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Business Sale Agreement:

How to Value a Business?
Use Business Valuation Tools

Want to sell your business? Before signing a business sale agreement, you need to know how to value a business and use business valuation tools. This is an important part of planning an exit strategy.

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There comes a time when you want to begin planning an exit strategy.

You may want to retain a share in the business, or sell your business over time, or sell it all as fast as possible.

Do you know how to value a business?

Use business valuation tools and techniques to get an understanding of what your business is worth before you sign a business sale agreement. But also recognize that you will need, at least, your accountant and lawyer to help you sell your business.

And it is a good idea to work with an accredited business valuation specialist, broker, or sales agent to help you sell your business for the best price, and with the best terms.

Don't sign a business sale agreement until you are sure you have a clear understanding of how to value a business and what your business value is.

Before signing a business sale agreement: use (or hire a consultant to work with you) Business Valuation Methods that will help you to determine the right market value.

Some Business Valuation Tools and Techniques:

  • Asset-based valuation: The business is valued for its salable assets.

    Book value of 'hard' assets: only to be used if the financial are recast to adjust the book value to current market value (current adjusted book value is the bare minimum value for your business).

    • Liquidation value: Amount left over if you sell business quickly and use sale proceeds to pay off debts.

    • Costs for selling your business include time, broker's commission, legal fees, accounting fees, clean-up costs, moving costs, and more (as applicable).

  • Historical Earnings Valuation: Based on the business' historical earnings and allows a goodwill value (above the market value of assets), if justified by earnings.

    (Assumes the past is a fair predictor of the future; this is particularly arguable if market conditions or economic conditions have changed or are expected to change or if the historical earnings had some significant trend variations).

    Usually a weighted average of the last three to five years is used or a trend line approach.

  • Debt Paying Ability: Will the business be able to generate enough cash to pay off a business loan (to buy the business)?

    To determine the business' debt paying ability start with historical free cash flow (net after-tax earnings minus capital improvements and working capital increase, and depreciation is added back in). Do not include interest on any existing loans; assume it is debt free at time of purchase (since the new owner will be financing new debt, not old debt). Multiply annual free cash flow by number of years in the acquisition loan term. Subtract down payment. Remainder is amount available for interest and principal payments and return on investment.

    For example: Assumptions - free cash flow is $40,000 per year on a 5 year term loan. 5 x $40,000 = $200,000. If the down payment was $20,000, then $180,000, or $36,000 per year, is available for interest and principal payments and to provide some return on investment.

  • Capitalization of earnings or cash flow: Determine historical annual earnings (that is, earnings before interest and taxes (EBIT) or earnings before interest, taxes, and depreciation (EBITD) is used.

    This figure is divided by a "capitalization rate" that represents the return the buyer wants on the investment.

    For example, if the EBIT is $10,000 and the buyer requires a return on investment of 25 percent, the capitalization of earnings method yields a price of $10,000/0.25 or $40,000.

  • Assets and Earnings Valuation: The excess earnings method of valuing a small business takes both assets and historical earnings into consideration.

    Use recast financial statements for the past three to five years. For the balance sheet, use the most recent month and recast for current market value. Then start with the net value of assets on the recast balance sheet and add the business' goodwill or other intangible value (goodwill and intangible value are more challenging to calculate).

  • Market Based Valuation: This is a fairly common method based on market prices for similar businesses (best used in relationship with historical and project earnings and financial statements): known as comparable sales, rules of thumb, and/or industry averages.

  • Future Earnings Valuation: Based on the business' expected earnings, discounted back to arrive at net present value (NPV). A time consuming method of valuation and dependent on accuracy of assumptions of the future.

  • Other business valuation tools and methods are gross income multipliers/capitalization of gross income, dividend paying ability, discounted cash flow method, and more.

Planning an Exit Strategy

It can be hard to sell your business: just a short time ago you were working on getting startup financing and focusing on achieving respectable gross profit margins and on profit maximization. Now, your focus has changed (or is changing).

When planning an exit strategy (and before signing a business sale agreement), consider selling a part interest or share in your business. You may want to sell a part to a member of your family or as part of a management succession plan? Or maybe you only own a part of the business, and you want to sell it?

How to value a business that is being sold in a part or piece? Consider minority interest discounts (usually less or discounted from the price that would be received if the entire business was sold) if you are selling a minority interest in the business. Or, if you hold a majority, consider majority interest premiums so that the majority shareholder receives a higher value or price for a larger share of the business.

Before you sign a business sale agreement, make sure you have been careful in planning your specific exit strategy and that you have done your due diligence in using appropriate business valuation tools for selling your business.

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Additional Reading:

How to manage working capital?

A business exit strategy needs to be part of your small business plan from Day 1 but often is overlooked: ensure that you include it in your strategy.

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Meeting Financing Challenges

Getting financing for starting up your new business is a challenge.

But just as challenging is ensuring that you have enough financing to operate your business.

Most businesses do not have a steady flow of cash incoming (or outgoing); it comes in 'fits and starts' no matter how much we try to plan for consistency in cash flow.

You need to ensure that you forecast your cash flow needs realistically and that you are on top of your accounts receivable; do not let your customers use you as their bank (by extending long payment terms), especially during the start up years of your business when every dollar is important to your success.

Make sure that you are clear in setting up new customer accounts: tell your customers what you need and expect in terms of payment (for example, cash on delivery (COD), 15 days from date of invoice, a deposit on order and balance on delivery, etc.).

However, also make sure that your invoice terms are competitive for your industry; check out what your competitors offer and make sure that your terms are competitive. For example, if you want payment in a shorter time frame than your competitor offer an incentive for that earlier payment: perhaps a discount of the next order, or a rebate, or a gift.

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Alternative Financing Strategies Include:

  • Merchant 'advances': from companies that lend money on credit card cash flow rather than collateral;

  • Accounts receivables or trade financing: from 'factoring' companies that buy and assume the ownership for the invoice from a customer;

  • Raise money through preferred shares (non voting) or common shares (voting) in your limited company;

  • Subordinate financing: typically a higher interest (because it is higher risk) loan based on cash-flow and receivables, rather than on assets.

For each of these alternatives, talk to your accountant and your banker: even if the banker isn't loaning you the money, they can provide valuable input and advice.