As an Advisor on BizBen.com I talk to many California business buyers, business owners, business brokers, and agents on a daily basis about valuing California small businesses. It always amazes me on how some of these individuals come up with the values on small businesses being sold. No wonder only 30% of all California small businesses actually end up selling!
In many instances no consideration is given to the total picture - like will the available cash flow of the business be able to pay the debt of a loan or some form of business purchase financing, will the deal as structured or priced even be attractive to financing sources, "cash" price vs. "note" price and how these factors figure into the equation!
I have seen many "professional valuations" where the asking price just doesn't make sense and owner/sellers wonder why their California business being sold just sits there with no action taken by potential business buyers!
There is a solution that is grounded in the fundamentals of economics, and time tested in the marketplace, where the influences of supply and demand ultimately determine where a business belongs on the price scale. One economist explains this market approach by comparing a business to a machine which has the purpose of making money: The more money it makes, the more it's worth. And that explains why, for example, there is a strong demand for a very profitable distribution business with few hard assets; and why it is worth more in the marketplace of available businesses, than a large machine shop that would cost nearly $1 million to duplicate, but can't make a living for its owner.
Adjusted Net Income
The first category of information needed is called adjusted net income (cash flow, SDC: sellers discretionary cash), and is the total amount of cash produced by the money machine. It's a figure that includes the profits, the owner's salary and all of the many cash-related benefits which are enjoyed by the principals of small businesses. Those benefits can include the use of a company car, the company-paid premiums for health, life and auto insurance, plus personal expenditures tucked into travel and entertainment, subscriptions and similar business expense categories. Interest expense should be added to adjusted net income, along with accounting entries "such as depreciation and amortization" that can divert money to the owner's pocket so that it never appears on the bottom line of the P&L.
While some of these items vary from business to business, any owner knows which categories of expenses in his or her financial records include sums of money that should be added to adjusted net income. Many business owners also know of cash income that never sees the business records in any way, shape or form. Some owners feel they should get credit for these sums in the calculation of value. But it's a poor policy to collect unreported income and then attempt to have it included in adjusted net income for evaluation purposes.
When selling, your buyer prospects want any statements you make about your business to be supported by evidence in the form of accounting records and other reliable sources. To admit that you are doing business "off the books" not only exposes you to problems with the IRS, it also sets a bad tone with prospects who if they are going to be interested in your business - need to believe your practices and record keeping are above reproach.
Adjusted net income is usually the first thing any buyer wants to know about when investigating a business; and not just the past few months' worth of income. A seller should be prepared to demonstrate a history of earnings, and have the documentation to back it up.
The next piece of the equation comes from the expectations working in the marketplace to shape the multiplier a figure which will be computed, along with the cash flow, to calculate a rough value. The validity of the multiple is that it reflects behavior in the market. There is no need to theorize about a proper multiplier. It's calculated by determining what buyers actually pay for small businesses in California. BizBen.com has a database of comps of pre and post California small business sales and we continually add more weekly. Most multipliers we find at this point in time are between 1X to 4X (provable) annual adjusted net income. The difference in the multiple depends on many factors - supply and demand for that type of business being sold/purchased, competition, history of earnings, and current operations of the business (possible future operations play a slight role).
Categories: BizBen Blog Contributor, Business Valuation Issues, Deal And Escrow Issues, How To Buy A Business, How To Sell A Business
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Phone: 925-785-3118 Cell, 925-785-3118 Text
Peter Siegel, MBA - Founder Of BizBen.com (since 1994), I am the Lead Advisor for the ProSell, ProBuy, & ProIntermediary Programs. I advise/coach buyers, sellers, and brokers daily about buying & selling small to mid-sized businesses throughout the Nation. I can be reached direct at 925-785-3118.
Comments & Feedback From Pro Intermediaries & Pro Advisors On BizBen:
Posted By: Joe Ranieri, Business Broker: LA, Orange Counties
Many new agents can "work the streets" and find new listings, but it takes time as a business broker to know how to price a business. After doing this job for so long, business brokers may develop a sixth sense of what the market will bear, but there are many factors that can ultimately determine a selling price. One of the factors I see, especially in the restaurant business, is rent. Many novice owners are intimidated by high rent, even if the monthly gross sales are high. I've found that once a rent goes north of around $5,500-$6,000, many novice buyers become uncomfortable. The higher the rent, the more experienced buyers I sometimes see, because they understand the costs associated with running a high grossing business.
Posted By: Business Appraisals, Valuations Advisor
Don't forget about my blended method which provides the most accurate appraisal.
There are a number of traditional accounting methods used to calculate business worth. None of these methods individually addresses all of the items that create value. One method looks at assets/liabilities while another will look at cash flow or market comps, each separately. It is not uncommon to see five different methods used for an appraisal, each being weighted or one being picked as the proper method with out any logical or statistical justification.
During my 23 years as a Business Broker and president of Business Appraisals I found that blending three of these different methods into one appraisal method captures all elements of a business that have value.
First I look at the P&L statement and cash flow. Adjustments are made in the form of add backs which, depending on the purpose of the appraisal reflect the cash flow of the business before discretionary spending of the owner/owners. A multiple that is statistically based on 25 years of business sales and appraisals is used to determine the cash flow value of the business.
Second I look at the Balance Sheet and the net worth (asset/liabilities). Again, adjustments are made based on the purpose of the appraisal. Book value is adjusted to reflect market value for equipment and real estate.
The third part of this appraisal process look at market conditions that reflect value, such as sales growth or decline, customer percentage of gross sales, profit margins and other market influenced items as needed.
All of this is then presented in a concise logical form with a description for each step in the process, giving the user a clear, understandable, accurate and affordable business appraisal.
Posted By: Timothy Cunha JD, Business Broker: San Francisco Bay Area
I have seen countless "business appraisals," "market valuations," "competitive market analyses," and similar sophisticated-sounding documents that purport to tell definitively what a business will sell for, prepared by someone with loads of letters after his name, except for the all-important C.S. -- "common sense." Often these are prepared by people who apply all kinds of fancy formulas but who have no practical experience in owning or selling a business.... and the resulting document has no relation to reality.
The methods Peter Siegel describes all make sense because they reflect real world conditions and realistic expectations of what value the business will have to a new owner; but, they are especially accurate when they are tempered by and filtered through the experience and common sense of a trusted business sales professional.
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