Best Buy When purchasing a business, how do you determine a fair price?
Opinions expressed by BIZ Experiences contributors are their own.
Q. What is a good rule of thumb in determining thepurchase price for a business? I have heard that a good formulauses the amount of profit times a multiple of 3. Is that true?
Lea Gionette
Via the Internet
Q. I have explored several small businesses in rurallocations for possible purchase, but I keep coming back to the sametwo issues: First, I start by determining the cash flow (takinginto account the cost of goods sold, depreciation, expenses,salaries, etc.). Then I divide the cash flow amount by a realisticcapitalization rate. Why would the resulting amount be increased toaccount for assets when assets were already incorporated indetermining the level of cash flow? Second, how can I reach anagreement with a business owner on the value range of the businessif the owner is reluctant to use the services of an experiencedbusiness appraiser or business broker?
Dennis Pabich
Via the Internet
A. David M. Bishop is an attorney-CPA and a businessappraiser with the Bishop Law Firm in Charlotte, North Carolina. Headvises business owners on business transfer strategies and hasvalued or sold more than 100 businesses:
The overwhelming majority of small-business sales are assetsales using earnings-based valuation methods, and business brokersordinarily assume an earnings-based valuation when quoting aselling price. That's because for most profitable businesses,the greaBODY value is in the earnings, not the individual assets(e.g., inventory, equipment). However, a company's individualassets are sometimes worth more than the company's annualearnings, in which case the price determinant would quite simply bethe value of the individual assets. But think long and hard beforepurchasing a business based strictly on the individual asset valuebecause the goal should be to buy an established business withproven cash flow.
The question on buying a rural business indicates you have madeuse of an earnings-based valuation methods; however, this methodmay be more appropriate for a medium-to-large-sized company thanfor the smaller situation you describe. In valuing the assets of asmall business (revenues of $2 million or less), the Owner'sDiscretionary Cash method is the one I would recommend because iteliminates arguments over what amount represents reasonablecompensation for the owner and what amount represents trueincome.
Owner's Discretionary Cash is an amount equal to the sum ofpretax net income, owner's compensation, interest expense,depreciation, owner's perks, extraordinary losses anddiscretionary expenses less extraordinary gains and income. Amongthe other types of earnings bases are net income, gross cash flow,net cash flow and earnings before interest, taxes, depreciation andamortization (EBITDA). Both the Owner's Discretionary Cashmethod and the EBITDA method indicate values for the"operating" assets (all assets less cash, accountsreceivable and nonoperating assets). Your reluctance to increasethe resulting value by the value of individual assets iswell-justified, unless the assets are nonoperating, such asmarketable securities not used in the business.
While an appropriate market multiple for the EBITDA method iscurrently 5, a common mistake is to mismatch an earnings base suchas EBITDA with the average market multiple for the Owner'sDiscretionary Cash method, which is 21|2 to 3. Begin byproperly matching the earnings base to the market multiple.
Before blindly applying a multiple to the earnings base,however, consider other factors that justify a higher or lowermultiple. For example, if a business depends on a handful ofcustomers, a key employee, or a contract that could be terminated,the company may be riskier than the average business and thereforea lower multiple should be used. Also consider whether the businessis so connected with the owner that it can't be transferred. Inthat case, the multiple should be very low to reflect the risksassociated with transfer. Are you buying stock (and therebyassuming all the liabilities of the business)? Again, making theappropriate adjustments in the valuation process is critical.
Remember: The danger with rules of thumb is that people forgetthey're merely guidelines. The rule of thumb may not beappropriate if there is more than one owner, the business owns realestate or has erratic earnings. A word to the wise: Before buyingany business, insist that you be given enough information to reviewwith your business appraiser. Do-it-yourself valuations can becostly.
