You shouldn't confuse the asking price for a business with the value of the business or what finance professionals call a Business Valuation or Business Appraisal. There are many ways to compute the value of a small business. The results can be wildly different and all correct. The issue isn't "what is a business worth?" as much as "what is the business value to you?". We'll breakdown the elements and suggest ways for you to go about the process of determining a fair value for a business.
For background it also might be helpful to read "What do you Buy when you Buy a Business?" . Also, you might want to review this Case Study How to Buy a Business - Case Study.
In this post we will discuss the elements that create small business value. As Business Brokers we have these discussions with buyers but more importantly we have the same discussions with business sellers.
Here are the key elements that drive the value of a business up or down. Investigating these elements will help you create your own business valuation to determine what price is reasonable:
- Stability of Earnings. A business with consistent earnings is worth more than a business that has wild swings in it's profits year to year. The small business profits are what allows a business buyer to pay down the loan (debt) used to buy the business. The reason small business profits are so instrumental in buying a business is simple........ a business can never pay the current year's expenses with next year's profits. If you buy a business with consistent profits you will be able to borrow more to finance the purchase and therefore you can pay more with lower risks due to the consistent cash flow.
- Customer Concentration - A company with 100 customers all doing 1% of the revenue is worth more than a business with one customer doing 70% and 3 others doing 10% each. If the customer that represents 70% of the business revenues leaves the business is in the tank. This can be a very important issue for the SBA loan if needed to buy a company. If you plan to use an SBA Loan for acquisition financing this will be closely scrutinized.
- Business has a high barrier to entry - Not many businesses have this but, if it does, it's worth a lot. The barrier to entry could be patents, highly recognized brands, special equipment not easily duplicated, exceptional location, etc. But beware, if the business has one of these it should be reflected in the business by delivering higher profit margins than average for the industry.
- Management/Employee responsibilities - The less the owner of the business is involved the more the business is worth. In his book Built to Sell author John Warrilow describes how this characteristic creates value. Also, Michael Gerber has written a great book E-Myth that talks about applying these principals to small business. If you are serious about buying a business I would highly encourage you to get both of these books and read them before you begin your business search.
Now here's a simple pricing model you might use. When looking at a business take each of the 4 elements above and score them on a scale of 0 - 4, with 4 being the best.
Let's say you're looking at a widget shop. The Widget Shop has seller's profits of $100,000 per year. You score the business this way on the above 4 categories 3,2,2,3. The average of those is 2.5.
Then simply multiply the business profits of $100,000 times 2.5 and you get $250,000. Using the above assumptions $250,000 is a reasonable value of the Widget Shop.
As you might imagine there are many resources to help you value a business. The book Small Business Valuation is especially good. Also, there is a great software package that includes Valuation and Business plan all in one called Business Plan Pro (we highly recommend this terrific business success tool.)
If you decide to buy a business you need to have some information and knowledge so that the asking price isn't the only reference point.
Remember, it's not what you pay relative to the asking price that's important, it's what you pay relative to the value to you that's important.
Business Library of Excellent Books
Business Library of Excellent Books