Valuing a Business
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 “Asking 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.
Rules Of Thumb: The selling price of other “like” businesses is used as a multiple of cash flow or a percentage of revenue.
Let's look at eack 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 “Rule of Thumb” method is too general. It's hard to find any two businesses that are exactly the same. Valuation must be done based upon what you, as the buyer, can reasonably expect to generate in your pocket, so long as the business’ future is representative of the past historical financial data.
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 Owner Benefits amount is the total dollars that you can expect to extract or have available from the business based upon what the business has generated in the past. The beauty is that unlike other methods (i.e. Income Cap), it does not attempt to predict the future. Nobody can do that. Owner Benefit is not cash flow! It is, however, sometimes referred to as Seller's Discretionary Cash Flow (SDCF).
The theory behind the Owner Benefit number is to take the business’ 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.
The Owner Benefit formula to use is:
Pre-Tax Profit + Owner’s Salary + Additional Owner Perks
+ Interest + Depreciation LESS Allowance for Capital Expenditures
Why Add Back Depreciation?
Depreciation is an expense that allows a business to deduct a certain amount of money each year from an asset so that its purchase value is reduced by its overall useful life. As an example: if the business buys a $25,000 truck and its useful life is estimated at 5 years, then each year the company can deduct $5000 off its income to lessen its tax burden. However, as you can see, it is not an actual cash transaction. No money is physically leaving the business or changing hands. Therefore, this amount is added back.
Why Add Back Interest?
Each business owner will have separate philosophies for borrowing for the business and how to best use borrowed funds, if necessary at all. Furthermore, in nearly all cases, the seller will pay off the business’ loans from their proceeds at selling; therefore, you will have use of these additional funds.
A Note About Add-Backs (Capital Expenditure Allowance)
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.
What Multiple?
Typically, small businesses will sell in a one-to three-times multiple of this figure. Now, this is a wide range, so how do you determine what to apply? The best mechanism I have found is that a one-time multiple is for those businesses where the seller is “the business”. In other words: "as out the door goes the seller, so too can go the customers". Consulting businesses, professional practices, and one-man businesses come to mind.
Businesses that have a strong track record, repeat clients, historical pattern of growth, more than 3 years in business, perhaps some proprietary item, or an exclusive territory, a growing industry, etc., will sell in the 3-times ratio. The others fall somewhere in-between.
So now the big question: what number/multiple do you apply to the Owner’s Benefit number? The answer is simple: nearly all small businesses will sell in the 1-to-3 times Owner Benefit window. Of course this is a very wide range.
The Rules To Apply To Establish A Multiple:
You also want to calculate the Return On Investment (ROI) that you can expect to achieve when buying a business. Let’s say that you have $100,000 for a down payment. If you go to Las Vegas and let it rip on “17 black” well you should be entitled to enormous odds. Wouldn’t you agree? On the other hand, if you invest it in commercial real estate, which is a solid, stable investment, then 10% return on your money seems about right, doesn’t it?
Buying a business is clearly riskier than real estate but definitely not as risky as the Las Vegas option, so you should expect something in-between. I’ve always felt that 25% return on your investment should be the minimum and you can, if negotiated well, get as high as 35% -50% ROI.
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.
• Calculate a multiple in the 1-3-times window based upon the business’ strengths and weaknesses.
• 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 too drastically overpay.
• Consider applying other valuation formulas simply as a test to your figure.
Professional Valuations: Do You Need One?
For most small businesses, hiring a professional to perform a valuation is not necessary. First of all, it is expensive, and more often than not, it simply does not reflect reality. I read a valuation recently on a local company handling specialized telecom components in a very restricted marketplace doing $700,000 a year in sales and netting $100,000. The valuation started off: “The company is focused upon the B2B telephony segment which is a $42 billion industry in North America.” I threw out the entire report after reading that one sentence. Why? How on earth can you possibly compare a $42 billion dollar industry and a $700,000 local distributor of telephone systems? Don’t waste time or money getting a professional valuation done. Let the seller do that if they so choose. 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’re subjective.
• Use a variety of methods.
• Owner Benefits is the number on which to base your multiple
• Uncover how the seller established the asking price
• Valuation is a personal formula - What’s the business worth to YOU?
• Consider the potential return on your cash investment
The 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!
Copyright 2001 – 2007 by Diomo Corporation Richard Parker. All rights reserved.
NOTE: The articles that appear on this website are the sole and exclusive copyrighted property of Diomo Corporation and or Richard Parker and may not be reproduced in any format whatsoever without the express written consent of Diomo Corporation and Richard Parker.
Valuing a Business - To learn more about this author, visit Richard Parker's Website.
Like this article? Share it with your friends
![]() | |
| |
No article feedback found. |
| |
Leave Your Feedback |
|
| |
| |||
David BarrDavid Barr is the President of Venture Opportunities, Inc. David has been a professional business broker/intermediary since 1980 focusing on General Business Brokerage and Mergers and Acquisitions representing client transaction value from $400,000 to $20,000,000. Mr. Barr has handled the sale of over four hundred and fifty companies. David earned a university degree from the State University of New York majoring in economics and business. David holds the Mergers and Acquisition Master Intermediary and the Certified Business Intermediary designations from the International Business Brokers Association. He is also a Senior Business Analyst and a Texas licensed Real Estate Agent. For more information about David and Venture Opportunities, visit www.bizdealmaker.com. - Visit David Barr's Website |
|||
Anne BarrAnne Barr has over 26 years experience in sales and marketing, six years as a franchisee. She has assisted over 367 business owners and purchasers to achieve their goals in career change, transition and exit strategy. She holds the designation of Certified Franchise Executive from the International Franchise Association, Certified Business Intermediary from the International Business Brokers Association and Board Certified Broker from the Texas Association of Business Brokers. Anne is active in professional organizations, networking groups and volunteers for non-profit entities. As owner/operator of four successful businesses, Anne has proven people skills and enjoys helping clients find the right "fit" in business ownership. Visit www.FranchiseOpportunitySpecialist.com for more information about me and my company. - Visit Anne Barr's Website |
|||
Casey GollanCasey Gollan, Business Coaching & Mentoring Programs. Add $1 Million to $10 Million in the next 1 to 3 years. Since 1996 Casey has to added hundreds of millions of dollars to businesses. Watch a free video see client results Business Coaching website. - Visit Casey Gollan's Website |
|||
Kim CastleWith nearly two decades in the advertising and design business, with clients like Domino's Pizza, General Motors, Direct TV, Pedigree, Wolfgang Puck, Higher Octave Music, Hollywood Celebrity Products, Disney, and Paramount, as well as thousands of entrepreneurs around the world define, structure, communicate, and position their business for greater profits, BrandU(R) co-creators Kim Castle and W. Vito Montone discovered that entrepreneurs could experience the same power that big brands command for a fraction of the cost with the world's only process-based results-drive Integral approach to business creation. BrandU(R) is helping entrepreneurs grow with the power of extreme clarity from idea...to brand...to market(TM) and helping one million entrepreneurs become successful and whole so that they can make a difference in the world. Are you one of them? If you want to experience clarity all the way to the bank(TM), get started now at http://www.brandu.com. - Visit Kim Castle's Website |
|||
Jeff FosterWebBizIdeas.com is a Minneapolis website design company founded to help people start an internet business by providing them with website, business, and internet resources that help foster the growth of successful online businesses and develop innovative Internet business ideas. We specialize in internet consulting & internet marketing. - Visit Jeff Foster's Website |
|||
David AchesonDavid Acheson is the founder of DCJA Consultancy. DCJA Consultancy is a management consultancy business specialising in B2B sales consultancy. They offer bespoke and packaged sales consultancy including Sales Optimisation Review, Interim Sales Management, Sales & Marketing Review, 1:1 Sales & Management Staff Analysis, Management Training, Solution Sales Training, Creation of New Pay Plan, KPI's, run Customer Feedback Campaigns, assist with Recruitment, Coaching, Appraisals and set up Strategic Marketing Campaigns. David spent his early career in accountancy and then moved into sales in 1982, working in Office Equipment, IT, Advertising, Training, Outsourcing and Consultancy. He has held many Senior Positions in SMBs and Global Organisations including Head of Sales Operations & Head of Business Development. His knowledge, skills and great experience of the Sales Industry has led to David making keynote speeches and running educational sessions to key businesses through organisations including The Chamber of Commerce and Business Link. - Visit David Acheson's Website |
|||
Leanne Hoagland-SmithAre your sales where you want them to be? Will you be one of the few who achieves sales or business success or one of the many who have failed to change? Are you tired of being told you are like everyone else? Then you may find my first book on sales of interest. Be the Red Jacket in the Sea of Gray Suits, The Keys to Unlocking Sales available at Amazon or at http://www.processspecialist.com/red-jacket.htm. This book is a reflection of my no-nonsense approach to improving sales to overall business results. If you are truly committed to making sustainable changes, then I can help you secure a positive return on your investment because I focus on executable solutions not telling you the problems you already know you have. From training to corporate (group) coaching to executive one on one coaching, my approach is to assess, create awareness, build a goal driven action plan and then execute. The bottom line question is "Not do you or your employees know it, but do you or they want to do it?" Please call for a free strategy session at 219.759.5601. - Visit Leanne Hoagland-Smith's Website |
|||
Cheryl MatthynssensCheryl is a life skills coach, licensed Chemical Dependency Counselor and a 20 year entrepreneur. Cheryl's dedication to achieving a life of balance led to her expanding her teaching from the simple managing of life's daily challenges to adding financial well being as well. A direct marketer with DrinkACT, she is gaining ground in the online community with her concepts of making sure business owners, entreprenuers and employees have well rounded life styles. She opened up a small affiliate site - The Balance Guide- to help others find resources for mental and emotional well being. Visit Cheryl's blog to see more of the diversity beyond business she has began offering online at www.thebalanceguide.blogspot.com - Visit Cheryl Matthynssens's Website |
|||
|
To learn more about the Evan Elite Author Program please contact us. | |||
![]() | |
![]()
| |
![]() | |
|
| |
![]() | |
|
| |
![]() | |||||||
|
![]() | ||
|
| ||
![]() |
| Have you written articles that would be of value to entrepreneurs? Become an expert on our site by publishing them! Expose yourself to a wide audience, drive more traffic to your website and get more sales! Click Here for details. |
|
|
![]() |
| Modeling the Masters: Learn the true secrets behind Walt Disney's business success factors & grow your company! Video produced by Phanta Media |
|
|
![]() |
"Learn straight from Evan how you can Make a Full Time Income (And More) from a Website"
Click Here To Learn More |
|
|
|
|
Get advice & tips from famous business owners, new articles by entrepreneur experts, my latest website updates, & special sneak peaks at what's to come!
|
![]() |
|
|
![]() | ||
|
Top 50 Raising Capital Blogs
Top Blogs To Watch In 2008 | ||
|
Top 50 Debt Blogs
Learn To Get Out Of Debt | ||
![]() | ||
![]() | ||||
| ||||
| ||||
| ||||
|
|
|
|
|
||||||||||||
|
|
|
|
|
| ||||||||||
|
| ||||||||||














Subscribe to Richard's articles











