This is a simplified way to buy a business. Because every person’s situation is unique, you must consult a professional before signing binding contracts.
VALUING a BUSINESS: CRITICAL POINTS
- There is no right or wrong amount. Only two things matter: what you’re willing to pay and what the seller will accept.
- Your pay depends on how much CASH you can earn from the business over the next years. (Many valuation methods exist, from complex mathematical formulas to simple sales percentages. These methods are a great way to cross-check the one suggested below.
HOW MUCH TO PAY – THE METHODOLOGY
STEP 1 NORMALISED PROFIT
Based on experience, calculate a “normalized” annual cash profit (before taxes) for the business. This is often done by starting with the last year’s yearly yield and adjusting items.
- Last year’s expenses, but not next year
- To be incurred next year, but not last year
- Items that are not cashable
Here are some examples of items that you might adjust
PROFIT INCREASE BY
- All wages and benefits paid to business owners (or people related to them) will cease to be in effect when the business is yours. These include wages, superannuation, and medical benefits.
- You will not be responsible for paying interest or any other finance costs.
- Depreciation and all other non-cash items
- Any non-recurring expenses that were incurred in the previous year (e.g., Legal fees for a case that is currently resolved
- Any new major customers will be expected to make an annual profit not included in sales for the previous year.
INCREASE PROFIT BY
- The market wage and benefits payable to you (and any partners/relations that will work in your business)
- Future expenses, such as rent or utilities, are not included in the last year’s profit. The business moved 3 months ago to a new location. This will decrease the gain to reflect the rental cost for the next 12 months, less than what was paid last year.
- Any revenue earned last year would be considered unusual or unlikely to occur next year (e.g., a large client was lost by a competitor or a ” special ” job that won’t happen again).
- An adjustment should be made if there will be substantial capital expenditure (new equipment) in the next 3-4 years. This is usually done by dividing the cost of the equipment by the expected years it will be used.
This stage will give us a value that represents the NORMALISED CREDIT PROFIT. This value represents the expected profit before the income tax the business will earn next year if it continues to operate as it did in the past.
STEP 2 – CHOOSE AN APPROPRIATE MULTIPLE
There are many books on choosing the right number of selections, but this RULE OF THUMB has helped me through many purchases. There are two ranges.
- Smaller Businesses (Profit Less Than $100,000) 2 to 3
- Medium Business (Profit $100,000 – $500,000) 3-4
This method is not appropriate for larger companies.
STEP 3 – CALCULATE THE VALUATION RANGE
Multiply Step 1’s NORMALISED PROFIT by Step 2’s MULTIPLES.
STEP 4 – NARROW THE VALUATION RANGE
You can narrow down the range by identifying factors that either increase or decrease the probability of you earning the normalized profit amount. This list is created in Step 1. Every aspect that increases the certainty will be able to support paying a higher range. Each factor that decreases confidence will allow you to pay a lower degree. You can narrow the content based on the importance and number of elements within each category.
Some examples of factors are:
1. Age of Business
A business that has been around for 20 years will have higher earnings and more market experience than one that has only existed for two years.
2. Size of the Business
The likelihood of a business surviving any adverse events is higher if it is larger.
3. Certainty in Revenue Stream
Many items can increase or decrease revenue, including.
- Is the revenue generated each year natural (e.g., An accounting firm that would see the same clients each year to prepare their tax returns? V’s carpentry company gets most of its customers via the internet or yellow pages advertising.
- Are there smaller clients than larger ones? While larger clients are more profitable, they pose a greater risk to the business if they move elsewhere.
4. Working capital required
The less you pay, the more working capital you will need (Debtors + Inventory Creditors). Compare two identical businesses. The first requires inventory worth $200,000, while the second allows customers to ship directly from suppliers. You save at most interest on $200,000 and the additional staff needed to receive, pack, ship, and stocktake the stock.
5. Economic Factors
What are the prospects for the next two years? If the economy or industry is expected to worsen, then your valuation should be more conservative.
6. Market Position/Competitors
How secure is your business? Are there many competitors in the industry (many competitors drive down profit margins), is there any new competition, and how difficult is it for a newcomer to enter the market? What impact will a new competitor have on the business?
Is the market expanding or contracting?
E.g., two businesses are making identical profits, one selling mobile phone technology and the other facsimile of sale machines. Mobile phone business will likely have stronger growth in the future, so you’re more likely to pay for it than you would for a facsimile business with an older technology with declining sales.
These are just a few of the factors. There may be other relevant factors (perhaps specific to your deal).