When entrepreneurs consider buying an existing business the first question they usually ask is, “how much is this business worth?” But if you are considering the purchase of a business, I suggest you modify that question and instead ask, “How much should I pay for this business?” Knowing how to really value a business is an important first step to answering that question.
What a business is worth will vary depending on who you ask. Every valuation expert and broker has a slightly different way to calculate the worth of a business.
And as if business valuation wasn’t complicated enough, every industry also has its own set of rules, formulas and traditions. For every category of business there is a different “rule of thumb” that will supposedly tell you how much the business is worth.
Here’s one truth that will go a long way towards simplifying the process and insure you don’t overpay for a business:
To figure out what a business is worth you must begin your valuation with its earnings not its revenues.
When you take over the business it will need to generate enough money each month for you to do 3 things.
1) Pay yourself a reasonable salary.
2) Pay off the debt you used to buy the business.
3) Execute your plan for growth.
If the business in question does not generate enough earnings to do these three things you shouldn’t buy the business. At least not at the current asking price.
And no amount of analysis of the sales figures or any rule-of-thumb will tell you at what price a business becomes affordable. Analyzing the company’s tax returns and profit and loss statements won’t either.
You need to know exactly how much cash the business makes available to its owner.
Specifically, you need to calculate what we call the “Owner’s Benefit”. (Sometimes called “Seller’s Discretionary Cash Flow”).
Calculating The Owner’s Benefit
The equation for coming up with the “Owner’s Benefit” is:
Annual Pretax Profit + One Owner’s Salary + Owner’s Perks/Benefits + Interest + Depreciation
Here is some detail on the factors in the equation:
Perks and Benefits: These include things such as automobile leases and travel expenses that are optional. They also include salaries for family members that are over and above the marker rate for the work they perform.
Let’s say the owner of the business you are considering has expensive tastes. The company has been making a lease payment of $600 a month on the luxury car the owner drives. And each year he and his wife go to all the trade shows in your industry and they always stay at the nicest hotels.
Additionally, lets say he has a teenager who works in the business during the summers for $20 an hour. But you feel you can hire someone off the street for $12.00 an hour. That’s $8 dollars of owner’s benefit for every hour the kid worked last year.
You may look at this business and determine that all these expenses are unnecessary.
None of this spending shows up as profit. But each item is a real benefit for the owner, paid for with real money generated by the business. Go through the company’s expenses and find all the money the business spends just for the benefit of the owner and his or her family.
You may want to spend money on these same perks, but you need to know the business provides the income to allow such spending.
One Owner’s Salary: This is the salary the owner has been paying himself. Perks and benefits not included.
Depreciation: This is what is called a “non-cash item”. It is a deductible expense even in years where no money is spent. This deduction is a way of providing credit for the business owner to buy new equipment when the old equipment wears out.
Let’s say a company owns a delivery van and that they paid $20,000 for it. If the company estimates they can get 5 years of useful life out of the van they can deduct $4,000 from their profits each year for the next 5 years to compensate for the decrease in the value of the van.
Depreciation is another one of those things that makes tax returns and profit statements misleading. It lowers a company’s reported profits without taking any money out of the owner’s pockets in the years the deduction is taken.
Now that you have calculating the owner’s benefit you know exactly how much money the business provides for its owner.
From that calculation you can then determine if you can do the three “musts” listed above.
If the answer is “no” then you know you can’t afford the seller’s asking price. That doesn’t mean you shouldn’t buy the business, just not at the current price.
By Pat Jennings. Pat Jennings is the founder of TheBizseller.com, a site dedicated to helping owners sell their business by bringing them together with qualified buyers.