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Using Rules Of Thumb To Value A California Small Business

Using Rules Of Thumb To Value A California Small Business

Many business buyers try to use a rule of thumb to value a small business in California. This is a valuable tool but if you actually try to purchase a business based on it, you are sure to regret it later. Last week I received a call from an experienced restaurant manager that wanted to buy his own restaurant. He wanted me to confirm that restaurants were selling at 3 to 5 times net profit. I told him that they were not selling in that range in the current market. He insisted that he had seen comparables to prove they were. I thought this would be an interesting subject for an article.

When valuing a restaurant or any business by using rules of thumb you need to have an accurate profit figure. This is rarely available. There are so many definitions for net profit that there is a book used in the business brokers association training class to teach calculating profit that it is actually 6 inches thick. This is not a book for CPAs but just business brokers.

Lets assume we have now come up with a profit figure that works for our purposes. The rule of thumb must clearly specify what profit figure it is based on. There are "Sellers Discretionary Earnings" EBIT (Earning before interest, and taxes but after reasonable salary for the owner) and "EBITDA" (Earnings before interest, taxes, depreciation and amortization) just to name the 3 major profit figures used by business brokers. The rule of thumb, if one exists is different for each of these three methods.

Lets assume you now have a profit figure and a rule of thumb. Lets assume the rule of thumb is 3 times net profit.

The problems with rules of thumb still would have to be addressed. Rental amount, type of restaurant or business, franchise or not, all are not addressed by a rule of thumb. Would you pay the same price for a restaurant with $2,000 rent as $10,000 rent even if they both had the same bottom line? I wouldn't. $50,000 is a salary not a business investment.

The next big issue then comes forward: Would you pay $150,000 for a business clearing $50,000 with the owner working 60 hours a week, if there were similar businesses available for $450,000 that were making $150,000 profit, with the owner working 60 hours a week?
I hope this is of some help in navigating the river of misinformation floating around regarding how to value a California small business.

Categories: BizBen Blog Contributor, Business Valuation Issues, Buying A Business, Deal And Escrow Issues, How To Buy A Business, How To Sell A Business


Willard Michlin
Areas Served: California
Phone:  805-428-2063
Willard Michlin, CPA #106752, offers buyers step by step training & assistance in doing Due Diligence Services when they are thinking of making an offer, or are in process of investigating a business purchase. He helps to determine the actual net profit even when there is cash. Call 805-428-2063.

Comments Regarding This Blog Post

When I receive a call off one of my marketing pieces or someone refers me to a potential seller and they ask "how much is my business worth?" I'll tell the potential seller that I don't do business valuations over the phone. I don't prefer to see a business in person before I give a valuation because I'm trying to persuade the seller in person to sell, but it's just that there are a number of factors which can affect the ultimate selling price and it's just bad business to give out inaccurate information. General rule of thumbs aren't bad, for example if a business has a net income of $50,000 a year, it simply wouldn't make sense for someone to buy it at $400,000, because most buyers expect to recoup their investment within 2-3 years, maybe a little longer depending on the lease and other factors. Some restaurants that are short hours and 5 days may sell for more, because it allows the owner to have a life instead of being there 6-7 days a week.

Another factor that cannot be overlooked in "valuing a business" is that business value is fungible and subjective, depending on who the buyer is.

The "occupational buyer" is looking for a job without a boss, with a certain amount of freedom, and with job security dependent only on himself. He wants a fair salary for himself -- actual or imputed -- plus a respectable but not necessarily high rate of return on investment ("ROI") beyond that "salary."

The "financial buyer or "investor" doesn't intend to operate the business on a full-time basis and will be an absentee or semi-absentee owner. This investor is looking for an ROI that makes sense for an entity that is relatively illiquid (businesses can take a long time to sell) and can be subject to unique and varied risks. With the stock market currently providing ROI in the teens on a commodity that is very liquid (you can sell a stock in minutes), it makes little sense for most investors to buy a small business unless it has an ROI of 25% to 30%, at the least.

The "strategic buyer" often will pay the highest price, because the value to him is based on the synergy and economies of scale that result from buying the business. Generally, this buyer is in the same or similar industry and is expanding by acquisition, whether that be eliminating a competitor, broadening geographic reach or deepening geographic concentration, attaining greater purchasing power through a larger critical mass of business volume, or sundry other reasons. The "value of the business" can often be the highest for this strategic buyer.

So, there isn't necessarily one magic figure. -- "Beauty is in the eye of the beholder." And, value is in the checkbook of the buyer.

Contributor: Business Appraisals, Valuations Advisor

Rule of thumbs are general averages of similar types of businesses. If all businesses were equal then the rule of thumb method would work, but no two businesses are alike. The problem to a buyer is that there are excellent and terrible businesses in this group of similar businesses. The only way to make sure you are buying one of the excellent businesses is to have all the financial records evaluated by an expert. It may cost to do this, but it could be the difference between success and failure.

  Helpful Resources To Assist In Selling And Buying California Businesses
Willard Michlin, CPA, Certified Fraud Examiner, Due Diligence

Willard Michlin, CPA #106752, offers buyers step by step training & assistance in doing Due Diligence Services when they are thinking of making an offer, or are in process of investigating a business purchase. He helps to determine the actual net profit even when there is cash. Call 805-428-2063.

Elizabeth McGovern: Escrow Services - San Francisco Bay Area

McGovern Escrow Services, Inc., is a leading independent escrow company. We are a trusted partner with our clients, assisting them through the tangled bulk sale & liquor license transfer process. We provide attentive, quality & innovative customer service. Phone Elizabeth McGovern at 415-735-3645.

Diane Boudreau-Tschetter: Escrow & Bulk Sale Services - CA

California Business Escrow, Inc. is a full service independent escrow company serving all of California and has expertise in a wide range of escrows. Our team prides itself on providing an exceptional escrow experience. For more info phone Diane Boudreau-Tschetter at 888-383-3331 or 209-838-1100.

Helen Yoo, New Century Escrow - Escrow Services In Southern California

New Century Escrow, Inc. is a fully licensed & bonded independent escrow company. Over 20 years combined experience in handling bulk escrow transactions. Multi-lingual staff that speaks your language, including Korean, Chinese, Vietnamese. Call Helen Yoo direct at 626-890-1151.

Janet Carrera: Escrow & Bulk Sale Service - SF Bay Area

Redwood Escrow Services, Inc. is a full service, licensed independent escrow company. We are EAFC Fidelity bonded, fully insured & licensed with the Department of Corporations. Committed to offering our clients the most comprehensive variety of escrow services available. Phone Janet at 510-247-0741.

Shalonda Chappel-Pilgram: Escrow & Bulk Sale Services - Southern California

Escrow services to brokers/agents, sellers, & buyers. Established 43 years. Extraordinary service. Experienced with handling difficult transactions. One stop for all your escrow needs: Bulk sales, lien searches, UCC searches, liquor license transfers, publishing & recording services. 951-808-3972.

Chuck Post: Laundry Buyer Representation, Consulting, Due Diligence

I have 32 years experience in the laundry industry, specializing in assisting laundry buyers with buying or starting up, building, re-tooling, laundries throughout CA. Laundry buyer representation, consulting, due-diligence, lease negotiations, laundry valuations. Contact me at 619-227-5711 Cell.

Steve Erlinger: Laundry Broker, Consultant

I specialize in the laundry industry broker and consultant in Southern California. I assist buyers navigate the many facets of finding, evaluating, and operating a laundry business. I also help current laundry owners find additional stores, sell, evaluate an existing laundromat. Call 949-500-5893.

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