account or an RRSP.

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David Page | An Alberta Business Broker