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Many people are convinced that there are some quick rules of thumb that could determine the value of a business. Some of these rules of thumb state, for example, that an insurance agency is worth 1.5 times annual commissions, or that a chemical manufacturing company is worth 6 times its EBIT. These formulas may indeed be fair averages, but they give very little help in determining the value of a particular business.

The problem with rule of thumb formulas is that they are statistically derived from the sale of many businesses of each type. That is, an organization might compile statistics on perhaps 50 chemical manufacturers that were sold over a three-year period. They will then average all the selling prices and calculate that the average chemical company sold for an amount equivalent 6 times EBIT. The rule of thumb is thus created. However, some of those companies may have sold for 2 times EBIT, while other for 7 or 8 times EBIT.

The business with expenses and profits that are right on target with industry averages may well sell for a price in line with the rule of thumb formula. Others will vary.

Rule of thumb approaches tend to work in two situations: One is in industries that are rapidly undergoing consolidation, especially if the rolled up companies are being taken public.  In the late 1990s and early 2000’s, for example, internet service providers (ISPs) were bought and sold based on number of subscribers or subscriber revenues.  The other situation in which rules of thumb work well is in acquisitions where the cost structure of the acquired company is almost irrelevant to the acquirer. An example is the payroll industry. When a large payroll processor acquires a small operation, the percentage of revenues spent on labor, software, rent, etc. becomes irrelevant as the customers are switched to the larger processors software and systems.

At any given time, a few businesses are actively on the market.  While you might find a few good acquisition candidates from the pool of businesses that are listed for sale, the odds of doing so are not great.  What’s more, once a desirable business is actively advertised for sale, it will attract several qualified buyers leading to significant competition among the suitors.

There are a lot of business owners that aren’t actively looking to sell but would consider selling under the right circumstances. We call these the gray area sellers. It is among these gray area sellers where we believe the best strategic acquisition opportunities lie.

Finding these gray area sellers is not easy.  Selling one’s business is an emotionally wrenching undertaking, such that even an owner considering selling will not always readily respond to a query about selling.

In future posts, I’ll outline some methods for finding gray area sellers.

Often, too often, a would-be buyers and would-be seller spend time in phone conversations, meetings, and information gathering, only to realize they are very far apart on valuation and terms.  It’s good to establish ASAP whether you are in “deal making range”.  We like buyers to submit an initial non-binding  proposal that sketches out price and terms.  This proposal can and should be market as “for discussion purposes only” and “not an offer”.  It’s fine if details are missing at this early phase.  The purpose is to discover whether a deal is within the realm of possibility.  If  buyer & seller are say  10% or 20% apart, a deal could well happen.  If however, the parties are say 50% apart on price and seller wants all cash and buyer expects  that seller to finance 70% of the deal, well there probably will be no deal and therefor no reason to spend more time trying to make one.

Much is made of this being the right time or the wrong time to sell one’s busienss based on the economy, the political climate, or other outside factors.  IMO, the right time to sell is when you decide you’d be happier doing something other than running your business every day.  I’ve seen it all too often: an entrepreneur builds a business and eventually looses enthusiasm for it, until it becomes more burdensome than fun.  If he holds on to the business beyond that point, it slowly but invariably deteriorates, ultimately to to the point where it is no longer a salable asset.

Having said that, the economy for M&A has improved lately.  Some lender money is flowing and prospective buyers are, well, becoming real buyers.

In summary: if you are ready to sell, don’t let the economy or the M&A climate hold you back.  You can no more time the best moment to sell your company than you can time the stock market.