Nine Factors that Influence Value

In strict quantitative terms, return-on-investment controls value.  Many other factors influence it.

Thus far, we have been speaking of “value” as the appraisal of what the business is worth.  Value, of course, is not synonymous with price, as the latter simply reflects what the seller either wants for the business or may sell it for.  Therefore, value remains a function of appraised worth while price remains a function of negotiation.  The only relationship between value and price is that value becomes the reference point or threshold from which price is to be negotiated.

Nevertheless, value and price are both affected by many factors:

1. Supply and Demand: This remains the first law of economics.  The value of a business is largely influenced by the number of buyers available compared to the number of businesses for sale.  This shift between a “buyer’s market” and  “seller’s market”  may alter price by 20% or more.  Rapid price increases can be seen in periods of high unemployment when a large number of unemployed turn to small business ownership as an alternative.  Values, of course, are never created in a vacuum, but will always be a function of competitive pressures.
2. Nature of the Business: Similar to the supply and demand, is the influence imposed by the type business involved.  Many small types of business are on the decline, forcing a general decline in interested buyers, and obtainable price.  Brokers report that fading industries such as independent clothing, hardware and drug stores are selling at very low prices in relation to earnings, while independent convenience food stores have returned in their cycle and are now selling at a premium.  Businesses not requiring specialized training and easy entry have historically sold for more than the one with limited market.
3. Risk: To many buyers the lack of risk on “downside” of the transaction justifies a higher price.  And it’s more than a reasonable concession.  When the buyer has little to lose either in down payment or residual liability on financing, he or she can afford to be more generous on price.  Consider for example, the buyer who acquires the shares of a corporation for $15,000 with the balance of a $150,000 price represented by existing debts of $135,000.  This same buyer will be less likely to resist the $150,000 price than one with the entire $150,000 at risk through down payment and/or personal obligations.
4. Down Payment: Leverage has been earlier mentioned for purposes of calculating return on investment.  However, down payment and the opportunity for a leverage buy-out can have a dramatic influence on price.  Buyers tend to focus on down payment requirements as much as price.  Price resistance goes down as the down payment requirements decrease.  Many sellers have reported that they had little difficulty selling their business at a premium price – often more than their original asking price – once creative financing was provided to cut the entry capital needed.  Reduced down payments, of course, expand the potential buyer market and may offer lower risk, which will in either case allow for a high price.  Conversely, a seller demanding all cash may be forced to discount the price by 30-40%.
5. Financing: Advantageous financing can eclipse price in importance.  Astute buyers always consider price in relation to financing, because the two together determine the total pay-out for the business.  High interest rates have depressed business values in the same way they have softened the demand for real estate, automobiles and other consumer items.  Consider the economic impact of a 22% interest on a 10 year, $1000,000 loan versus the same loan at 15%.  The interest differential is about $35,000, encouraging higher price if the seller provides lower than market financing.  (Figures used are for illustrative purposes only).   Some buyers take the position that if financing requires interest in excess of the prime rate, the excess is charged against the value.  If the seller, however, offers the financing at a lower than prime rate, they add the interest savings to valuation.  Interest is one financing criteria that can effect value, but in the mind of some buyers, cash flow can be even more important.  A long term pay-out can insure a surplus cash flow to be used for expansion or modernization.  The pay-back period can also put a lid on price as most buyers will limit price to what the business can afford to pay-back from its cash flow, on a self liquidating basis.
6. Potential: Although valuation is largely dependent on the present profitability of the business, the price must be influenced by the potential of the firm.  There is a considerable difference between the seller selling an enterprise with the profits in place rather than one dependent upon the buyer to achieve the profit potential.  Many sellers attempt to sell marginal (or loss) operations on the basis of potential in the hands of the right buyer.  While the buyer is essentially buying potential, the obvious question is why the buyer should pay the seller for what the buyer will himself produce?  The clear answer is that he shouldn’t.   At best the seller may be entitled to a nominal payment of one year’s anticipated profit, or less, to reflect the potential factor.  An opposite situation is when the business is already at its top earnings potential and there is no realistic way to improve upon its performance.  At best, the buyer can hope to stabilize sales and profits at it present level.  While the seller has the right to demand a price proportionate to the current income stream, the buyer should use a more conservative valuation because the business lacks increased potential.  Most experienced buyers agree that the best acquisition candidate is one operating at a fraction of true potential, can be acquired at a price consistent with present earnings, and can be rapidly turned around.  These buyers typically pay slightly more than what the business is worth by strict valuation standards, yet these acquisitions ultimately prove to be a bargain based on later performance.
7. Motivation: How anxious is the seller to sell?  How anxious is the buyer to buy?  Personal pressures ranging from illness and death to unemployment can have a dramatic effect on the price a business will be sold for.
8. Personal Goals: As a seller may develop an emotional attachment to his business, a buyer will also expect the business t o satisfy certain non-financial objectives.  The buyer may be willing to pay a premium for the “right” business that offers considerable enjoyment and self-satisfaction.
9. Cash Flow: The projected cash flow can be a decisive factor in the valuation of a business.  Oftentimes companies are acquired at a premium because they do generate a substantial cash flow compared to business with equivalent “paper” profits.

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