How A Business Is Valued

How A Business is Valued

by North American Alliance of Business Brokers

www.naabbonline.com

GUESS WHAT: “It’s what the owner wants” IS NOT a viable explanation from
business brokers to how their businesses for sale are priced. Ask the business
broker or seller for a detailed explanation of how it was priced. If business
brokers or sellers decline your request on their businesses for sale THEN GET
AWAY!

Too many business brokers do not do ANY due diligence in pricing their
businesses for sale and most sellers do not have any concept on pricing a
business to sell. IN ADDITION, “my accountant told me” is also not a valid
reason because an accountant places a hard value on a business NOT a market
value as is needed when selling a business.

There are many models used by business brokers in placing a market value on
businesses for sale. In some form of the analysis, a cash flow (true profit) and
true gross sales figure needs to be determined. If real estate is involved, it should
be added in as a separate figure.

The following independent pricing models are widely used by business brokers
and accepted throughout the industry – it is also easily verified (not including real
estate)…

• Cash Flow x Industry Multiplier usually 2 – 4 ( cash flow is the bottom line
+ all unnecessary expenses added back into the bottom line) depending
on industry and growth.
• Cash Flow x 1 – 3 + all equipment and inventory (depends on industry &
growth)
• 70-100% of gross sales for retail or manufacturing related businesses
(depends on cash flow)
• 60-80% of gross sales for food related businesses (depends on cash flow)
• 30-60% of gross sales for service related businesses (depends on cash
flow)

Look past gross sales multipliers as they can be misleading.

If you encounter a detailed and confusing market value formula from business
brokers or sellers then we suggest stepping back because an old ploy by some
business brokers is to complicate a formula to where a buyer gives up and trusts
the business broker or seller. If a business broker can’t give you the cash flow
and gross sales values then move on.

Too many business buyers concentrate on gross sales without proper knowledge
of the basic operating expenses to profit on businesses for sale (cash flow).
Cash flow is the true profit of the business and you should demand that the
business broker show you the cash flow and how it was derived from the tax
returns and/or other financial statements.

Cash Flow – not gross sales – determines the profitability of the business.
What is Cash Flow?

Cash flow is profit before taxes. It is what the owner is truly making. Cash Flow is
determined by taking the Net Profit or Loss from the tax returns then “adding
back” to the Net Profit or Loss any non-essential, non-business related or paper
expenses (amortization, depreciation and interest). There are additional “add
backs” like one-time expenses or payroll expenses on an employee no longer
with the business – just to name a couple.

For example – we have a fictitious business named Widgets Inc. In looking at
their latest tax return we see that it has a Net Profit (bottom line) = $68,787.
In looking at the expenses on the tax returns we automatically add back to the
Net Profit or Loss…

1. the $6,424 Depreciation expense
2. the $3,178 Amortization expense
3. the $1 674 Interest expense

In looking at the expenses on the tax returns we then question the seller and
determine the following…

A. the $12,676 expense for “insurance” was all personal on the owner and
wife
B. the $18,900 expense was a one-time expense for redesigning the interior
C. the $5,323 expense was for the owner’s personal vehicle not made part of
the sale not needed to operate the business.
D. the $4,568 expense was for his yearly dues at the country club – obviously
not needed to operate the business.

So in determining the cash flow…
* Take the Net Profit = $68,787
* then “add back” 1-3 above (cumulative $11,276)
* then “add back” A-D above (cumulative $41,467)
_______________________________
TOTAL (Cash Flow) = $121,530
So while the tax returns showed a NET profit of $68,787 – the actual profit (cash
flow) is $121,530.

The business broker or seller should show you the exact cash flow analysis like
above! And the business broker should show you the actual expenses from the
tax returns. Don’t assume anything – ASK them to show you ALL supporting data.
If you hear terms like EBIT or EBITA and don’t understand it – Don’t panic. Here
is a simplified explanation…

• EBIT (Earnings Before Interest and Taxes) – Cash Flow Above less
Interest
• EBITA (Earnings Before Interest, Taxes and Amortization) – Cash Flow
Above less Interest & Amortization
The EBIT for Widgets Inc above would be $119,856 (cash flow less the $1,674
Interest Expense)
The EBITA for same would be $116,678 (cash flow less the $1,674 Interest
Expense & $3,178 Amortization Expense)

What You Should Be Prepared For

Being Qualified – unless you have 100% cash to buy a business, you will need
either seller financing or lender financing. If financing is needed at all then the
general rule of thumb to follow is that you will need relevant experience in that
type of business (or self-ownership), have at least 20% cash of the overall asking
price to place down and you have good to great credit (credit score of 650 or up).
To determine the price of a business you can afford – take the amount of cash
you have now to place as a deposit then multiply by 5 times that. This will be the
maximum you can spend on a business.

To determine relevant experience – draw up a professional resume on yourself
for the last 3- 10 years or more. A lender will want to see this – but now consider
any field where you have at least 3 years experience in the last 10 years may
apply (3 of the last 5 years is optimum). Relevant means just that – retail is retail
whether it is a liquor store or convenience store. If you have extensive and
successful self-ownership experience then this may apply as relevant experience
in most types of businesses.

To determine your credit score, use one of the credit reporting services like
freecreditreport.com to determine your credit score. NEVER leave a credit report
with a broker or seller unless you authorize a release to them – in writing.
Be prepared to work hard on buying a business while experiencing various
pitfalls that may seriously stress you. There is no perfect business to buy so the
work involved in buying a business is intensive and full of legal issues and
agreements.

Business buyers who try to buy without representation and documentation
eventually find that they get in too deep into areas where they have no
knowledge or experience. At this point the buyer may be in a position to lose
deposits as the deal falls apart.

So make sure you have an attorney and accountant on call to assist you.
Next you should be prepared to place reasonable offers. The reality is that full
offers would be nice but owners understand that offers may come in for less. The
owner will almost always consider all offers – if they are within reason.
Next be prepared to frequently meet with sellers. Most buyers are first time
buyers and while they have to be qualified they do experience fears of the
unknown. Buyers are encouraged to meet with sellers – frequently more than
once – prior to placing an offer.

Last is that you have to be prepared to manage in upwards of 20+ contingencies
before and after the offer process. Failure to understand these contingencies will
almost surely result in a damaged or failed transaction.

FAILURE TO BE PREPARED COULD RESULT IN A FAILED CLOSING

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