Richard Parker: is the author of the How To Buy A Good Business At A Great Price© series which is sold in over 80 countries. He is the founder of Diomo Corporation and has personally purchased eleven businesses. Learn more about Richard and his materials at diomo.com (www.diomo.com)
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.
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 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”.
Note: You will come across different terms on various websites and in business for sale profiles for Owner’s Benefit such as Seller’s Discretionary Earnings, Adjusted Earnings, and others as well. Make certain that the seller provides you with the exact formula of how they arrived at this figure – this is critical.
The Owner Benefit amount is the total dollars that you can expect to have available from the business (based upon the past financials) to pay yourself a salary, service any debt, and market the business assuming that everything remains status quo after you take over. The beauty is that unlike other methods (i.e. Income Cap), it does not attempt to predict the future. Nobody can do that.
(Very Important: Owner’s Benefit is not cash flow and cash flow is not profit. Cash Flow is probably the most misunderstood and misused accounting term. Cash Flow is simply the amount of cash a business had at the beginning of a period, how much it had at the end of a period and what happened in between to it.)
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 to fund future expenditures. Under this formula, you will arrive at a “net” Owner Benefit number or true Free Cash Flow figure.
Typically, small businesses will sell in a one to three-times multiple of this figure. Now, this is a wide range, and some businesses will sell for more, so how do you determine what to apply? The best general rule to keep in mind und 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, a large customer base, or an exclusive territory, a growing industry, etc., will sell in the three-times ratio (and sometimes more). The others fall somewhere in-between.
The Rules to Apply To Establish A Multiple
The most important part of valuations is to consider this as two pieces to a puzzle. Part one is easy because it deals with the numbers and numbers don’t lie (people do, and sellers especially do, but the numbers are the numbers!) You will use the historical financials to establish the Owner Benefit figure for each of the last three years or more.
Next, a weighted average must be applied to arrive at an “Average Owner Benefit” figure.
That’s the first part.
The second part is to establish the actual multiple. To do so, you need to consider the fundamentals of the business, the years it has been around, the competition, the suppliers, the lease terms, the strength of the customers, the conditions of the assets, how easily the business will transition to a new owner, will customers continue to buy from you, and on and on the list goes. In other words, this part is really measuring the core of the business outside of the numbers.
Establishing the multiple is the most important aspect of the valuation exercise. It is also the part that traps most people who don’t have a wealth of experience buying businesses. The good news is that with our guide, you also get access to a proprietary valuation spreadsheet that actually compiles the multiple and valuation for you. It is called the Diomo Business Assessment Method (DBA) and it was developed using over one thousand actual business investigations and valuations. It completes both pieces of the puzzle for you. All you do is enter the financials, answer some questions, and it does the rest of the work for you. (To read a review of The Diomo Business Assessment Method done by renowned valuation expert Ney Grant click here)
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 crucial if you want to be successful in this process. Learning how to read and analyze statements is simple, and can be done quickly. Lesson # 11 in our guide will take you through this entire exercise and within an hour you will know how to read financial statements.
§ 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 an accurate multiple based upon the business’ strengths and weaknesses.
§ If the business is right for you, it is all right to pay a slight premium, but not too drastically overpay. Keep in mind as we teach in the course section on negotiating the deal, the value is often in the terms you get, not necessarily the price you pay.
§ 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.
The Final Word: Accurately valuing a business is obviously a critical component to the business buying process. However, you always want to be certain that the business is right for you, not simply priced right. Knowing how to compile a valuation will not only assure you of paying the right price, but it will also demonstrate your knowledge when seeking financing for the deal. To eliminate the guesswork, make certain you use the automated valuation spreadsheets in the program How To Buy A Good Business At A Great Price©.