Buying an existing business: What you should pay
much should you pay for the business you want? Determining the worth
of a business is difficult and involves a process called "valuation."
There are several types of valuation
techniques, none of them is very simple, and none is considered
a golden standard, according to Internal Revenue Service rules.
Your certified public accountant can direct you on
the best method for valuing a business in your particular industry.
The two most common approaches have to do with replacement of assets
Sometimes called book value or balance sheet method, this process
basically involves totaling the replacement value of the tangible
assets. An outside appraiser usually does the work. Intangible assets
may or may not be a part of the equation. Rely on the combined input
of your accountant and attorney to properly appraise the value of
intangible assets. Subtract liabilities from appraised assets to
come up with a company's net worth and a base for negotiating fair
Income statement valuation
What will the rate of return be on your new investment? Surely you
want it to be better than the one you can get in a money market
fund, a federally insured certificate of deposit or even the stock
market. Your main reason to invest in a business is to make a profit,
so you need to compare the rate of return for this investment with
that of others. Start by calculating the future earnings of the
business based on historical data of cash flow and expenses.
Review the historical performance of the financial
ratios and of the sales that appear on the income statement.
Finally, review the trend of economic data in the County Business
Patterns, Economic Census Data and the Yellow Pages. These will
provide the basis for making assumptions about projected sales,
net profit and returns on investment.
If there are any inconsistencies in the historic
trends of the business, examine the footnotes to the financial statements.
For example, long-term liabilities -- perhaps a real estate loan
-- may have been paid off early, causing cash on hand and retained
earnings to decline. This can dramatically reduce liquidity and
earnings ratios. On the other hand, short-term liquidation of a
sufficient amount of discontinued merchandise in inventory can dramatically
increase cash on hand and the
quick ratio, while the current ratio may decline.
So, what is it worth?
Having projected future earnings, you have to calculate the present
value of those earnings by selecting your optimum return on investment.
According to the Small Business Administration, the lower the risk
associated with the investment, the lower the required rate of return,
which can range between 20 percent and 50 percent.
If you divide the projected earnings by the return
on investment, you'll come up with what's considered a fair price
range. For example, if the asking price of the business is $140,000,
and projected annual earnings are $26,000, then a fair price for
someone seeking a 25 percent return on investment would be $104,000
($26,000 divided by 0.25) and $130,000 for a 20 percent return.
($26,000 divided by 0.20)
But other factors also will come into play when determining
a fair price, including the nature of the business, the economic
condition of the industry, interest rates and the availability of
financing. Of course, even after all those calculations, you can't
overlook the true value of the business, or the bottom line of what
the buyer is willing to pay the seller.
To find out more about how to value a business for
sale or purchase, you can fill out an online order form for the
publication, "How to Buy or Sell a Business" (Publication MP16).