I was asked this question today from buyer who asked about a valuation/equipment dilemma he was pondering when looking make an offer on a business with substantial equipment included in the deal.
Here is the buyer's question:
“ I am about to make an offer on a machine shop, the asking price is $1.9M, the adjusted net income on average for the last three years has been $287K with equipment valued at approximately $600K, it seems to me the business is overvalued – with a multiple of 4 the price seems like it should be more like $1.2M. The question is do you add the equipment value to get a valuation of $1.8M or should the “equipment value” be included in the price of $1.2M?"
Several responses from our BizBen panel of experts:
From Joe Atchinson, Business Broker, CBI, CBB, CPA, MBA - Sunbelt Business Brokers
"My opinions on your machine shop valuation question are:
First, this machine shop is not worth anywhere near 4.2X to 6.6X SDE ($1.2M to $1.9M asking price) unless there are some extremely unusual circumstances like just landing a very large, non-cancellable, multi-year production contract from a reputable customer. I think that the starting point should be 2X to 3X, max.
The most relevant year is the 2007 which is just over two weeks from being over. If 2007 revenues and net are considerable higher than 2006 then value it up. If 2007 is a down year, especially if it is the second or third down year in a row, value it down – perhaps way down.
What is the capacity utilization? If only at 40% of capacity, value it up. If at 90%, value it down.
What are the quality, concentration and geography of the customer base? Value up or down depending on the answers.
As for the equipment, that is what was necessary to produce the $287K SDE so there is no adjustment for the equipment unless there is an unusual circumstance like the seller recently purchasing a high productivity piece of equipment that would reduce unit costs and improve margins and, better yet, allow them to get contracts that they did not have the capacity or capability to produce in the past.
What are the competitive threats - especially from the customer going offshore to China, India, etc.
Does the seller have long-term, talented employees?
Does the seller have a long-term lease with favorable terms?
How large of a note is the seller willing to carry? An all cash deal will sell for a big discount compared to the price of a financed deal.
What is the sellers purchasing leverage – probably not much; and what is the seller’s pricing leverage?
Nothing was asked about the value of the inventory (raw stock, work-in-progress/semi-finished and finished goods). That is another important question with the biggest issue being how much do I discount the cost value for excess and obsolete inventory?
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From Willard Michlin, Business Broker and Due Diligence Specialist:
"The equipment is always included in the price when usuing the income approach. . Why? The rule is that whatever is necessary to produce the income stream or to produce the product must be included.
What the seller is trying to do, in this example is to use two different appraisal methods in order to raise the price.
Under the income approach, the value of this business is based on the owners benefits approach. Your example is 4 times but can be some other number times the net income or total owners benefits. This value includes the equipment and everything else with the exception of the accounts receivables and inventory. In some cases, even these are included in the price.
If the seller is valuing the business based on the assets which includes the equipment then he might also add the accounts receivables, inventory and the value of the customers. In this case you can not also use the income valuation approach."
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From Rick Eggleton, Business Broker at BizSellers Inc.:
"Valuations for any business are not a simple matter of setting some multiple of sales or adjusted net income. There are other factors you need to consider like premise or equipment leases, customer mix or concentration, revenue trends, inventory, and many more.
In this case $1.9 million seems overpriced on adjusted income of $289,000 even with equipment of $600,000. Here is a quick and dirty formula for Machine Shops according to the Business Resource Guide: 65-70% of annual revenue plus inventory, or 2 times EBIT, or 1.5 times EBITDA. In each case those prices based on recent sales don't seem to be on the same playing field let alone in the same ballpark. I'd drill down and find out where the adjusted income number comes from and how it was adjusted. I don't use that term, I use Seller's Discretionary Earnings defined as the last year's tax return taxable income plus amortization, depreciation, interest expense, seller's salary (and portion of employment taxes, seller's perks, and one time expenditures. While most brokers are unwilling to provide detailed financial information you should expect to receive at minimum the worksheet leading you to the adjusted income they are claiming BEFORE you make an offer.
Another I always recommend is that you use a small business CPA to handle the financial due diligence for you. That way you are assured you are seeing the real deal. Find someone who is a small practitioner (3-10 person office) who focuses on entrepreneurial small businesses to do this work. Don't use Uncle Manny or Cousin Fred or the business' CPA.
After you've got the real numbers the acid test is affordability as outlined in a Loan Requirements ROI Summary. Or simply by finding out if the business will qualify for an SBA loan of 70-80%."
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From Bob Klein, Business Appraiser:
"There are two things that determine the value of a business, asset value and cash flow. Use the true equipment value (not equipment book value) and all the business's assets, then use a reduced multiple. Machine shops usually have high asset values. This is not only because of the equipment but also the tooling, fixtures and inventory.
In the question there was no indication as to what the last 12 months cash flow was. The last three year average is interesting but the last 12 months should be the basis of the business's value. At the least a weighted 3 year average with the last 12 months at 50% of the average would be more accurate."
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From Bob Hughes, Business Broker – Hughes Properties:
"The equipment should be included, this is part of the required equipment to have the cash flow as shown. Equipment should be part of the 1.2 million. This would be a great business to finance since banks love hard equipment as compared to a service business. The standard these days is 3X cash flow with a top end of 4X, with the equipment you could go to the 4X level. That’s is what works for me in the field."
Peter Siegel, MBA is the founder and President of BizBen.com - Businesses For Sale In California. A nationally recognized author (3 books and a syndicated small business blog) and expert consultant (national SBA small business specialist) on selling and buying businesses, he provides professional assistance to business brokers, agents, and business owners in getting maximum response in their advertising & marketing efforts in regards to selling small to mid-sized businesses. If you are selling a business and need professional assistance utilizing high performance advertising, marketing, and highly effective strategies, or individual customization with your BizBen Power Search options in buying a California business, you can reach him at 866-270-6278.
Posted on April 1, 2009 | 
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