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Buying an existing business: What you should pay

Small Business BasicsHow 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 and return-on-investment.

Asset valuation
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 price.

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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 SBA publication, "How to Buy or Sell a Business" (Publication MP16).


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