A business always has a value, just ask the IRS. Its value is constantly changing. An appraisal is like a photograph, a moment in time. A business appraisal is always done for a specific time, usually a year end or fiscal year end date. The appraisals I do for the sale or purchase of a business end up with three different values. I do this because the terms of the sale, mostly payment terms affect the value. All cash warrants a lower price then 20% down and a 10 year payout. This tells a seller there is a small range of value he can work with.
A business is worth nothing until there is a ready, willing, and able buyer. All attempts at "valuation" are anticipating that such a buyer exists. So how to obtain a truly objective opinion about what that buyer will pay? In my experience, the best way is to see what value a potential lender will place on the business for the purpose of providing a purchase-money loan. And, the prudent business broker will obtain three years of tax returns from the seller and submit them to a lending resource (such as BizBuyFinancing.com) to pre-determine what an objective third-party will not only say it's worth but also will back up its assessment with cash. Not only does this help to sell the business; but, it also provides the buyer with some gauge is to what it's "worth."
Buying or selling a business is probably the largest financial transaction a buyer or seller will ever make in their life. It may involve their life's savings, new debt or their entire retirement prospects. There are many situations where a buyer has paid too much for a business and can't make it work. The buyer looses his investment, a bank may loose on its loan, and the seller will loose money he has lent to the buyer and possibly get a worthless business back. Doesn't it seem important to confirm that the business you are buying or selling is a wise, or at least not a foolish sale or purchase? A business appraisal should be a mandatory process for any business sale or purchase. It definitely will increase the chance of success and protect the buyer's and seller's hard earned assets.
I agree with Tim that the real value of a small business can only be determined when a buyer and seller come together on a price with no undue influence on either side. Rules of thumb, weights, multipliers, and even comps are only guidelines. The right business may be worth substantially more to the "right" strategic buyer than to a buyer looking at a transaction purely as a financial transaction.
For example, how much is it "worth" that a business is largely absentee-run? Or that it has thrived for 25 years rather than having been established two years ago? What about a business that has a "lock" on a certain niche? And how do you value web traffic, social media followers, positive reviews, etc.?
The answer is, "it depends". It depends on the number of interested buyers and the value of those criteria to those buyers.
I advise my clients to focus on buying a great business first--however "great" is defined given what they need and want. If they can do that it is difficult to truly over-pay in the long run.
As a Certified Business Broker it's almost without exception that the owner of a business thinks their business or practice is worth much more than a buyer or lender. Equally a buyer can explain in great detail why a business is not worth what the seller wants.
The simplest solution is to have the business appraised before it goes onto the market so all the add-backs and other values are identified and detailed plus I go that one step further and speak to lenders to see if they would be willing to offer third party finance to the right buyer. These extra steps increase the chances of a business being sold to the right buyer and are all good business.
Recently, I was involved in a divorce trial testifying on behalf of the wife who had an interest in the business her husband ran. Besides my business appraisal there was another business appraisal presented by the husband's appraiser. The method he used is called "The Excess Earnings Method" and was developed by the US Treasury Department in 1920 to estimate lost goodwill suffered by breweries and distilleries because of Prohibition. It was never intended to be used to appraise businesses. The problem with this method is that it is hard to understand and therefore very easily manipulated.
The sales of the business were $635,000, with cash flow of $266,000 and assets of $186,000 (including $146,000 cash). The husband's appraiser came in at $196,000. My appraised value was $560,000. My appraisal worked out to be less than two times the cash flow plus the assets and was an accurate valuation.
Don't take for granted that every appraiser will produce an unbiased appraisal, especially those using the Excess Earnings Method.
When a small or mid-sized business is offered for sale or is the subject of negotiations between a buyer and the seller, a key issue is the business valuation. In other words, what is the business worth? There are no manufacturer's suggested retail prices as often are attached to new cars, or comparable sales charts to give clues about the value of homes on the market. There is no 'Bluebook' listing appropriate prices for many models of used vehicles. Because no two businesses are alike, it is very difficult to establish what might be an accurate business valuation for a particular retail store, distribution service, restaurant, vehicle repair or other kind of company.
But there are several theories and methods used by accountants, business intermediaries (brokers and agents), financial institutions and others to offer a 'best guess' recommendation about what should be the selling price, and thus the market value of a business.
The most popular and probably the most accurate methods of business valuation focus on the buyer's anticipated return on investment. One commonly used approach relies on a formula that ties the value of a company to its income. It stands to reason that the more money a company makes, the higher its business valuation. Among these methods is a computation that includes the seller's discretionary annual income and multiplies it by a factor customary for the industry in which the business is involved. If restaurants in a particular location typically sell for about 2.5 times the owner's average annual discretionary income over the past five years, the seller who collects $100,000 per year can estimate that her business is worth about $250,000. This multiple varies from industry to industry and location of the business, and is influenced by other factors, such as terms of the deal.
Another business valuation method simply totals the market value of the assets of a company. That includes equipment, furniture, fixtures, and other tangible and intangible assets. That's not an accurate indicator of market value, however.
The ultimate rule of business valuation is, of course, whatever price the buyer and seller agree on, assuming there is no extreme pressure on either party to make a deal at any cost.
