Ways to Determine the Value of a Business

Determining the value of a business you are considering purchasing is a tricky subject. Most owners think their businesses are worth far more than they are. And in the end the true value of anything is determined by what a willing seller is willing to sell it for and a willing buyer is willing to buy it for.

Step one would be to acquire the use of West’s Business Brokerage Handbook and skim through the rules of thumb sections. If you are looking at a dry cleaning business Tom West, the author, describes the nationwide average values of dry cleaning businesses using either the gross sales percentage method—usually from .75 to 1.5 times the annual gross sales; or the cash flow method, which is usually 2.5 times the net income plus discretionary spending the owner benefits from. Value of real estate included is added to this figure. As you can see there can be a wide variance.

Of course, nothing really beats a true business valuation, or third party independent appraisal of the value of the business. A business broker who is also a certified business intermediary can probably arrange for a valuation from one of the companies the SBA recognizes. These valuations for a small business can range in price from $800 to $1,500 with a reputable company. But beware! There are several companies charging from $5,000 to $10,000 for worthless “valuations” that are simply overpriced opinions. If considering a valuation, first check the price and make sure it is in the lower range. Then ask the representative if it is accepted by the SBA and if he can prove it. Your banker, if he is experienced in business purchase loans can probably recommend a company.

Another recommendation in determining the value is observation. Remember that many small business owners have underreported income and over reported expenses on their taxes, with the goal of paying as small a tax burden as possible. If you can spend a few days in the business observing, with a notebook and calculator, you’ll get a good idea of what the average customer spends and therefore what the gross sales should be averaging.

After determining the cash value of the company, the most important thing to determine is, what is the value of the company to you? You may have found an under priced bargain when you think of the freedom to determine your own destiny provided by business ownership.

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The Basic Steps of Buying a Business

Buying a business could be your most important decision in life, but many people treat it in a cavalier fashion. Most people would consult a professional in any other major transaction, but don’t think of going to professionals for business purchases. With that in mind, consider using a reputable business broker.

A good broker can be found in your area simply by calling or emailing their professional association, the IBBA, or International Business Brokers Association. Or, ask friends who own businesses if they’ve had good or bad experience with a business broker in the area. Business brokers who have earned their profession’s highest professional credential will have CBI after their name on business cards. This stands for Certified Business Intermediary and assures the buyer that the broker has been properly trained and is held to high ethical standards.

If you don’t use a broker and represent yourself, then you must first determine that the business is right for you. Is it something you will enjoy doing? Then check the financial health of the business. After signing a standard non-disclosure agreement the seller should be willing to show you his tax returns for the past three years and allow you a chance to visit with his CPA.

Make sure that the business is brining in enough money to pay for itself, pay you a decent salary and cover its own debt service. If there is real estate involved this could be a 15 to 30 year loan. Without real estate, most lenders prefer seven year loans.

Determining the true value of the business and making sure that it matches the owner’s asking price is next. After looking at the tax returns and a profit and loss statement you should be able to determine true owner’s cash flow, which is net income plus discretionary spending from which the owner benefits, such as health insurance, a company car or a company owned cell phone.

Take the cash flow and multiply by two, then add in the wholesale value of any inventory, fixtures, furniture and other odds and ends. This will show you the value of the business itself. If there is real estate involved, hire an appraiser and add in that figure. These rules of thumb hold true for most businesses, but when you talk to your banker or SBA representative you may find some exceptions.

Determine how much of the purchase price the owner is willing to carry as owner financing, and if the amount seems reasonable, your next and final step is to find an attorney who is experienced in business closings. Have him check the contract carefully and you are usually in good shape.

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Buying a business is an important step and a life changing experience. Checking the financials of a business is the first step of course when making a decision to purchase. Ensuring that there is adequate cash flow to support the business, support you as the owner, and pay off the debt service in a reasonable amount of time makes sense. But the next step that is at least equally important is making sure that the business is the right fit for you, the new owner. Make sure that you wake up in the morning say to yourself “I get to go to work today” not “I have to go to work today.”

Determining that the business is the right fit for you is different from person to person. If you’ve been in the auto mechanics business all of your life, then owning a muffler shop or a quick lube might be tailor made for your personality and life style. But, if you are thinking of buying a pizza parlor and have never worked in food service before, that’s almost life buying a three piece suit without ever trying it on, or a new Mercedes without taking it for a test drive first.

If the business is new to you, then work in it for a while before you make your decision. If you’ve picked a business out that you are interested in, tell the seller your offer is contingent upon first working in the business with him for 30 days to determine that the fit is right. If you haven’t picked a business out yet and are just curious about an industry, nothing replaces getting an entry level job in that industry to get a feel for it.

If you buy a business you’ll own it for years to come, and perhaps for the rest of your life. Making sure that you truly enjoy what you are doing is the real American dream, so take the business for a test drive.

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