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How much is a business “worth”?

Accurately valuing a small business is often the most challenging part of the process of buying or selling it. Both buyer and seller may be willing to give-and-take over the price, but the negotiation has the best chance of a successful outcome if both base it on a realistic recognition of the “market value” of the business.
A seller’s “asking price” is usually not the purchase price. And quite often it does not even remotely represent what the business is truly worth

Similarly, a buyer’s first “offer” is usually quite different from what the business is objectively worth. Buyers don’t want to pay more for a business than they absolutely have to, so they often want to offer a “lowball” price.
However, in neither case is that how you determine the value of the business. The challenge for both buyer and seller is to calculate a value that is accurate, which is to say, a value that will provide an appropriate return on investment based on a combination of earnings and assets.
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.
  • Income Capitalization:  Future income is calculated based on prior earnings data and a variety of assumptions.
  • Rules Of Thumb: The selling price of other “like” businesses is used to estimate a multiple of cash flow or a percentage of revenue. 
  • 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 Multiple: The net income of a business is subject to a certain multiple to arrive at a selling price.

Asset-based valuations do not generally 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 itself? Conversely, if a business has limited assets, such as computers and office equipment, but makes a ton of money, isn’t it worth more than the resale value of those computers?
Income Capitalization is generally applicable to large businesses and most often uses a factor that is too arbitrary for the small business environment.
The “Rule of Thumb” method is too general. It’s hard to find any two businesses that are exactly the same. Valuations must be based on what the buyer can reasonably expect to generate in revenues, 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 isn’t the end of the story, because earnings can actually mean different things in different businesses.
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 revenues that you can expect to extract from the business based upon what the business has generated in the past. This methodology, unlike some others (i.e., Income Capitalization), does not attempt to predict the future. Nobody’s very good at that.
The process for arriving at 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. Then, a multiple, based upon a variety of factors, is applied to this number and a valuation is established. (More on that in a moment.) This methodology, while not fool-proof, is the most effective way to establish the valuation of a small business.
The Owner Benefit formula looks like this:
Pre-Tax Profit
+ Owner’s Salary
+ Additional Owner Perks
+ Interest
+ Depreciation
-Allowance for Capital Expenditures
= Owner’s Benefit

Why Add Back Depreciation?
Depreciation is way of recognizing that the equipment a business buys won’t (a) be consumed in one year, but that it (2) won’t last forever, either, and therefore will eventually need to be replaced. It lets the business deduct a certain amount of money each year from an asset’s “value”, spreading the cost of the equipment over its 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 $5,000 off its income. Depreciation both lessens the company’s tax burden and helps to more-or-less accurately estimate the “real” value of the truck (and the business) at any point in time. But because it is not an actual cash transaction, this amount is added back.
Why Add Back Interest?
Each business owner will have his/her own philosophy for or against borrowing. In the event that an owner has borrowed for the business, they will most often pay off the outstanding loans from the sale proceeds, so a new owner will have the use of these “freed up” funds previously required for interest loan payments.
Capital Expenditure Allowance
It is also important to take into consideration the future capital requirements of the business. In a business 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 to 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 1-x to 3-x multiple of this “net” figure. Now, 1-3 is a wide range, so how do you determine what to apply? The best mechanism seems to be that a 1-x multiple is for those businesses where the seller is “the business”. Consulting businesses, professional practices, and one-man businesses are examples of this kind of business.
Businesses that have a strong track record, repeat clients, an established 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-x ratio. The others fall somewhere in-between.
How 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 one of the new casinos in Macau and let it rip on “17 black” on the craps table, you should expect enormous odds. On the other hand, if you invest it in commercial real estate, which is a solid, stable investment, then 10% return on your money might seem about right. 
Buying a business is clearly riskier than real estate but definitely not as risky as the Macau option, so you should expect something in-between. 25% return on your investment might be an appropriate ROI to shoot for.
First Things First

  1. Work with your accountant, if necessary, to determine the true Owner Benefits of the business.
  2. 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.
  3. Calculate a multiple in the 1-x to 3-x range based upon the business’ strengths and weaknesses.
  4. Determine your investment level and an acceptable ROI.

Value is Personal
If the business is right for you, it is all right to pay a slight premium, but not to drastically overpay.
Remember that valuations are not science; they’re subjective. You might pay a bit of a premium for a business because you want to live in that area, or because you think you can make it more profitable than the previous owner did. You might get it for a bit below its “value” because the owner needs a quick sale. But to make those decisions, you need to have a realistic idea of the business’ “real” value.
In the final analysis, in a free market, a business is a business is worth what a willing buyer, and a willing seller, agree on. Good luck!

 
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