Buying anything for the best price is a matter of skilful negotiation. But if you are considering an acquisition, you should apply one of the following methods of valuing the target business. Even if you are only considering a merger, you should be aware of how much the other business is worth.
Net asset value
This is the value of the business' assets as stated in the audited accounts, minus outstanding liabilities to creditors or tax authorities, bank borrowings and redundancy payments due. It provides a baseline from which to start the valuation process.
Entry costs versus cost of acquisition
Compare the cost of acquisition with the cost of starting up a similar business, which might include the assets, product development, employment and marketing costs. Include any savings you can foresee by merging the business with your own.
Forecast the target's cashflow for a number of years and discount these numbers to obtain a net present value. If you are unfamiliar with this method, an industry expert will be able to advise on how to choose and apply discount factors.
Price/earnings ratio (P/E)
A P/E ratio is calculated by dividing the company's share price by its earnings per share. If the company's share price is £30 and it is earning £3 per share, its P/E ratio is ten.
To use P/Es to value an unquoted (ie privately-held) business, look up the P/E ratio for the relevant sector in the financial press, eg the Financial Times, then typically apply a discount because the target business is not on the stock market - shares in a public company are much more liquid and seen as more valuable.
Check the private company price index. If you have no prior experience of this, seek expert advice.
A business run by one person is generally valued at around half the value of a comparable private company run by a team of three or more experienced managers. Customers are probably loyal to the owner-manager and may not remain with any new owner.
The economic cycle also affects private business valuations. During a downturn - small private companies sell on multiples of between six and eight on average whilst during a boom - the same companies may sell for between ten and 12 plus.
Accountants, lawyers and tax advisers often have extensive experience in valuations - using their experience will reduce the danger of you paying too much or owning unforeseen debts. Find a solicitor in your area.