· Balance sheets
· Outstanding debt
Each and every prospective buyer will complete his own valuation of the business, analyzing each of these factors to one extent or another in an attempt to compare available business opportunities. The experienced business valuation expert must be able to justify his valuation to these buyers.
Current Financial Position
The first question from prospective buyers will be ‘how much money is the business making’. In fact, in today’s search engine marketplace, buyers will not even be presented with businesses whose ‘bottom line’ isn’t within their desired range.
In order to minimize tax liability, sellers choose accountants who can organize the numbers so that the business appears to be making as little money as possible.
There are a myriad of legal accounting options to lower or postpone tax liabilities, which lower the profit shown and in turn lower the value of the business. In a process of ‘recasting’, the business valuation expert makes adjustments, called ‘add-backs’, to the financial documents to show the buyer the true profit of the business. The justification for each add-back is documented on the recast sheet.
For example, an owner may legally pay a spouse or child a higher than market salary in order to reduce the total tax liabilities. That “above market” expense should be reduced to reflect the expense the buyer would have incurred.
Similarly, the business owner may also own the business real estate and therefore have paid no rent. The fair market rent for the property must be charged against the profits to show the true business expense. On the other hand, property taxes, maintenance and insurance (referred to as “Triple Net Charge”, “Triple Net” or “NNN”) for the building should be backed out of the expenses unless the seller (who will become the landlord) intends to charge the buyer (who will become the tenant) for those costs in addition to the rent.
Other business owners funnel a substantial amount of profit back into the business to purchase additional inventory or equipment. These are not actual expenses but are in reality capital investments. A difference between the prior year end inventory value and the current will show the additional capital investment, which must then reduce the cost of goods.
Business Financial History
Buyers want to see steady growth in profits. They expect financial statements for a minimum of 3 years. Many times a business is being sold because the owner has become ‘burned out’ after many years of the same routine. The revenue and profit trends begin to level off as the owner dedicates less time to growing the business.
This can be seen by the savvy investor as an opportunity to step in and ‘add fresh blood’ to the business, implementing new ideas than make the business more profitable and thereby more valuable.
From coffee shop to widget manufacturing, each industry has normal ratio’s that have remained consistent over the years. A restaurant should pay no more than 20% of gross sales in rent, a maid service company should pay no more than 26% in salaries, etc.
By analyzing “sales by industry” year after year, these normal net-to-cost ratios become obvious and very consistent. If your business varies significantly from these ratios, the buyer will want to know why.
Similarly, there are industry norms relating the asking price to the revenues as well as the asking price to the net profits. These ratios also remain remarkable consistent over the years and buyers will shy away from any opportunity that is not priced within the norms.
SBA guarantee availability and bank lending rates vary each quarter. The ability to purchase a profitable business with minimal out of pocket investment directly impacts the demand for the business. A large¬±~¯
Beyond these factors, you can determine the value of a business using several different methods discussed below.
Simply put, some owners gauge the value of their business by using a multiplier of either the monthly gross sales, monthly gross sales plus inventory, or after-tax profits. While the multiplier formula may seem complex and quite accurate to begin with, if you delve a little deeper and look at the components used to arrive at the stated value, there is actually very little to substantiate the arrived at price.
Most of the multipliers aren't based on fact. For example, individuals within a specific industry may claim that certain businesses sell at three times their annual gross sales, or two times their annual gross sales plus inventory. Depending on which formula the owner uses, the gross sales are multiplied by the appropriate number, and a price is generated.
For instance, if the business was earning $100,000 a year and the seller was using a formula in which the multiple of gross sales was 30 percent based on industry averages, then he or she would generate a price using the following equation:
100,000 x .30 = $30,000
Of course, you can check the monthly sales figure by looking at the income statement, but is the multiplier an accurate number? After all, it has been determined arbitrarily. There usually hasn't been a formal survey performed and verified by an outside source to arrive at these multipliers.
In addition, even if the multiplier was accurate, there is such a large spread between the low and high ends of the range that it really just serves as a ballpark figure. This is true whether a sales or profit multiplier is used. In the case of a profit multiplier, the figure generated becomes even more skewed because businesses rarely show a profit due to tax reasons. Therefore, the resulting value of the business is either very small or the owner has to use a different profit factor to arrive at a higher price.
Don't place too much faith in multipliers. If you run across a seller using the multiplier method, use the price only as an estimate and nothing more.
This is a fairly accurate way to determine the price of a business, but you have to exercise caution using this method. To arrive at a price based on the book value, all you have to do is find out what the difference is between the assets and liabilities of a company to arrive at its net worth. This has usually been done already on the balance sheet. The net worth is then multiplied by one or two to arrive at the book value.
This might seem simple enough. To check the number, all you have to do is list the company's assets and liabilities. Determine their value, arrive at the net worth, and then multiply that by the appropriate number.
Assets usually include any unsold inventory, leasehold improvements, fixtures, equipment, real estate, accounts receivable, and supplies. Liabilities can be anything. They might even include the business itself. Usually, though, you want to list any unpaid debts, uncollected taxes, liens, judgments, lawsuits, bad investments--anything that will create a cash drain upon the business.
Now here is where it gets tricky. In the balance sheet, fixed assets are usually listed by their depreciated value, not their replacement value. Therefore, there really isn't a true cost associated with the fixed assets. That can create very inconsistent values. If the assets have been depreciated over the years to a level of zero, there isn't anything on which to base a book value.
Return on Investment
The most common means of judging any business is by its return on investment (ROI), or the amount of money the buyer will realize from the business in profit after debt service and taxes. However, don't confuse ROI with profit. They are not the same thing. ROI is the amount of the business. Profit is a yardstick by which the performance of the business is measured.
Typically, a small business should return anywhere between 15 and 30 percent on investment. This is the average net in after-tax dollars. Depreciation, which is a device of tax planning and cash flow, should not be counted in the net because it should be set aside to replace equipment. Many novice business owners will look at a financial statement and say, "There's $5,000 we can take off for depreciation." Well, there's a reason for a depreciation schedule. Eventually equipment does wear out and must be replaced, and it sometimes has to be replaced much sooner than you expect. This is especially true when considering a business with older equipment.
The wisdom of buying a business lies in its potential to earn money on the money you put into it. You determine the value of that business by evaluating how much money you are going to earn on your investment. The business should have the ability to pay for itself. If it can do this and give you a return on your cash investment of 15 percent or more, then you have a good business. This is what determines the price. If the seller is financing the purchase of the business, your operating statement should have a payment schedule that can be taken out of the income of the business to pay for it.
Does a 15-percent net for a business seem high? Everybody wants to know if a business makes two, three, or 10 times profit. They hear price-earning ratios tossed around, and forget that such ratios commonly refer to companies listed on the stock exchange. In small business, such ratios have limited value. A big business can earn 10 percent on its investment and be extremely healthy. The big supermarkets net two or three percent on their sales, but this small percentage represents enormous volume.
Small businesses are different. The small business should typically earn a bigger return because the risk of the enterprise is higher. The important thing for you, as a buyer of a small business, is to realize that regardless of industry practices for big business, it's the ROI that you need to worry about most. Is it realistic? If the price is realistic for the amount of money you have to invest, then you can consider it a viable business.
Valuing a business based on capitalized earnings is similar to the return-on-investment method of assessment, except normal earnings are used to estimate projected earnings, which are then divided by a standard capitalization rate. So what is a standard capitalization rate?
The capitalization rate is determined by learning what the risk of investment in the business would be in comparison to other investments such as government bonds or stock in other companies. For instance, if the rate of return on investment in government bonds is 18 percent, then the business should provide a return of 18 percent or better on the investment into it. To determine the value of a business based on capitalized earnings, use the following formula:
Projected Earnings x Capitalization Rate = Price
So, after analyzing the market, the competition, the demand for the product, and the organization of the business, you determine that projected earning could increase to $25,000 per year for the next three years. If your capitalization rate is 18 percent, then the value of the business would be:
$25,000 / .18 = $138,888
Generally, a good capitalization rate for buyouts will range between 20 to 40 percent. If the seller is asking much more than what you've determined the capitalized earnings to be, then you will have to try and negotiate a lower price.
Some business owners try to sell goodwill as an asset. Normally, in everyday accounting procedures, most companies put down perhaps one dollar as the value of goodwill. There is no doubt that goodwill has value, particularly if the business has built up a regular trade and a strong base of accounts. But it is the financial value of the accounts, not their psychological value, that should be placed on any financial statements.
Goodwill as such is not an asset. You as a buyer would assess the business based on the return on investment. Certain rules of the game may change when you enter the fields of acquisition and merger. Suppose you buy out your competition, merge all your facilities, and double your volume. Now the labor and overhead factors are much lower. Thus, even if the seller was losing perhaps 5 percent a year, if you bring them into your company, which is making 15 percent a year, it might allow you to increase sales and end up making 20 percent.
The Art of Business Valuation
Business Valuation, estimating the fair market value of a business, is a complex process. It requires an in-depth knowledge of the business’s
· Current financial position
· Financial history
· Growth opportunities
· Client base
· Current lease terms
As well as...
· Industry norms
· Financing options and availability
· Market history
· Current market conditions
· Seller’s motivations
It takes years of experience and research to weigh all these factors and extract\
The Price that a Buyer is Willing to Pay
for your business. A business valuation expert must be able to analyze
· Tax returns
· P&L statements
The place to go to buy or sell a business.®