Establishing Value: There are many factors to consider before purchasing a business. Use these tips from Ask BKH to figure out what a business is really worth.
Dear Janet,
I’ve always wanted to start an appliance repair shop, and have now heard about one that’s up for sale. I’m planning to meet the owner and find out how much he wants for the business, but how do I determine if the business is worth whatever he asks and what else do I need to know?
–Mr. Fixit
Dear Mr. Fixit,
It takes a combination of industry knowledge, experience, mathematical calculations, and common sense to come up with a figure that is representative of what the business is really worth.
Accountants and appraisers may use several of these calculations to determine what the business is worth.
NET BOOK VALUE. This is the combined value of all assets as they are listed in the business’ books, minus the business liabilities. The accuracy of the resulting figure depends on whether the inventory, receivables, and equipment are accurately valued on the balance sheet.
ADJUSTED BOOK VALUE. Instead of using the book value of the business assets to calculate the company’s worth, you use the present value (what they’d actually sell for) of the assets.
COMPARATIVE VALUE. This considers what businesses similar to this one have sold for lately. If a business like this recently sold for 3 times earnings, you might expect to pay 3 times earnings for the one you want to buy.
DISCOUNTED EARNINGS. Future earnings are projected based on the earnings in prior years, and then that future projected is discounted a certain percentage to allow for inflation.
APPRAISED VALUE. This is the price tag independent appraisers put on your company.
Each of these calculations may give a different value – and could be quite different from what the current owner is asking.
Get the Whole Picture
The results of such calculations aren’t all you should consider, however. You need to look beyond the company’s books to determine the business’ real profitability. The business’ past years tax returns will give some indication of its profitability. Information about whether the company pays its vendors and suppliers on time can also be useful in judging profitability.
Owners often like to point to the good will they have established as an asset. And it may be. But, in a small service business, the success (and profits) can be so closely tied to the participation of the current owner in the business, that when they go, so, too, do the customers. Of more value, potentially, is what ads the business is currently running. Is it in all the local yellow books? Has it been there for years? Was the ad renewed for the upcoming edition of the yellow pages? Or do you still have time to do that once the deal is closed?
Find out what the owner’s reason for selling is, and be sure to have the seller sign a noncompete agreement that your attorney should draw up. Without a noncompete agreement, the seller could conceivably sell you his business today, then open up a competing one in the same area a month or so later.
Take the time to find out all you can about the business you want to buy and the surrounding community. If you are assuming a commercial lease with 3 years left on it to run, you wouldn’t want to find out after the purchase that the business has been granted a yearly zoning variance to operate at its present location and that the city does not plan to renew the variance after next year. Neither do you want to wait until after the purchase to find out a major new competitor is moving into the area.
Good luck!
