By George Obst, Certified SCORE Mentor
If you think about buying a business or selling your business you need to arrive at a fair market value. This can be a very complex process and this article touches on a few of the factors in business valuations. In concept, it is similar to selling a house. You arrive at a fair valuation by looking at recent sales of similar homes in the neighborhood, the condition of the home, and the housing market in general.
So, what is a business worth?
Business valuations take into account these factors and many others. Although it is important to note that it is much more complex than valuing a home, it is not an exact science. If you are buying a business you will want the fair market value to be low. If you are selling your business you will want the fair market value as high as possible.
There are many valuation variables but the most important in determining the value of a business are the following:
- Sales. Not only sales at a given point in time, say the past year, but the sales trend. Are they growing or are they going down?
- Cash flow. You’ve heard the expression, ”cash is king”. The net cash flow is the revenue generated minus expenses and is key to determining value. Cash flow and profits are closely related but differ in that profits take into consideration non- cash items such as depreciation. The trend in cash flow and profits over the last two or three years are very important factors in determining value. Debt influences this cash flow analysis and, in general, may mean that the valuation will be reduced.
Other factors that are important to value include items such as:
- Equipment (age and condition)
- Competitive position in the marketplace
- Facility condition and lease terms
- Patents owned,
- Strengths of management and staff (if any)
- Internal systems (controls and procedures)
- marketing programs
- and the best “guestimate” about the future sales and cash flow. ..
An intensive, close examination of the past, present, and future of the business are key to determining value. The past and present, as far as the numbers are concerned, are fact. The future is a value judgment and as such is subjective.
It can be stated that the value of a business, i.e. what is being bought and sold, is primarily a judgment of the business’ future income.
Many businesses may sell for a multiple of the last two or three years average cash flow. Some business’ may sell for a multiple of annual sales or a combination of sales and cash flow (profits).
Keep in mind that when you look at cash flow, you should not include the salary the owner draws out of the business. If it represents the appropriate salary for someone performing that job, it is normal operating expense. Any excess paid to the owner above the going rate may be added to the cash flow calculation. However, if the owner draws out less than the going rate for that job, there should be a reduction in the cash flow calculation because the buyer may have to pay more to hire someone to do that job.
There can be significant differences in valuing business’ in one industry vs. another. Some industries are considered “sexier” than others and may have a higher valuation. Thus, research into recent sales of like business’ should be part of the process. Of course, even within the same industry, business’ can be quite different. As a minimum, recent sales will contribute some idea how the market values the industry.
In the final analysis, a business is worth what an enthusiastic buyer is willing to pay and what a motivated seller is willing to accept.
Whether you are buying or selling you will need to consult with professional advisors such as accountants, bankers, attorneys and professional appraisers. They are most important in the evaluation process of an existing business.
Of course, SCORE has professional mentors who can walk you through the process (at no cost to you). They are not a replacement for your accountant or appraiser, but they are a professional unbiased resource. Call 602 745-7250 or click here to make an appointment with a SCORE mentor.