When you begin exploring businesses for sale, you don’t know exactly what a given business is worth and you risk overpaying for that business if you jump into a deal too soon. However, with time and the right resources, combined with a little investigative work, you can get a good handle on a particular business’s worth, which may or may not be close to the owner’s asking price.
You can start by taking a cue from smart home buyers and real estate investors: To find out how much a property is really worth, consider comparable sales — that is, the amounts that similar properties have sold for. Compared to business buyers, however, home buyers have it relatively easy. Real estate transactions are a matter of public record; small-business sales generally aren’t. So you have to do some extra sleuthing to find the specific price and terms of comparable businesses that have sold.
In the end, however, after you’ve done the math and developed a dollar value for the business, remember one thing: Similar to buying a house, the real worth of a business is what you, or someone else, will pay for it. A business isn’t a car with a factory sticker price; it’s a multidimensional, complicated organization of people, assets, and systems. Its true value is in the eyes of the beholder, and the beholder is you.
In this article, we will walk you through the process of valuing a business. You won’t have to go through every step (especially if you hire a business broker to manage the process for you), but each one is a viable option to consider.
1. Exploring valuing methods: Multiple of earnings and book value
Many methods exist for valuing a business. Some are unnecessarily complicated; others won’t provide you with sensible answers. For example, some advisors and business brokers advocate using a multiple of revenue to determine the value of a business — that is, if a business has $300,000 in revenues, it may be valued at $450,000 (a multiple of 1.5 times revenue).
However, revenue is a poor proxy for profitability. Two businesses in the same field can have identical revenue yet quite different profitability due to the efficiency of their operations, the pricing of their products and services, and the types of customers they attract. Also, the multiple of revenue that a business may be worth varies depending on what industry the business is in. For example, the multiple for a manufacturing business is typically higher than the multiple for a retail establishment or a restaurant.
Other measures are more exact. Here are our preferred valuation measures for small businesses:
Multiple of earnings
When you compare the sales data for comparable companies to the sales data for the one you’re interested in buying, determine what multiple of earnings these businesses sold for. Divide the price the business sold for by its annual pre-tax earnings (profits) to arrive at the multiple of earnings (also known as the price-earnings ratio) of that transaction.
When the multiple is low, say 3 to 1 (for example, if the business had earnings of $50,000 and a selling price of $150,000), the buyer and seller don’t have great expectations for the business’s future earnings. However, when the multiple is high, say 12 to 1 (if the business had earnings of $50,000 and a selling price of $600,000), the buyer’s and seller’s expectations of future earnings are correspondingly high.
Future earnings are what will provide the return on the buyer’s investment; therefore, the higher the buyer expects those potential earnings to be, the more he or she is willing to pay for the business. (In general, a business should be able to pay for itself in three to five years. If the time period is any longer than that, you’re probably paying too much for the company.)
Small, privately held businesses typically sell for lower multiples of earnings than larger companies in the same line of business. The reason: Small companies are less established and are riskier from an investing standpoint. Plus, your investment in their stock will be illiquid (that is, even in good times, the stock generally can’t be converted into cash within a reasonable period of time).
In addition to looking at the sales price of other businesses relative to earnings, you can consider the value of a company’s assets. The book value of a company is the company’s assets minus its liabilities, which is the same as the net worth of the business as stated on its balance sheet.
Which approach is better?
Of these two approaches, each of which has advantages as well as imperfections, the multiple-of-earnings approach is generally considered to be far superior to the book-value method. After all, what you’re purchasing when you buy a business isn’t primarily its assets but rather its ability to generate profits (earnings), using those assets.
Some businesses, such as consulting firms, have little in the way of tangible assets — the personnel may be the firm’s greatest asset, and valuing that is difficult. Because the determination of a price-earnings multiple figure is based on an income-generating formula, it’s generally a better indicator than the book-value approach, which simply measures the difference between assets and liabilities.
Keep in mind that the figure you come up with when using the multiple-of-earnings approach represents the goodwill portion of the business only and doesn’t include the value of the business’s assets. (Goodwill is, in essence, the value of the business’s reputation and existing customer list.)
Thus, you have to add the value of the assets to the goodwill number. The assets involved in a typical small-business purchase include accounts receivable (make sure that they’re all collectable); inventory (make sure that what you’re buying is merchantable); and equipment, furniture, and fixtures (the fair market value thereof).
2. Getting a professional appraisal
Business appraisers make a living out of estimating the value of businesses. If you want to buy a business and your initial investigation suggests that the seller is committed and serious about selling the business, consider hiring an appraiser. Although the fees professional appraisers charge varies depending on the size and complexity of the prospective business, you can usually expect to pay somewhere north of $5,000 for the typical small business.
Tax advisors, lawyers, and business consultants who specialize in working with small businesses may be able to refer you to a good business appraiser if they can’t do the appraisal themselves. The National Association of Certified Valuators and Analysts (http://www.nacva.com) can provide you with a list of association members in your area. Also, check the business-to-business Yellow Pages in your area under “Appraisers-Business.”
3. Tracking businesses you’ve explored that have sold
If your search for a business to buy lasts months or perhaps years, keep track of similar businesses you’ve considered that eventually sell. These sales provide valuable comparables because you’ve seen the businesses up close and have obtained details about their financial position that give you perspective in assessing the sales.
Obtaining the final selling price of a small business can be challenging. You can try asking the ex-owner, or you can speak with advisors or business brokers who are involved in such deals.
4. Tapping the knowledge of advisors who work with similar companies
Business consultants, attorneys, and tax advisors you work with can assist you with pinning down sales data for companies comparable to the one you’re considering buying. The key is to find advisors who have knowledge of, and experience with, both small businesses in general and businesses similar to the one you’re thinking of buying.
If you end up buying a small business, you’ll benefit from having competent advisors on your team who have worked on comparable deals. But before you hire an advisor for tax, legal, or business advice, be sure to check references. Also ask the advisor for a comprehensive list of business deals (including the purchase or sale price and the industry) that he has been involved in over the past year.
Don’t be deterred by the cost of such advisors, especially tax advisors and attorneys. The terms you agree to in the purchase of a business will be with you for a long, long time.
5. Consulting research firms and publications
Finding the details on similar companies that have sold can be difficult. Wouldn’t it be helpful if a service compiled such information for you? Well, you’ll be happy to know that some companies do publish comparable sales information or conduct company searches for a fee.
One such company, BIZCOMPS, releases an annual publication that provides sales price, revenue, and other financial details for businesses sold. This compendium of sales information is available for different major regions and industries in the United States (Western, Eastern, Industrial, and Food Service). Visit www.bizcomps.com for a sample of this publication. Each directory sells for $370. The company also offers online access to business sales data through an annual membership fee (which varies).
6. Turning to trade publications
Trade publications can help you find out more about a particular industry, as well as how to value companies within that industry. Most publications are willing to send you past articles on a topic, typically for a small fee. Or you may be able to access articles from the publication’s website.
7. Enlisting the services of a business broker
If you’re already working with a business broker (a salesperson who lists small businesses for sale and who works with buyers as well) or looking at a business listed for sale through a business broker, the broker should be able to provide a comparable market analysis of similar businesses that the broker’s office has sold.
Don’t put too much weight on a business broker’s analysis. Unfortunately, a broker’s “analysis” may be less analytic and more sales oriented than you want. After all, business brokers earn commissions based on a percentage of the selling price of the business that you may buy through them. (The commissions generally range from 6 to 10 percent, depending on the size and complexity of the deal.)
Also, understand that business brokers generally have access to sales data only on the small number of similar businesses that their particular office has sold. Unlike real estate agents, business brokers who work for different brokerage firms in a given community don’t share their sales data with one another.
Before enlisting the services of a broker, be sure to check her references carefully — especially given the fact that business brokers are in a virtually unregulated industry that requires no specific credentials or educational training to enter.
Be sure to involve your own attorney when the closing comes around. Having your own attorney takes the broker’s bias out of the equation and helps ensure that what you get is best for you. You can generally depend on your attorney to represent your best interests; the same cannot be said about your business broker.