This article are provided for information purposes only, and are not intended as legal advice.


How do buyers price a business?

October 16th, 2009
You are selling your business and you came up with a selling price. Presumably you analyzed your information and priced the business at what you believe market to be.
 
The buyer also does their calculation to determine if your purchase price that you are asking makes sense. Buyers like to be able to pay for the purchase in 3 to 5 years. Don’t forget that in order to recover the cost of the acquisition the buyer of the business must make enough money to pay income taxes on the profits in addition so that the net after tax earnings retained in the company is equal to the purchase price.
 

If the business makes on a normalized basis $100,000 per year and you paid $300,000 for the business and were able to borrow the entire purchase price.

 

Let’s use an example to explain how this works.  If we assume the tax rate to be 20% that means that the business has to earn $375,000 before tax to net $300,000 after tax. Factoring in interest this investment would take approximately 4 years to recover the original investment.

 

If the tax rate was 50% then the company would need to earn $600,000 pre-tax to pay taxes and retain enough in the business to cover the cost of the acquisition.  In this example it would require 6 years of earning to recover the original purchase price on an after tax basis.  If you factor in financing, it will take even longer.

 

This example shows that the period to recover the original purchase price is dependent on tax rates. If this was an asset purchase, you may be able to claim amortization on some of the assets purchased. This will shelter some taxes and reduce the pre-tax income that you need to earn to payback the original investment.  If you allocated $200,000 to fixed assets and if you could amortize those assets at 10% per annum you would shelter $4,000 in taxes if your tax rate was 10%.  Although this is not a large saving, every little bit counts.  Buyers of the business want to purchase assets of the company because they can reduce their exposure to unreported liabilities and they can write off part of their purchase price to shelter taxes.  This in turn reduces the amount of money the business has to earn to recover the cost of the original purchase price.

 

 

A good investment will pay back in 5 years. If the investor already owns a business and can generate some synergies then the payback time will drop because they will be able to earn more than the original business made with the same revenue.


Filed under: Buying a business — Gary Landa @ 7:29 am


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