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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. 
Willard MichlinAbout The Author: Willard Michlin, CPA (106752) offers business buyers Due Diligence Services (Second Opinion, Offer Assistance, Final Due Diligence) when they are thinking of making an offer on a business or in the process of investigating a business purchase. He has written numerous articles on the due diligence process and can be reached direct at 805-428-2063 for more information and an appointment.

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

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 Services

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.

Helen Yoo: Escrow & Bulk Sale Services - 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.

Diane Boudreau-Tschetter: Escrow And Bulk Sale Services

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.

Mark Chatow, Esq.: Legal Services For Buying, Selling Businesses

Mark has a broad range of small business purchase & sale experience from analyzing potential acquisition targets to successfully guiding buyers and sellers through the purchase & sale of small businesses. Mark can assist with contracts, negotiations, legal matters, etc. Reach Mark at 949-478-8393.

Mani Singh, Business Broker, Inland Empire

I have successfully represented clients sell & acquire multitude of businesses ranging from Gas Stations, Liquor Stores, Markets, Super Markets, Smoke Shops, Postal Stores, Restaurants, General Retail, Auto and Construction related. Phone me for assistance with selling or buying at 951-296-7646 Cell

Lee Petsas, Business Broker - Orange, San Diego Counties, Inland Empire

UBI Business Brokers has been successfully selling businesses in Southern California since 1965. Our Agents have over 100 years of experience in selling small to medium size businesses throughout Southern California. We service Orange County, Inland Empire, San Diego. Phone Lee at 714-363-0440.

Joe Ranieri, Business Broker, Orange & LA County Areas

Having owned retail/restaurant businesses for over 20 years, my interest turned to listing and selling businesses rather than owning them. I specialize tend to specialize in Orange County high volume restaurants, fast food independents and chains, bars and liquor stores. Call 714-292-5448.

Ryan Clark, Business Broker, Southern California

The Veld Group provides a refreshing approach to Business Brokerage, Mergers & Acquisitions and Business Consulting and Valuations. From Your Street to Wall Street, we cater to Main Street Businesses as well as more complex Strategic Firms and Start-Ups. Phone Ryan at 310-652-8353.

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