How much should I pay?

2008-04-14 00:00

Every year, more and more South Africans are leaving corporate structures and going into private enterprise. Over the years, many such would-be entrepreneurs have asked if I would tell them the formula for fixing a purchase price on a business. It is as if they believe there is a cast-in-stone methodology by which a price is determined by the seller that would be acceptable to the buyer: "X minus Y plus Z = selling price".

The truth is, no such formula exists. In fact, setting a price is an inexact procedure and has a great deal to do with negotiating technique and what the market will bear. As ever, in all negotiating circumstances, the seller wants as much as is possible and the buyer wants to pay as little as possible. Over the next couple of weeks I will address this subject from a number of different perspectives.

The most important consideration in terms of price is that value does not equal price. Price has so much to do with how much the buyer desires or wants the business and, as I have said, also with the individuals’ negotiating skills.

As a general rule, the buyer should be able to recoup the price he or she paid for the business in the first two years of ownership. If, for whatever reason, the buyer desperately wants the business, then this factor could be pushed out to three years.

On a number of occasions I have referred to one of my books, The Margate Approach. The "Margate Formula" contained in it can be extremely useful for evaluating the selling price being asked for against this general criterion for its recovery.

Let me explain how this is so. Assuming that early negotiations have indicated a buying price of R200 000 as appropriate for the business, simply take the business’s annual fixed cost (overhead) level including interest payable and add to this number R100 000 (that is, half the purchase price) and divide the sum by the gross margin percentage shown in the last year’s audited accounts. What this sum is telling you is how much turnover is required in order to produce the R100 000 profit at that level of fixed and interest costs and that gross margin percentage.

If you compare this turnover number to the actual turnover level in the audited accounts, you will be able to assess how realistic the buying price actually is when related to the two-year recovery period. If the number is excessively high in comparison to the annual level produced, then quite simply, at that asking price the deal is off. If, on the other hand, the resultant turnover expression is in line with what the business has been achieving, then the asking price would seem to be realistic and negotiations can continue.

By carrying out this exercise, I am not suggesting you simply say, "Ah yes, that price is fine, here’s the money". What I am saying is that this is the first-stage checkpoint and a positive result will move you on to stage two, possibly "due diligence", which I shall talk about next week.

However, before leaving the considerations of buying price, it is important to appreciate that past earnings (profits) are just that: past, finished. What you need to be interested in is the business’s future earning potential.

When we look at due diligence, one of the most important factors that we need to consider and evaluate will be all that relates to sales, order book, supply contracts, product availability and customer relations, etcetera. In other words, factors that affect future potential.

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