Placing The Right Value On A Small Business
Cliff Ennico
www.creators.com
#147;I am thinking about buying a specialty food store that has been operating in town for 30 years. The owner is willing to sell, and has provided me with copies of his financial statements and tax returns for the past few years, but has asked me to make him an offer. How can I figure out a fair price for a business like this?#148;
There#146;s a science to putting a fair value on a small business, but you can also come up with a reasonable estimate on your own, according to business valuation expert Roger Winsby of Axiom Valuation Services in Wakefield, Massachusetts (
www.axiomvaluation.com
) and co-author of #147;What Every Business Owner Should Know About Valuing Their Business#148; (McGraw-Hill, $21.95). The first thing, Winsby advises, is to base the value on the future potential of the business, not its past performance: #147;the history is context, but you#146;re buying the assets of the business so you can hopefully get a better return than the current owner.#148;
For a business like this one, Winsby says, estimating a value is a five-part process:
first, you look at the financial statements and tax returns and determine how much profit the business is making each year before interest expense, and income taxes; be sure to adjust for #147;reasonable#148; compensation that the owner is taking out of the business (i.e., add back to profits if the owner takes a salary that is more than you would need to pay an experienced person to manage the business day-to-day; or vice versa --accountants call this #147;earnings before interest and income taxes#148; or EBIT;
second, take the company#146;s EBIT for the last two to five years, add them up, and divide by the number of years (in other words, calculate the #147;average#148; EBIT); subtract from the average EBIT the expected income taxes (safe assumption is 40% of average EBIT); and then add the average depreciation expense; accountants call this #147;average free cash flow#148;.
third, take the average free cash flow and divide it by your #147;discount rate #148; #150; Winsby says this should be somewhere between 18% and 35% depending upon the type of business and how stable it is (for example, you would insist on a high return rate for an Internet consulting business that could shut down tomorrow, and a low return rate for a grocery store in business for 40 years with a stable clientele) #150; you now have a possible #147;purchase price assuming no future growth in free cash flows; to estimate the value if you think the business could increase profits by 3% per year, then adjust the required rate of return by subtracting 3% from your original estimate of the required rate of return (18% - 3% = 15%); this will give you a reasonable range of values.
fourth, divide your purchase price by the business#146; current sales #150; the resulting ratio is called a Price to Sales multiple; and
fifth, compare that #147;multiple#148; to those of other similar businesses that have sold in the past year (for $17.50, a standard reference work, #147;Small Business Valuation Formula Multiples#148;, with a range of multiples for over 170 different small businesses based on recent sales figures, can be downloaded as an Adobe Acrobat file from
http://valuationresources.com/Misc/ValuationMultiples.htm
).
But be careful -- Winsby warns against simply using an average multiple from any source and then applying them to a particular business. #147;These figures are based upon statistical averages,#148; Winsby explains. #147;When you plot out the actual transactions from which the averages are derived, they are all over the map. Don#146;t ever assume that the business you are looking to buy is an #145;average#146; business #150; it may be at the high or the low end of the range depending upon a number of factors.#148;
Customer attrition, for example. A solo law practice can be expected to have a high rate of attrition after it is sold, because many clients have a high degree of personal loyalty to the seller and will #147;go elsewhere#148; when the practice is sold. Such a practice should command a low multiple, unless the seller is willing to spend a long period of time #147;transitioning#148; the business to the new owner. A specialty food store that#146;s been in town for 30 years, on the other hand, can be expected to have a low rate of attrition after it is sold, because most customers have accustomed themselves to visiting the store regularly and will not change their habits just because there#146;s a new owner. Such a business should command a relatively high multiple . . . unless a major competitor is planning to open across the street in a few months!
What if you really don#146;t want to do the valuation yourself? While many accountants will value a business for you, Winsby advises that you approach someone who specializes in valuations to get the best deals. A #147;certified valuation#148; (one that would be acceptable to the IRS or a court of law), Winsby says, will cost between $5,000 and $10,000, but for about $2,000 to $3,000 you can get an #147;estimated valuation#148; or a #147;robust estimate#148;, which should be acceptable to most sellers, SBA lenders, and private investors.
Cliff Ennico (
cennico@legalcareer.com
) is a syndicated columnist, author and host of the PBS television series 'Money Hunt'. This column is no substitute for legal, tax or financial advice, which can be furnished only by a qualified professional licensed in your state. To find out more about Cliff Ennico and other Creators Syndicate writers and cartoonists, visit our Web page at
www.creators.com
. COPYRIGHT 2005 CLIFFORD R. ENNICO. DISTRIBUTED BY CREATORS SYNDICATE, INC. Permission granted for use on DrLaura.com
