Pricing a business you own is thrilling and scary. You may have poured your heart and soul into the company so you need to make sure it is worth what you’re asking for.
Many people are interested in how to determine the selling price of a business. The value of a company is determined by how much money it makes, how long it’s been around, and its future prospects. You can use the following formula for determining a ballpark figure:
Where “N” is the number of years remaining until retirement, “EBITDA” stands for earnings before interest and taxes divided by total assets (assets minus liabilities) and “K” represent the expected rate-of-return on investments owned by shareholders.”
Return on Investment Method
This approach treats the business as a whole and calculates how much money it would cost to purchase the company’s assets outright, then subtracts the sum of all liabilities.
The value is calculated as follows:
Where “P” represents the selling price in dollars and “L” represents total liabilities (debt).
Weakness of the ROI Method
From an investor’s point of view, this method is more difficult to determine because it doesn’t take into account how a company’s assets are financed.
It also provides no consideration for liabilities, which will affect the total selling price and may result in an inaccurate calculation of value.
Similar to discounting cash flows, investors can also build in various assumptions about future growth rates, the time period over which assets are discounted, and how to account for inflation.
The ROI Method is more useful when there is an observable market value of tangible assets or investments in place that can be calculated by a third party.
Sales of Comparable Businesses Method
It doesn’t matter what the ROI is: your business is worth what someone will pay you for it.
This method is useful when there are no comparable businesses in your market or industry, due to a lack of quantifiable data.
It relies on sales of other “comparable” companies that go through the same process as yours with regards to assets and liabilities – though this can be difficult if they don’t operate in the same geographic area.
The more similar the two companies are, the better idea you’ll have about how much your business should sell for by comparing their sale prices.
A word-of-mouth price comparison could also be helpful here: find out what people from outside the company think it’s worth!
Weakness of the Comparable Method
In one sense, this is a great approach because it gives you a concrete number to use. The downside, however, is that it relies on other companies selling in a similar market as yours and going through the same process of assets and liabilities: so if you happen to be unique or atypical for your industry (for example, an independent bookseller), then this method might not work well – there’s no one else quite like you!
There are also problems determining how much comparable businesses paid for their own assets when they bought them. This can make estimating what your business should sell for difficult because any decision will have been made based on a different set of circumstances than yours; while it may still provide some indication about the potential sale price of your company, it isn’t necessarily representative.
The Industry Formula Approach
Many financial information services have created formulas for how to determine the worth of a company in different industries. These can be very useful, especially if you need an estimate quickly and don’t have time to do your own research.
In general, these formulas are based on inventory, sales volume, costs of goods sold (COGS), gross profit margins or net earnings before taxes plus depreciation expense. The industry formula approach to determining the selling price of a business is less accurate than some other methods because it takes into account only limited aspects of what makes up total value; but it’s straightforward enough that most people should find it relatively easy to use and understand.
Weakness of the Industry Formula Approach
The weakness of this approach is that it doesn’t take into account the following factors:
· The type of inventory, such as high-end or low-volume items.
· Whether a company earns revenue from services instead of products.
· How many employees are needed to operate the business at optimum efficiency levels.
Asset Value Approach
This approach begins by totaling the value of all assets the company owns. A valuable approach is to then take this asset value and divide it by how many years it will be until the business can break-even again with new customers or without any growth in sales.
The asset value approach can provide a good estimate of the selling price but it’s not as accurate and dependable as if you don’t adjust for them first. So how do we know what is relevant? Research! This can come either from an experienced accountant, people who have been through startups before, friends in similar businesses or by talking to other companies in your industry about their pricing strategies and why they chose them over other ones available today.
Regardless of which method you choose to use when finding the best way to determine the sale price- there are some questions that need answering:
- How much equity will be allocated to each shareholder?
- What type of company structure should be used (corporation vs sole proprietorship)?
Which Way Is Best for You?
Try roughing out an appropriate sales price using each of these approaches and then make your decision based on how you feel about the risks and benefits. Going through the calculation process for each method will help you decide which one is the right fit for your particular needs.