How to Choose Your Initial Offer Price When Buying a Business

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When buying an online business, it can be difficult to know how much to offer initially. Obviously you want to get the best price possible for the business, but you also want to make sure you get the business.

For most buyers, there is a fear of ‘overpaying’ by making your first offer too high. But what does it actually mean to ‘overpay’? What determines if you actually paid too much for the business?

Do you overpay if market prices are lower than what you are paying? Or, are you overpaying if you could theoretically get the seller to accept a lower price?

In this article, I want to explore how you can figure out how to make that initial offer without overpaying. I’ll also explore the nature of business values and how they are not objective, but rather relative.

A Business’s Value Is What Someone Is Willing To Pay

To start off, I want to establish an important, yet simple, principle.

Business valuation formulas do not determine the value of a business. They attempt to predict the value of a business.

If a business valuation says that your business is worth $1.2 million, this doesn’t mean that this is what a buyer must pay for your business, it is simply a prediction of what the marketplace will likely pay for your business.

But if there isn’t a buyer who is willing to pay that $1.2 million, then the business valuation doesn’t mean much.

So when we think about business values, it’s important to start with this basic principle. A business’s value needs a buyer who is willing to pay that much for the business itself.

A Business’s Value Is Also Dependent On The Seller

While this first principle is probably pretty obvious, it is also important to recognize that the seller has some determination in a business’s value.

If a business valuation report says that the market value of your business is $1.2 million, you may see that figure as being lower than what you would be willing to sell your business for. In fact, this is a scenario that happens all the time.

When we provide our free valuation services for website owners, most owners prefer to hold on to their businesses rather than sell them. What these owners are essentially saying is that their business is more valuable to hold onto than what the market is currently willing to pay.

no deal

I like to refer to this as a business owner’s separation value. An owner’s separation value is the amount of money it would take to convince them to sell their business.

Most of the time, this separation value is significantly higher than what the marketplace is willing to offer. It is only when an owner’s separation value drops into the market values, or when a buyer is willing to break out of market values, that a deal can get done.

Even Within the Market, Values Tend To Be Relative

In an effort to find out what you ‘should’ pay, many buyers look to seller comparable reports to see what other buyers are paying for similar businesses. Marketplaces such as BizBuySell publish these marketplace reports and advertise that they can help you determine what a ‘fair’ asking price should be.

BizBuySell_–_Business_Valuation_Reports

But the idea that this report can help you determine a specific asking price for a business you want to acquire is misleading, at best.

The fact is, business values vary greatly from one business to the next. And this can be seen in these reports.

I ran a report with BizBuySell.com and graphed out the last 40 deals they recorded to see just how easy it would be to predict the value of a business based on their data.

At first, it seemed as if they offered a simple, straightforward answer:

Valuation_Report_for_Consumer_Services__B2C_

Based on this report, I should offer a multiple close to 2.03 on the cashflow of the business I want to buy.

But if you break down the data that makes up this report, it becomes clear that almost none of their reported sales sold for a flat 2x multiple on the cash flow.

Below is a graph showing the last 40 sales that BizBuySell used to come up with their 2.03 multiple. Each dot represents an individual sale:

scatter chart

While there are a few sales that happened on or close to the average multiple, the vast majority of sales strayed from this average number fairly significantly.

In fact, some sales had multiples as low as 1x cashflow while others were as high as 4x cashflow.

How would this impact your offer price? Well, assume that the business you want to acquire has $100,000/year in cashflow. BizBuySell suggests an average asking price of $200,000. But historical data shows some businesses that would suggest an asking price of $100,000 all the way up to nearly $500,000!

Business Values Are Extremely Relative

While business comparable reports can be useful to judge the macro-health of a marketplace, they are really not useful to determine a specific asking price for an individual business.

The reason for this is that the value of a business depends on multiple relative factors.

How Value Differs From One Buyer to the Next

A few months ago I wrote an article on an acquisition I made that failed spectacularly. In that article, I explain what went wrong (which was a lot of different things). One area that really tripped me up was the fact that I did not have any experience in e-commerce.

This lack of experience in e-commerce raised the level of risk for me personally. When I acquired this business, there was a lot of factors that carried an extra learning curve and several new areas of potential mistakes and failures (which I frequently fell into).

But while this failed acquisition was relatively risky for me to pull off, an experienced e-commerce owner would not have carried nearly the same level of risk. For someone experienced in e-commerce, they would not have been exposed to nearly the same number of potential mistakes since they would have had plenty of background to protect them from falling into some of the rookie mistakes I made.

This dynamic among buyers is common: the relative value of an individual business will vary from one buyer to the next based on their experience, their assets, and their individual abilities.

So while a $500,000 e-commerce business with a warehouse and self-fulfillment might represent a number of risks to a first-time buyer, for a buyer who already owns their own warehouse and fulfillment staff, it won’t be nearly as risky. Because of this, that first buyer will likely need to pay less in order to account for their relative risk.

So How Do You Determine An Offer Price?

If the value of a business is so relative and so fluid, how can you ever determine an offer price for a business you want to acquire?

I would recommend you follow the three steps below.

First, Start with Market Comparable Prices

Yes, the prices within the marketplace can vary widely depending on the individual business. So using market comparable prices to determine a specific asking price is probably a bad idea.

However, market comparable prices can put you in the right vicinity to make an offer. Even though the prices of the businesses from the market comp report varied significantly from one business to the next, around 90% of the businesses fell within a certain range of multiples.

scatter chart 2

So this becomes your starting point for making an offer.

Next, Consider What the Seller Wants

Buyers often make the mistake of thinking that a seller is being ‘unreasonable’ if they want a price higher than what the market is willing to pay. But this thought is wrong.

Sellers aren’t being unreasonable for wanting more than what the market is willing to pay. Rather, sellers who want more than what the market is willing to pay understand that their business is worth more to retain than what the market is currently willing to pay.

As I explained above, sellers have their own ‘separation value’. Typically this separation value is significantly higher than what the market is willing to pay. Only when a seller’s separation value comes close or within the range of market prices does it make sense to sell that business.

But even when these prices intersect a seller still has a minimum separation value. In the venn diagram below, you can see that you may still make an offer that the market says is acceptable, but doesn’t meet the seller’s minimum threshold.

Because of this, you need to consider the seller’s asking price and general expectation. Ask yourself the following questions:

  • What do you think is the motivation for selling the business?
  • How long have they owned the business?
  • How long has the business been on the market?

Based on these and other questions, you can get a sense for how firm their asking price really is.

Finally, Determine Your ROI & Risk

The most important step in determining how much you should offer for a business is to understand what you expect to get in terms of a return, and discount this for your relative risk.

This is really where you develop your offer price.

As we have already discussed, each business has a certain value to you as an individual. Most businesses for sale will actually have very little value to you, especially if you are not interested in the business itself.

Ask yourself the following questions:

  • How much monthly and quarterly cashflow do I want to earn?
  • How much work is it going to take to maintain that monthly & quarterly cashflow?
  • What skills will I need to have to run this business?
  • What could upend this business and disrupt that cashflow?

Consider this from your personal point of view. If the business requires heavy SEO and you have little to no experience in this, then the risk is high. If the business is located in a niche that you know little about, then the risk will be even higher.

Know When It Makes Sense To Walk Away

If you do this basic exercise outlined here today, an offer price will begin to take shape.

A mistake that buyers often make is to skip these considerations and become obsessed with the idea of ‘winning’ the acquisition. This sort of emotional decision-making pushes them into making bad investments.

Understand what ROI you need from the business and make your offer accordingly. It is possible that the relative value for the seller will be higher than your relative value. If that’s the case, then it is better to walk away.

Hopefully, however, the seller’s relative value will coincide with yours and a deal will be done, mutually beneficial to both sides.

Conclusion

Deciding how much you should offer the seller is extremely important in getting the best bang for your buck. Putting together your offer is an art which takes time to perfect, so don’t be discouraged if you get knocked back a few times. Take your own personal circumstances into account, decide how much you can afford to borrow and subsequently pay back, and make your offer.

You may be pleasantly surprised at the seller’s response.

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