Something changed in your life and you decided to own a business. You could probably start from scratch, but considering all pros and cons decided to purchase an established business. Well, it's a very wise decision as long as you do it right. Let say that you found a suitable candidate. You like the business and ready to make an offer, but for how much? What is the true value of this business to you? Yes, it is the right question, because value of the business may vary depending on buyer's circumstances and terms of purchase. Lets get into details of the business value from business buyer's point of view.
If you decided to look up online term "business valuation" you'll find three types of articles: (1) completely useless that give you vocabulary lesson; (2) methods more applicable to public or larger private companies and have very little to do with valuing small businesses in today's market; and (3) articles written by hands-on guys who do it on daily basis, like yours truly.
Among available business valuation methods only income multiple method makes sense for small businesses. This method calculates business purchase price as a multiple of Owner's Discretionary Earnings, aka Adjusted Net Income, Seller's Discretionary Earnings, Owner Benefit, Seller's Benefit, etc.
Purchase Price = M x Owner's Discretionary Earnings,
where M is a multiplier.
The reason I used term Owner's Discretionary Earnings (ODE) rather than Seller's Discretionary Earnings is because its value, most likely, will be different for buyer and seller. If you're buying a business, your business valuation should be based on earnings you'll be getting out of this business, hence Buyer's Discretionary Earnings. Seller's perception of the business value is often skewed by personal emotional attachment and by desire to recuperate expenses incurred over the lifetime of the business. However, as a business buyer, you're solely interested in financial and other benefits that you will be getting from it.
ODE represents all benefits that the owner gets from the business: net income, owner's salary, personal expenses charged to a business, plus interest on business loans, depreciation and amortization. The reason we add interest is because different owner may not have such expenses, it's really subjective to a particular owner. Depreciation and amortization are added because they are accounting adjustments, not real monetary expenses. Calculating ODE is relatively easy and straight-forward procedure. Calculate the correct multiplier is the most challenging part.
Lets start with an example. Lets look at two shoes store. Both stores are on the same block, across the street from each other. Both stores carry similar merchandise, both stores have annual sales around $500,000 and both generate ODE of around $80,000 per year. Does it mean that both businesses have the same value and will be priced identically?.. Not necessarily. In store A the owner is working 12 hours a day, plus his wife is working with him, they don't have any employees as they don't have any days off or vacations. They get all their merchandise from a cousin who offers them special pricing and they pay him in cash. Majority of in-store sales is paid in cash and they don't ring it through the cash register. They don't have a computerized inventory system and the owner keeps everything in his head. In store B the owner is working 15-20 hours per week, primarily doing general management. All day-to-day operation is done by employees and supervised by a manager. They purchase merchandise from a distributor with whom they arranged for credit terms. All sales is going through the cash register and POS also has inventory control system. The company is producing monthly financial statements and they're reviewed and analyzed by the owner. Needless to say that store A will have substantially lower purchase price than the store B. If multiplier range for retail stores is 1 - 2.5, store A will be closer to 1 or even less, whereas store B can score 2.25 - 2.5 multiplier. It means that how business is operated is just as important to business buyers as sheer numbers that it produces. Moreover, store A may never sell at all.
It is very hard to quantify the multiplier. That's why they say that business valuation is more of an art than science. It takes years of experience selling various businesses to develop sense to multiplier value and all influencing parameters for various businesses. Rules of thumb are grossly inaccurate. Specialized software is more accurate, however it also can't account for all circumstances that distinct one business from another. If you're indeed concerned with the price that you're about to pay for the business, do yourself a favor and hire a business broker to run unbiased business valuation for you. Isn't it worth a few thousands for valuation to know that you're not overpaying tens of thousands for a business? I think, it is.
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