Make an offer that works: the power of incentive
Would you expect to buy a new Lexus for $10,000? Or a house on 3 acres with 9,000 square feet of living space in a new section of town for $75,000? How about a gallon of gas for $1.85?
It doesn’t seem like that long ago that gas was selling for $1.85, but today you couldn’t dream of getting it for that price. Why? There is not enough incentive for the owner of the fuel to give it to you for that price when he has others who would pay much more. It probably cost him more than $1.85 to purchase the fuel and refine it! So how much is enough? When you’re about to make an offer to buy a business, the million dollar (or more) question becomes “Will you guess the correct purchase price?”
Many people struggle with this question. And guess what, it’s not just you who fights. Even the best people in the business who buy and sell other businesses try to figure it out. The truth is that value, like beauty, is in the eyes of the beholder. There is no scientific justification for why a company is worth 8 times its annual EBITDA one year and then 5 times a month later.
Yes, market conditions and attitude play a big role in determining the value of a going concern. But how much is it really worth? Nobody really knows. The price of a business is determined solely by what you pay. Under normal circumstances, companies are purchased in an arm’s length transaction. As the definition states, the fair market value of a business is what a seller and a buyer, both in possession of all relevant facts and conditions, and not under harshness, agree on as price.
But since you are the buyer, what price should you offer? We get that question a lot. Be careful here. As a buyer, make sure you have objective advice when and if you want to determine an offer price for a business. Remember, most brokers and dealers are actually agents of the Seller and as such should ethically caution you against asking them for pricing advice. They cannot be targets on your behalf.
They may help discuss issues with you, but in the end it is you and ONLY you who make the final decision on what to offer. Your paid advisors are usually hired to highlight the flaws and risks of a decision you want or need to make. The actual level of risk that you accept and are willing to take is something you need to own. no one will do it for you.
When YOU want to bid on a business of your own, YOU are the only one who can take that leap of faith as to how much is enough. That winning PRICE is something that tips the scales in your favor. It is something that makes the business owner take a break and think about its value to him. In a word, it is a price (and terms) that INCENTS them.
A buyer should only make an offer based on the value of a business. But that offer should incentivize the business owner to accept the sale. Unaware of the process to use to determine the value of a business or determine an offer price, many buyers get confused and make unrealistic offers, both high and low.
An offer price that encourages a seller to sell, but is not representative of the value of the business, is a bad offer. Offering a high price to ensure success could be disastrous. The company’s cash flow may not support debt service or provide a competitive return on investment to shareholders. An informed seller may be afraid of the possibility that you will not pay the money you owe and then be forced to take back the business, something that you probably don’t want to happen.
Unfortunately, the opposite is also true in many cases. Buyers bid on everyday deals that don’t work out. Why, because the buyer did not offer the business owner enough incentives to sell. This article isn’t trying to help you price a business, but keeping that in mind will help you understand the psychology of a sale. HAS good business that is profitable, has a strong positive cash flow and has an excellent outlook for continuing operations, has definable value. As a buyer, you must determine how to assign a value to the business that is attractive to you and meets your needs.
You may never know exactly what will incentivize the Seller. However, during your discussions with the Seller and other investigative work, the Seller should try to determine what would incentivize them. I have seen businesses sell for 10% of their value because a salesperson wanted to walk away and just make sure their customers continued to be served. But, as you probably guessed, that happens once in 10,000 times.
When determining what price to offer, first determine a price range that makes sense to you. Ask yourself how much you need to earn. What are the possibilities to increase cash flow? What are the risks? Find comfort with the range. It’s not unusual to be nervous about that much, especially at the top end. But, it still has to be feasible for you.
Now try to determine what the Seller would consider reasonable, and it would incite them to give you the kidneys. Keep the following items in mind when trying to make this determination:
- How much is the cash flow multiple? Is it within current industry standards or not? If it is too low, the probability of a better offer from someone else is very high.
- Are the mix or the price and terms reasonable? There is a big difference when a price is actually paid off with loan payments or profits. Remember this formula that a seller will consider:
- Price=Cash Now + (Cash in the future * collection risks).
- How long would it take for an owner to EARN the money you are paying them? at closing and that there is no risk of collection? If it takes 2-2 1/2 years OR LESS, most sellers would prefer to stay in business, keep what they earn in that time, and then just shut it down. They will not have closing costs, aggravation of a sale, nor will they have to deal with a third party in control during the transition period.
- If the assignment of your transaction will result in a high tax consequence for the Seller, it may not be profitable for you to sell. Ask your broker or tax accountant the true implications of an assignment both for you and (not directly obvious without considering your personal tax situation) for the Seller.
- An offer can be seen as insulting (in dollars or terms) and not indicate to the owner what the value of their efforts has been. This could lead to being disqualified from receiving a counter offer or even negotiating a new offer!
- You are not doing the seller a favor by buying their business. They are likely to be proud of what they have built, and would not sell it for a lower price or condition than they would give away a prized painting they own because they have had it for too long.
- Offers should be priced non-emotionally. However, that does not mean that in all cases the Seller will evaluate it without emotion. If you, as a buyer, believe that a seller will place too much emphasis on emotion versus value, he may be wasting his time. You need to evaluate both the vendor and the business to ensure that you are using your time, money, and resources effectively.
When you finally get a business owner to agree to an offer price, chances are neither you nor the seller got exactly what you wanted. You’ll think you paid too much, or maybe you made the terms more in the seller’s favor, and they’ll think you got a bargain price and are being too harsh on your terms and payment requirements. That doesn’t mean there was a disagreement. It’s just the nature of negotiations. No one thinks he really won.
To be prepared! Understand the psychology of what motivates a seller. Be careful to offer only what a business is really worth. Understand that you may have paid more than you intended, but if you have faith in the business, as well as your experience and skill set, hopefully your investment will pay financial and psychological dividends for years to come.