How to Value the Purchase Price of a Business You are About to Buy. A Word of Advice! Be Realistic in Your Analysis
Determining the true value of a small business is very challenging. You must realize that valuation is often imprecise, more often an art, not a science. Always keep in mind that the “asking price” is NOT the purchase price. Quite often the asking price does not even remotely represent the business’ true worth.
Your challenge as a buyer is to formulate a value that is accurate and will in the end (and after the closing) provide you with an acceptable return on your investment.
There are several recognized ways to calculate the value of a business:
- Asset Valuations: This approach calculates the value of all the assets of a business to arrive at the appropriate purchase price.
- Liquidation Value: This approach 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: The valuation of the business by future income which is calculated based upon historical data and a variety of assumptions.
- Income Multiple: Valuation equals the net income (profit/owner’s benefit/seller’s cash flow) of a business subject to a multiple to arrive at a selling price.
- Rules Of Thumb: The selling price of other “like” businesses is used to establish a likely future cash flow or annual gross revenue.
Learn the basics of each valuation method to determine what is the best technique for your purchase.
When you are buying a business or looking to buy out your business partner, look at its tangible assets like land, buildings, marketing and equipment. Are there financial assets involved? If so, look at the accounts receivable and other financial investments. What about intangible assets like patents and copyrights, customer lists, customer and vendor contracts, leases, claims and lawsuits? Moreover, you must investigate the liabilities and contingent liabilities of the business like accounts payable, bank and other loans, pension and tax liabilities, contract obligations.
Asset-based valuations are not generally appropriate for a small business purchase. Assets are used to generate revenue and nothing more. If a business is “asset rich” but doesn’t make much money, then unless you want those assets to help expand your existing business, the business may not be valuable no matter what the business assets are worth. Conversely, if a business has limited assets, such as computers and office equipment, but it makes a ton of money, it may be worth more.
Income Capitalization is mostly applicable to large businesses and is used as a factor that sometimes is arbitrary. Since this site is not intended for the large, mega company I will not discuss this valuation method further.
The Multiplier Method is clearly the way to go. (You have probably heard of businesses selling at “x times earnings.”) 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 Owner Benefits amount is the total dollar amount (gross and net) that you can expect to receive or have available from business operations based upon what the business has generated in the past. The beauty is that, unlike other methods (i.e. Income Cap), Owner Benefits do not attempt to predict the future. Nobody can do that. Owner Benefit is not cash flow! It is, however, the total economic value to the business owner from all sources.
Using the Owner Benefits formula, you first add up the business’ profits, the business owner’s salary, benefits and other “perks”, and the business’ non-cash expenses. This methodology, while not bulletproof, is an effective way to establish the valuation of a small business. Then, a multiple, based upon a variety of factors (generally there is an industry standard), is applied to this number and a valuation is established.
The Owner Benefit Formula to Use is:
Pre-Tax Profit + Owner’s Salary + Additional Owner Perks + Interest + Depreciation less Allocation for Capital Expenditures
Professional Valuations: Do You Need One?
For most small businesses, hiring a professional to perform a valuation is unnecessary. It can be expensive and often does not reflect reality. Do not waste time or money getting a professional valuation done for a small business acquisition; let the seller do that if they so choose. Moreover, if you want to look at a variety of scenarios, there are some very good, inexpensive software packages available that will do the same thing at a fraction of the cost.
The Key Points:
Remember that valuations are not scientifically based; they are subjective, using a variety of methods. Owner Benefits is simply the number on which to base your offer. Discover through questioning how the seller established the asking price. And again, valuation is a personal formula – What is the business worth to YOU?
Consider the potential return on your cash investment
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!… and profitable!
I own several small businesses. I’m good at what I do but legal matters and dealing with lawyers and legal issues is stressful. I called Fredrick P. Niemann and have developed a great relationship with his lawyers and staff. They have reviewed my leases, negotiated the buyout of my former business partner, handled land use problems in a neighboring county and generally have really been there for me. I really like them personally and professionally. If you are a small business owner, give them a call.
Mike Halsey, Middletown, New Jersey
Do you have questions about the purchase of a business or the interests of a business partner in New Jersey? If so, then please contact Fredrick P. Niemann, Esq. toll-free at (855) 376-5291 or email him at firstname.lastname@example.org. He welcomes your call and you’ll find him to be a savvy business advisor.
Written by Fredrick P. Niemann, Esq. of Hanlon Niemann & Wright, a Freehold Township, Monmouth County, New Jersey Buying a Business Attorney