Buying a business is the quickest
and fastest route to entrepreneurship. Instead of spending time
pre-planning and starting a business, you will have in your hands a
business that may have already proven viable. An existing business may
come with a solid customer base, supplier relationships, and even a
well-developed brand. This is the best option for you if you want less
hassles, less groping for strategies, and less mistakes compared to
starting a business from the ground up.
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As the buyer, the process of setting the price is often the most
challenging aspect of buying a business. This is often fraught with
emotions and conflicts, as both the seller and buyer have different
ideas of what the business is worth. The party most prepared with an
assessment of the business' value will have the upper hand during the
negotiations.
While there are no hard-and-fast rules in setting the price of a
business, certain factors figure prominently in its computation. One is
the prevailing economic condition: the price of a business usually goes
up during a growth period, but decreases during times of recession or
slow growth.
Another factor is the reason why the seller wants out and how bad he
or she wants to sell the business. A seller who wants to sell the
business as fast as possible is more likely to accept a discounted
price. Word of warning, though: don't show how badly you want to buy the
business as the seller can leverage this information against you during
negotiations.
Determining the value of a business is more of an art than a science:
it is not precise. Several methods commonly used in calculating the
value of a business are:
1.
Multiplier or market valuation. This
method calculates the value of a business by using an "industry
average" sales figure as a multiplier. You can use average monthly
gross sales, monthly gross sales plus inventory, or after tax profits of
comparable businesses in the industry. For example, the seller of a
business with annual sales of $250,000 may peg the multiplier at 0.30 to
generate a sales price of $75,000 (e.g. $250,000 X 0.30 = $75,000).
To determine the multiplier of the industry of the business you're
buying, contact your trade association or consult the services of a
business appraiser. You can also check out Richard Snowden's book
"The Complete Guide to Buying a Business," which lists the
multipliers of some industry. Snowden shows sample multipliers of some
industries below:
Travel agencies - .05 to .1 X annual gross sales
Ad agencies - .75 X annual gross sales
Retail businesses - .75 to 1.5 X annual net profit + inventory +
equipment
It is, however, difficult to substantiate multipliers. It can be a
random number that may not truly reflect industry realities. Since it
deals with average values, the formula does not take into account the
differences of businesses within the industry. If a seller uses this
approach, use the value only as an estimate but do not rely too much on
it.
2. Asset
Valuation. Some
businesses are worth no more than the value of their tangible assets. If
a company is asset-intensive, such as retail businesses and
manufacturing companies, you can use the asset valuation method. This is
a particularly good method to use if the business is losing money or
paying the owner(s) less in total than fair market compensation.
The goal of the seller in using this approach is to get the best
possible price for their equipment, inventory, and other assets of the
business. This method is a summation of the following factors:
- Fair market value of fixed assets and equipment (FMV/FA), or the
price you would pay to purchase the assets or equipment
- Leasehold improvements (LI), or modifications to space that would
be considered part of the property if you were to sell it or not
renew a lease.
- Owner benefit (OB), or the seller's discretionary cash for one
year
- Inventory (I), including raw materials, work-in-progress, and
finished goods or products.
3.
Capitalized Earnings. This
method of valuation is suitable for service companies and other
non-asset intensive businesses. This method places no value on fixed
assets such as equipment, and takes into account a greater number of
intangibles. This valuation method is best used for non-asset intensive
businesses like service companies.
The formula used to determine capitalized earnings is:
Projected Earnings/Capitalization Rate = Price
Where normal earnings are used to estimate projected earnings, and
capitalization rate is an estimated risk level of investing in the
business compared with other investment instruments such as stocks or
bonds. The capitalization rate is an average of several factors, and may
include length of time the company has been in business, length of time
current owner has owned the business, reasons for selling, risk factors,
profitability, location, barriers to entry and exit, level of
competition, industry potential, technology, and others.
4.
Intangible Value. Some
businesses, particularly those that are not asset-intensive, may be
harder to quantify. Service companies and dot-coms are examples of
businesses where this kind of valuation may work. In many cases, this
involves measuring the "goodwill" or psychological value of a
business, rather than its financial value.
For example, the valuation of an executive recruiting company may use
the cost of recruiting an executive and use that calculation to
determine the possible savings it will give to the buying company. The
worth, therefore, of the executive recruiting firm is not in its
overhead systems (e.g. offices, computers, phones) but in its intrinsic
value.
In the dot-com world, most of the fallen companies based the value of
their businesses on their customer base. Customers with a high
likelihood of being retained are valuable in most industries. Other
industries where companies are bought and sold based upon the value of
the customer base include insurance agencies, advertising agencies,
payroll services, and bookkeeping services.
5. Owner
benefit valuation. This
formula focuses on the seller's discretionary cash flow and is used most
often for valuing businesses whose value comes from their ability to
generate cash flow and profit. It uses a fairly simple formula -- you
multiply the owner benefit times 2.2727 to get the market value. The
multiplier takes into account standard figures such as a 10% return on
investment, a living wage equal to 30% of owner benefit, and debt
service of 25%.
6. Return
on Investment. The
most common form of determining the value of a business is through its
return on investment, or the amount of money the buyer will realize
compared to the performance of the business. Industry experts define a
good buy if the business can provide you with a return on your cash
investment of 15 percent or more.
About
the Author:
George Rodriguez is a staff writer for Power Homebiz Guides.
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