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Accurately valuing a small business is often the most
challenging part of the process for prospective business buyers.
However, it doesn't have to be an overwhelming or difficult undertaking.
Above all, you should realize that valuation is an art, not a science.
As a buyer, always keep in mind that the "Selling Price" is NOT the
purchase price. Quite often it does not even remotely represent what the
business is truly worth.
Naturally, a buyer's valuation is usually quite
different from what the seller believes their business is worth. Sellers
are emotionally attached to their businesses. They usually factor their
years of hard work into their calculation. Unfortunately, this has no
business whatsoever being in the equation.
The challenge for you, the buyer, is to formulate a
valuation that is accurate, and will prove to provide you with an
acceptable return on your investment.
There are several ways to calculate the value of a business:
- Asset Valuations: Calculates the value of all of the assets of a business and arrives at the appropriate price.
- Liquidation Value: Determines the value of the company's assets if it were forced to sell all of them in a short period of time (usually less than 12 months).
- Income Capitalization: Future income is calculated based upon historical data and a variety of assumptions.
- Income Multiple: The net income (profit/owner's benefit/seller's cash flow) of a business is subject to a certain multiple to arrive at a selling price.
Let's look at each to determine what's best for your purchase:
Asset based valuations do not work for small
business purchases. Assets are used to generate revenue and nothing
more. If a business is "asset rich" but doesn't make much money, how
valuable is the business altogether? Conversely, if a business has
limited assets, such as computers and office equipment, but makes a ton
of money, isn't it worth more?
Income Capitalization is generally applicable to large businesses and most often uses a factor that is far too arbitrary.
The Multiple Method is clearly the way to go. You
have probably heard of businesses selling at "x times earnings."
However, this can be quite subjective. When buying a small business,
every buyer wants to know how much money he or she can expect to make
from the business. Therefore, the most effective number to use as the
basis of your calculation is what is known as the total "Owner
Benefits."
The theory behind the Owner Benefit number is to
take the business's profits plus the owner's salary and benefits and
then to add back the non cash expenses. History has shown that this
methodology, while not bulletproof, is the most effective way to
establish the valuation basis of a small business. Then, a multiple,
based upon a variety of factors, is applied to this number and a
valuation is established.
A Note About Add Backs
After completing any add backs, it is critical that you take into consideration the future capital requirements of the business as well as debt service expenses. As such, in capital intensive businesses where equipment needs replacing on a regular basis, you must deduct appropriate amounts from the Owner Benefit number in order to determine both the true value of the business as well as its ability fund future expenditures. Under this formula, you will arrive at a "net" Owner Benefit number or true Free Cash Flow figure.
If You're New at This, Here's What to Do:
- If you don't know how to read an income statement, then learn. It's important for this process. It's simple, and can be done quickly. Work with your accountant, if necessary, to determine the true Owner Benefits of the business.
- Be careful about the add backs. Make certain that any benefits being added back are not necessary expenses needed to run the business. You can only add back something that has been expensed. Determine your investment level and an acceptable ROI. Understand that value is personal. If the business is right for you, it is all right to pay a slight premium, but not to drastically overpay.
- Consider applying other valuation formulas simply as a test to your figure.
Final Word: Never, ever buy a
business just because the price is right - first and foremost be certain
that the business itself is right for you!
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