Valuing a Business

Valuing a Business
by BizHelp24
October 19, 2005

Chapter 6: Valuing a Business

Arguably, a business is worth what-ever someone is willing to pay and therefore will vary from person to person.

Today, there are over twenty different ways of valuing a business and this is why many people cumulate different prices. The price that the seller asks for is almost never what they will receive and is usually reduced in value through negotiations between themselves and you- the buyer.

It is important that you value the business yourself (with the help of assistance) so that you can be sure that you are not over paying for a business.


By paying too much, you will encounter further financial problems if the business doesn't turn out to be successful. On the other hand, those businesses that do prove successful will serve justice to the amount you paid.

In most cases, a business should be valued against the ability it has of generating a good cash-flow. In other words, the price will be dependent on the level of consistency the business has at making profits. All businesses are unique and therefore it is important that you use the most appropriate valuation method to determine a realistic value.

6a) Be Aware!

There are many people out there who use the wrong valuation methods to price a business and consequently pay too much. To give you an idea, look at a couple of them - the first of these is the Comparison Approach:

Say a small business has a Net Profit figure of £5,000 a month and was sold for £200,000 and the business that you want to buy also has the same Profit figure. You would be wrong to think that because they have the same Profits, they should both have the same value. The business that was sold for £200,000 may have only been operating for a few months and therefore, chance is that the profits are likely to increase. The business you have interest in may have been running for a number of years and profits may have stabilized. Also, that business may have a shorter operating period, say, five days a week, compared to your potential business' operating period of six days a week. The moral is that you should never compare prices to businesses with similar profits.

Quite often, many people have confidence that the seller has provided a realistic value and therefore they try to make a bargain by reducing this price by say, 10%. The trap that you may have fallen into here is that the seller may have inflated the price anyway in an attempt to make a bit more money out of the deal. So in theory, you haven't made anything from using this approach and consequently will have paid the price that the business is worth or maybe even more.

http://www.bizhelp24.com/business-start-up/valuing-a-business.html

Valuing a Business: The Asset Value and Payback Value

6b) The Right Approach

Different methods are also used depending on the size of the business and so we have stuck to the main ones that are generally used to valuing Small Medium Enterprises - 'SME'. During this time, you should consult your accountant to determine the best approach and also allow them to make the necessary calculations: despite the simplicity they may show, the figures involved may take time to reach through previous calculations taken from the accounts. Further, most of the figures and values you need should have been obtained during your due-diligence period.



6c) Asset Value

Using assets to value a business is more commonly used when it is considered as asset-intensive i.e. the assets heavily contribute to the level of profit that is generated. The Net asset value can therefore be obtained from the sum of the following:

•An accumulated value of all the fixed assets including plant, land and machinery.

•The value of any leasehold improvements: this includes any refurbishments or modifications the owner may have made such as new office space and/or equipment. You should note that the leaser can make the owner return the leasehold to the original state should these changes not be beneficial to you. Any improvements would therefore not be included in the overall value.

•The value of the inventory which can include raw materials, stock and anything that may be considered as work-in-progress.

•The value of intangible assets which not only includes goodwill but also logos, trademarks, and any patents.

6d) Payback Value

This is where you will set a price determined by the period that you expect to get a return for your initial investment. For example, a newsagent has a Net Profit of £30,000 and you expect to start making money after the third year. In which case, you would multiply this period by the Net profit i.e. £30,000 x 3 years = £90,000. This method strongly validates the fact: a business is only worth what someone is willing to pay.

http://www.bizhelp24.com/business-start-up/valuing-a-business-the-asset-value-and-payback-value.html
 
 
Valuing a Business: Return on Investment, Income Value & Owner Benefit Value


6e) Return on Investment/Capital

For a return on investment value, we are assuming that no fixed price has been given for the business and therefore you will use the net profit and your proposed return on investment percentage to determine a price. For example, a business makes a net profit of £20,000 and you expect an investment return of 10%. In which case, £20,000 divided by 10% gives a value of £200,000.

A return on capital approach would assume that a fixed price has been given for the business in which you can use to determine whether it is a wise investment. It may be that your money is worth investing elsewhere such as a bank that offers an average return of around 5%. Using basic terms, let's say the business is for sale at £100,000 and the net profit is £10,000. To find the return rate, you would divide the net profit by the business price and then work it out as a percentage: (see below)

£10,000 divide by £100,000 = 0.1

0.1 x 100% = 10% Return on Capital Employed

With a 10% Return on Capital Employed, It would therefore be a good investment as the rate is higher than that of the bank.

Should the rate be unacceptable, you would use the return on investment method to determine a more suitable price in order to give you your desired return.

6f) Capitalization of Income Value

This method is used more commonly for services and therefore considers the intangible value of the business. Such businesses are usually contract orientated and consequently you can fall into high risk situations. It would further be wise to use an accountant to determine that the business would have a favourable outcome should it suffer from a change of ownership.

This method involves using factors to determine an average figure called the "capitalization rate", say, between 1 (low) and 5 (high) to multiply against the owner's discretionary income (profits, owner's salary, non essential expenses etc) the following list has a low score potential of 11, and a high of 55. Such factors will include:

•Profitability (concentrate on future, not past, profitability)

•Competition (present and future)

•Customer base, particularly those under contract

•Full risk analysis

•Your suitability (your standard of experience and knowledge in the industry)

•Future potential for the industry

•Why the present owner is selling

•How long the business has traded

•How many past owners

•Location of business to customers

•Where growth lies within the business

If after rating the above as, say, 20 and the discretionary income is £20,000, the sum would be:

20 x 20,000 = £200,000 purchase price

As these factors are very subjective, it could be difficult to agree an exact "capitalization rate" and therefore an alternative valuation method should be adopted if you are too far from the sellers rate.


6g) Owner Benefit Valuation

This method uses a figure between 2 and 3 (depending on what you think is appropriate) and multiplied by the owner's discretionary cash-flow. Discretionary annual cash-flow can be referred to as the money that is not used in the operations of the business - profits, owner's salary, non essential expenses etc. Using this approach gives a value that reflects the business' ability to generating cash-flow and profits. If you want, say, 2.5 times the owners total benefits and the discretionary income is £20,000, the sum would be:

2.5 x 20,000 = £50,000 purchase price

http://www.bizhelp24.com/business-start-up/valuing-a-business-return-on-investment-income-value-owner-benefit-value.html


Valuing a Business: The Multiplier Valuation




6h) Multiplier Valuation

This area is very subjective and there will be a variation in people's attitudes and opinions for the figures involved. The figures that we have given are USA based and should be used for guidance purposes only to give you an idea of the differences between industries. The value of the business is derived from the multiplication of a figure (or percentage) and a financial value of the business.

Below are multiplication figures that have been supplied by the Business Brokerage Press, located in the USA, from their publication 'The 2001 Business Reference Guide'.

Type of Business "Rule of Thumb" valuation

Accounting Firms 100% - 125% of annual revenues

Auto Dealers 2-3 years net income + tangible assets

Book Stores 15% of annual sales + inventory

Coffee Shops 40% - 45% of annual sales + inventory

Courier Services 70% of annual sales

Day Care Centres 2-3 times annual cash flow

Dental Practices 60% - 70% of annual revenues

Dry Cleaners 70% - 100% of annual sales

Employment & Personnel Agencies 50% - 100% of annual revenues

Engineering practices 40% of annual revenues

Florists 34% of annual sales + inventory

Food/Gourmet Shops 20% of annual sales + inventory

Furniture & Appliance Stores 15% - 25% of annual sales + inventory

Gas Stations 15% - 25% of annual sales + equip/inventory

Gift & Card Shops 32% - 40% of annual sales + inventory

Grocery Stores 11% - 18% of annual sales + inventory

Insurance Agencies 100% - 125% of annual commissions

Janitorial & Landscape Contractors 40% - 50% of annual sales

Law Practices 40% - 100% of annual fees

Liquor Stores 5% of annual sales + inventory

Property Management Companies 50% - 100% of annual revenues

Restaurants (non-franchised) 30% - 45% of annual sales

Sporting Goods stores 30% of annual sales + inventory

Taverns 55% of annual sales

Travel Agencies 40% - 60% of annual commissions

Veterinary Practices 60% - 125% of annual revenues


http://www.bizhelp24.com/business-start-up/valuing-a-business-the-multiplier-valuation.html

Valuing a business & Buy It Without Fear

"How to Value a Business & Buy It Without Fear"
http://www.howtovaluebusiness.com/

http://www.pnesbitt.com/business_transactions/valuing_a_business.pdf

4 Tips to Valuing a Business For Purchases

4 Tips to Valuing a Business For Purchases
By Ted E. Sanders Ted E. Sanders
Level: Basic PLUS

Mr. Sanders is a self described “serial entrepreneur,” and teacher. Mr. Sanders has purchased 4 businesses and started too many businesses to remember. Mr. Sanders ... Article Word Count: 646 [View Summary] Comments (0)

You've made the decision to buy a business. Good choice! Buying a business can be the best way to increase your personal wealth. You've found this wonderful illustrious business that has incredible potential and you know you are absolutely going to love working there for the rest of your life, or at least until you make your first million ;) Now the seller is asking a price that sounds right, but how did they come to that price? Valuing a business is more than often an ambiguous process that comes down to more opinion than fact. Market value for your business is the price that a reasonable buyer would pay and reasonable seller would pay for in a normal market of business sales. If you're reading this article - you're not normal. I say this in a good way. You're actually above normal. Most people who ATTEMPT to buy a business do very little studying and research into the process. Consequently they either don't buy the business due to insecurities or inadequate funding or they buy the business and fail due to poor preparation. So how much is that business worth? Here are 4 tips to assist you in valuing the business.

1. If the business is making a profit, how much of a profit does it REALLY make? I've seen business brokers, and listing agents come up with all sorts of amazing projections on what the business should be making and then trying to sell it based on that number. If the business broker or seller can predict the future then they shouldn't be in entrepreneurship - they should be in the stock market! If the price is based on earnings, and the earnings are based on "pro-forma" or projected income (not actual) then forget any price they put to the business. You're buying income not income potential. If you want some great income potential I have some swamp land for sale for you in Florida that is definitely going to go up in value - some day.

2. If the business is losing money, it's worth the assets current resale value minus the debt that you're assuming in the business. This means if the business has 1 widget that they bought for $100,000, business debt of $20,000 - you don't know the value of the business! If you can sell the widget for $40,000 and the business debt is $20,000 the business is worth $20,000.

3. What is the business worth to you? Most of the buyers I coach are individuals who are more interested in buying a business/job instead of investing millions of dollars into a business that can be made into a public offering. Consequently buying a business means replacing a full-time income for twice the work as your previous job. However people seek self employment for a variety of reasons, income, pride, the freedom of spending more time with family etc. List 10 reasons why you want to be self employed. Now put a price tag to every item you've listed. If any of those price tags are "infinite" self employment is for you.

4. The four P's - Pick your Price based on Past Performance or what was Put in the Previous owners Pocket? - Pay for past performance - never pay for what the business could or should be. Remember that you are the buyer and you should try to pick your price based on how much money the business has put in the previous owners pocket. All formal and informal business valuations are established on "net present value." Please remember that off book money absolutely can not account for the price! Off book money is money not reported to the IRS. If the seller didn't declare it as income or benefits then it does not count for the income to determine the price.

Do you want to learn more about how to buy a business? I have just completed a brand new guide in buying a business "The Corporate Raider's Guide to Creatively Financing Your First Business." Download it free here: http://www.corporateraidersguide.com/


Article Source: http://EzineArticles.com/?expert=Ted_E._Sanders



http://ezinearticles.com/?4-Tips-to-Valuing-a-Business-For-Purchases&id=2695770

Valuing a Business (Power Point Presentation)

Earnings Multiple (Value-to-Earnings) Ratio: 
A ratio is determined by dividing the firm’s value by its earnings that can be compared to representative ratios of recently-sold similar firms.

Normalized Earnings:  Earnings that have been adjusted for unusual items, such as fire damage, and all relevant expenses, such as a fair salary for the owner’s time

Type of Firm ####Earnings Multiple
 
Small, well-established firms, vulnerable to recession ####7



Small firms requiring average executive ability but operating in a highly competitive environment ####4


Firms that depend on the special, often unusual, skill of one individual or a small group of managers#### 2

 
 
Risk and Growth in Determining a Firm’s Value:


Risk and Growth are Key Factors Affecting the Earnings Multiple and Firm Value


The more (less) risky the business, the lower (higher) the appropriate earnings multiple and, as a consequence, the lower (higher) the firm’s value.

The higher (lower) the projected growth rate in future earnings, the higher (lower) the appropriate earnings multiple and, therefore, the higher (lower) the firm’s value.


 
Cash Flow-Based Valuation


Determination of the value of a business by estimating the amount and timing of its future cash flows

Step 1. Project the firm’s expected future cash flows.

Step 2. Estimate the investors’ and owners’ required rate of return on their investment in the business.

Step 3. Using the required rate of return as the discount rate, calculate the present value of the firm’s expected future cash flows, which equals the value of the firm.

 
http://www.andrews.edu/~schwab/sbm-appb.ppt#8

Deciding on the right type of business to buy

Ideally any business you buy needs to fit your own skills, lifestyle and aspirations. Before you start looking, think about what you can bring to a business and what you'd like to get back.

List what is important to you. Look at your motivations and what you ultimately want to achieve. It is useful to consider:

•Your abilities - can you achieve what you want to achieve?
•Your capital - how much money do you have to invest?
•Your expectations in terms of earning - what level of profit do you need to be looking for to accommodate your needs?
•Your commitment - are you prepared for all the hard work and money that you will need to put into the business to get it to succeed?
•Your strengths - what kind of business opportunity will give you the chance to put your skills and experience to good use?
•The business sector you're interested in - learn as much as you can about your chosen industry so you can compare different businesses. It's important to take the time to talk to people already in similar businesses but the internet and a large local library will also be good sources of information. Find out how to comply with all the regulations and licences that apply to Your business sector.
•Location - don't restrict your search to your local area. Some businesses can be easily relocated

http://www.adelbb.com/tipsMore.php?id=27

****Best Businesses to Start or Buy: Recurring Revenue Business Models

Best Businesses to Start or Buy


Recurring Revenue Business Models
Starting a business? Buying a business? If so, there's one question that you absolutely must ask. Does your new venture have a recurring revenue business model? If not, you might want to go back to the drawing board and look at other options.

The best businesses to own are recurring revenue businesses.
(article continues below)

If you are a new entrepreneur or are searching for a business to start or buy, you might overlook this simple fact. If so, you are making a huge mistake.

To make the most money as a business owner, you want a business model that has built-in recurring revenues.

Examples of Recurring Revenue Business Models

Here are a couple of examples of recurring revenue businesses.

One friend of mine sells telecommunications services. In short, his company sells bandwidth to companies. The offerings include T1 lines, T3 lines, OC3 lines, OC12 lines and other internet access and point to point telecom offerings.

His business is a reseller of telecom services from big companies like AT&T and MCI. He doesn't have the massive overhead that those companies have. He just sells their services and offers a small amount of first-call support services.

The business has recurring revenues because whenever he sells, say, a T1 line, my friend gets a commission on every single payment the buyer makes. In other words, it's not a one-time fee. Rather, it's an annuity. As long as the customer keeps that T1, even if it's for 10 years, my friend is making money. He only had to sell the deal once, the customer typically renews every year, and he just watches as MCI and AT&T transfer money into his bank account.

That's the beauty of a recurring revenue business. In essence, you earn money now for work you did in the past.

Here's another one. Another business acquaintance of mine sells health insurance to companies. At any given time, he has maybe 50 companies with an average of 40 employees each. I'm not sure exactly what an average health premium is for his clients but let's guess that it's $500 per month. For having sold the health insurance plan, he gets 4% of every premium payment made to the health insurance company.

So, do the math. He's making 50 X 40 X $500 x 12 X .04 per year. That works out to top line revenues of $480,000. Not bad.

He has one employee on staff…a troubleshooter who handles those situations when an employee of one his clients runs into an issue with a health insurance claim. He also has rent expenses on a small office. All in, I'm guessing he's pulling in $300,000 net before taxes worst case.

If he left the country for a year to take a long vacation, he might lose a few clients. But his able assistant could handle most of the service issues. He'd still be receiving revenues in the form of commission payments. In other words, he'd be benefiting from the recurring revenues related to work he did years ago.

Alternatives to Recurring Revenue Business Models

The mistake that many new entrepreneurs make is that they don't figure out how to build a recurring revenue business.

Instead, they earn only as much money as they deserve based on very recent efforts.

This is the taxi company business model. You get a fare, drive them, and get paid. Now, to make more money, you need to find a new fare.

There are no rewards for what you do long ago. There's no cumulative building up of revenues. It is always "What have you done for me lately?" from customers. No new sale, no new revenues.

Entrepreneurs on this track are on a treadmill. If they get off the treadmill, they stop making money.

Always Look for Recurring Revenues

The key takeaway from this article is that owning a business is not a generic concept. Every business out there has different dynamics to it, which in aggregate amount to a business model.

Some business models are better than others. As an entrepreneur, you need to evaluate the business models that are available to you and choose the most profitable…offering the maximum reward for the minimum effort and risk.

Take our word for it. The best business to buy or start will be one that has recurring revenues built into the business model. Without that, you can do OK but you will always be on the treadmill. In that case, the business owns you instead of visa versa.

Related Articles

Want to learn more about this topic? If so, you will enjoy these articles:

Evaluting Business Models When Buying a Business


http://www.gaebler.com/Recurring-Revenue-Business-Models.htm

Valuing a Business for Sale in New Zealand

Valuing a Business for Sale in New Zealand
Written by: Richard O'Brien | Posted on 06 November 2009. Tags: business mindset, selling a business

When you are planning to buy or sell a business how can you work out how much it is worth?

There are many different ways of calculating the value of a business. Many of these methods have been devised for large businesses, especially those listed on share markets. Smaller businesses (i.e. those that have less than 20 employees, – and 96% of all New Zealand businesses are in that size range) need a different approach. Sales contracts for small businesses normally define the value as the sum total of the inventory (stock), plus plant & fittings, plus goodwill. (Debtors and creditors are not normally part of the sale contract.)

The value of a business is largely influenced by profit. A person who buys a business is purchasing a future cash flow. The higher the anticipated cash flow, the higher the value of the business.

Past profits may be a good indication of future cashflow, but there is no guarantee that profits will continue at the same rate. In some cases there will be signs that profit is increasing, in others a downward trend may indicate lower expectations. Other factors such as impending rent increases, new competitors or the loss of a major contract may also raise concerns about the level of profits that can be expected in the future. Each party to a sale must form their own ideas about the future cash flow.

Defining Profits for Valuation:
There are many different measures of profit. (e.g. profit before tax or profit after tax etc.) When valuing small businesses the most useful measure of profit is known as EBPIDT – Earnings Before Proprietors Income (wages or drawings) Interest and Depreciation. (This is sometimes called the Sellers Discretionary Cashflow.) This determines the basic earning capability of the businesses before any other variables.

Valuation Method:
One method of valuing a business is to use an Earnings Multiplier. For example, a business which has a profit of $60,000 may sell for $90,000. The Earnings Multiplier in this case is 1.5 ($60,000 X 1.5 = $90,000)

Earnings Multiples:
How do you work out what earnings multiple to use? Avoid “Rules of Thumb.” Most of these are likely to be out of date at best, and downright misleading at the worst.

There are several ways of finding an appropriate Earnings Multiplier.

◦Ask acquaintances who have recent sold/bought similar businesses to the one you are interested in.
◦Ask your accountant. They may have had clients who have been involved in sales of similar businesses.
◦Your business broker can share his/her experience.
◦Use a commercial data base which lists sales by business brokers throughout NZ “BizStats”. This will tell you what earnings multiples have been used in recent sales. It will cost you $125 + GST but may provide useful guidelines.

Buying or selling a business is a major investment decision. Careful research and professional advice can help you to get the right value.

http://businessblogs.co.nz/2009/11/06/valuing-a-business-for-sale-in-new-zealand/

How to value a business

Valuing a business can be one of the most worrying parts of buying an existing business.

There are several valuation methods you can use. For specific advice on valuation methods see our guide on how to value and market your business. Your accountant may be able to help you value the business, but a business transfer agent, business broker or corporate financier will be best qualified to provide valuation advice.

A healthy business

To get a general idea of how healthy the business is, look at:

•the history of the business
•its current performance - sales, turnover, profit
•its financial situation - cashflow, debts, expenses, assets
•why the business is being sold
•any outstanding or major litigation the business is involved in
•any regulatory changes which might have an impact on the business

As part of your investigations, talk to the vendor and, if possible, the business' existing customers and suppliers. The vendor must be comfortable with you doing this and you must be sensitive to their position. Customer and suppliers may be able to give you information that affects your valuation, as well as information about market conditions affecting the business. Such research can also be done on the internet or at your local reference library.

For example, if the vendor is being forced to sell due to decreasing profits, your valuation might be lower.

Intangible assets

The most difficult part is valuing the intangible assets. These are usually difficult to measure and could include:

•the company's reputation
•the relationship with suppliers
•the value of goodwill
•the value of licences
•patents or intellectual property

You should consider how the value of these assets could be affected if you decide to buy the business.

Other considerations

The list below details other factors that will affect the value:

•stock
•location
•assets
•products
•debtors
•creditors
•suppliers
•employees
•premises
•competition
•benchmarking - what other businesses in the sector have sold for
•who else in the sector is for sale or on the market

Once you have considered all these factors you can then decide how much you want to offer, or whether you want to buy it at all.

If you do decide to make an offer, and agree a price with the seller, a period of time is allowed for you to verify that all of the information you have been told is accurate. This is known as due diligence.


http://www.adelbb.com/tipsMore.php?id=29

****Evaluating Business Models When Buying a Business

Tips for Buying a Business

Evaluting Business Models When Buying a Business
Buying a business? Of all the things to consider when buying a business, a thorough evaluation of the business model is the most important consideration.

When buying an existing business, it's important to thoroughly evaluate the business model.
(article continues below)

In essence, when evaluating a business model, you must ask three questions:

• How does the company I am about to buy currently make money?
• Can I continue to make money after I buy this business using the existing business model?
• Is there something I can do to change the business model to greatly improve the potential of this business?

How Does the Business Model Make Money?

At first blush, this question would not seem to be very illuminating:

How does a Subway franchise make money? Well, they sell sandwiches. Duh.
How does a local drycleaning business make money? They take in clothes, dry clean them, and get paid to do that. Duh.
How does a PR firm make money? They get clients to pay them money to get media placements. Duh.
How does a website development firm make money? They build websites and get paid to do so? Duh.
How does a lawn mowing service make money? They mow lawns and get paid to do so. Duh.
How does a telecomm value-added reseller make money? They sell businesses T1 lines and other telecomm services and get paid to do so. Duh.

To evaluate the business model, you have to ask probing questions that take the discussion up a notch. Here are a few sample questions to ask when evaluating a business to buy and that company's business model:

Is the business dependent on individual talent or can it still do well even when existing employees are replaced with new employees? In the case of a Subway franchise, the business is systematized and existing employees can be replaced. However, in the case of the PR firm, the customers may have been buying the skills and relationship of a single individual. If that individual is not there, the business model may not perform as well.

Is their repeat business and a recurring revenue stream? A lawn mowing service can sign up clients for an entire summer, and have repeat revenues from customers every week. In contrast, a website development company might only be earning money while working on a specific project. In that respect, the website company is like a taxi driver. No fare, no income. A telecomm value-added reseller locks into a growing recurring revenue stream because they are typically compensated by the provider (e.g. MCI, Sprint, etc.) as long as their client keeps the service. Hence, in the fifth year of business, they are still earning revenues from companies they signed up five years ago, four years ago, etc.

Is the value proposition unique and can a competitor steal the business away? A dry cleaner could lose a lot of business if a comparable business opened up across the street and offered the same services at half the price. The key to a strong business model is some sort of unique positioning that cannot be easily replicated by competitors.


Can I Continue to Make Money With the Current Business Model?

Just because the current owner is making money with the existing business model, doesn't mean you will be able to continue to make the same amount of money in the future.

In the case of the PR firm mentioned above, will those existing clients all stick with you? Will you be able to service clients well? Will you be able to attract new clients? The answers to these questions have a direct impact on how your business model will do for you.

At the end of the day, business models are not abstractions. They are personalized entities that succeed or fail. One person may do very well with a given business model, while another fails miserably.

So don't ask: is this a good business model? Instead, ask: Can I make money with this business model?

Can the Business Model Be Improved Upon?

This is where the real money is made.

If you simply plan on buying the existing business model and running it as is, then you will, in most instances, have to pay a price commensurate with what the business m model will generate.

However, if you can change the business model in a way that improves it, you can transform the price you paid for buying a business into a much higher value.

For example, maybe you buy the lawn service and transform it into a lawn service and landscaping company that also shovels sidewalks and driveways in the winter. You get a bigger share of your customer's wallet and you are well-positioned to grow the business because you have improved the value proposition.

Maybe, you buy the website development company and convert the model from a one-time contract business to a business that has upfront contracts but also has ongoing maintenance contracts. By doing so, you lock into recurring and predictable revenue streams that the previous owner never had.

You get the idea. When buying a business from an existing business owner, you need to look for the opportunities that the previous owner was never able to capitalize on.

Those subtle shifts in the business model are what can allow you to make buying an existing business the best decision you ever made.

Related Articles

Want to learn more about this topic? If so, you will enjoy these articles:

http://www.gaebler.com/Recurring-Revenue-Business-Models.htm
Recurring Revenue Business Models

http://www.gaebler.com/Evaluting-Business-Models-When-Buying-a-Business.htm

How to Buy a Business: Valuation Process

How to Buy a Business

Valuation Process
Written by Bobby Jan for Gaebler Ventures

Buying a business? If so, defining how much a business is worth is very important. This article will help you by breaking the valuation process into five easy steps.

If you are looking to buy a business, you are probably wondering about business valuation.
(article continues below)

The valuation process might seem daunting for somebody who is new to the business of buying businesses. Although this is a difficult process, we can break it down into five smaller steps.

Step 1: Defining the Valuation Assignment

First, it is important to clearly define the parameters of the problem. What business or portion of a business is being appraised? What is the goal of the valuation?

Step 2: Gathering Facts

After step 1 is well established, now it is time to gather the necessary facts. We can further break down the facts into two categories:

• facts that are directly related to the business and
• facts that are indirectly related to the business.

Some examples of directly related facts are accounting records, past performance, client relationships, liquidation value, etc. Some examples of indirectly related facts are competition, regulatory climate, and macroeconomic trends, etc.

Step 3: Analyze the Facts

This is perhaps the most demanding step in the valuation process. After the right facts has been collected, these pieces of information must fit together to help determine the value of the business. You should use many approaches and methods to analyze the facts. In fact, in this step, you might reach many different conclusions.

Step 4: Final Estimate of Value

After exploring many approaches in step three, a conclusion, however rough or precise, must be drawn. This is important set a ceiling to how much you are willing to pay for a company.

Step 5: Prepare Valuation Report

If you are appraising a business for a client, then it is essential for you to prepare a presentable valuation report. Even if you are not making a presentation, it helps to put down your ideas down on paper or be able to explain it clearly to somebody else since this will help you solidify your finding, reasoning, and conclusion.

Cheng Ming (Bobby) Jan is an Economics major at the University of Chicago who has a strong interest in entrepreneurship and investing.

http://www.gaebler.com/Valuation-Process.htm

http://www.gaebler.com/Articles-on-Buying-a-Business.htm

http://www.gaebler.com/Business-Valuation-Trends.htm

Key Factors to Consider When Buying a Business

Buying a Business


Key Factors to Consider When Buying a Business
Written by Anna Lempereur for Gaebler Ventures

It is essential to consider key factors before buying a business to be sure that it is right for you. Here are some tips that will help you make the right decision, and prevent you from heading in the wrong direction.

When buying a business, it is important to know what to look for, and to not rush into anything.
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It takes a lot of time and thought to buying a business, and failure to consider these factors may result in harming the business overall. Here are some basic factors to consider when buying a business…

Buying the Right Business for You

Many people make the mistake of buying the wrong business. It is vital to buy a business that suits your interests, personality, skills and knowledge.

Try looking for one that has some sort of relevance to work you have done in the past, or classes you have taken. If you are buying a business just for the sake of buying, that business may not be right for you.

You will know if the business is right for you because you are interested in it, and are confident enough that you can offer what is necessary to make it successful.

Research the Business's History

After you have chosen a business that you feel suits you best, do a little research on its history and finances.

Be sure to carefully review copies of the business's certified financial records, including cash flow statements, balance sheets, accounts payable and receivable, employee files, including benefits and any employee contracts, and major contracts and leases, as well as any past lawsuits and other relevant information.

This research will give you a thorough background on how the company works, as well as alert you to any problems that may be faced in the future. It is important to have a full understanding on the way the business runs before making any decisions.

Hope for the Best But Plan for the Worst

What if your projected sales for the business are off by 25% in the first year? Will you survive?

It's important to evaluate various worst case scenarios to see if and how you will survive them.

We know one entrepreneur who bought a drycleaning business and then watched the business revenues plummet by 50% when the economy dipped into a recession. He survived but said it was an extremely painful business lesson.

Develop a Plan for Promoting the Business

Although the business is already established, it is necessary to have some sort of advertising and marketing plan that will maintain the momentum of the business after you take over.

No matter how many customers the business already has, promoting the business is still a priority. Don't think that the work is already done for you, because you indeed have plenty of work to do. Be sure to have plans made for promoting the business, because it is very possible for the company to head for a downfall if you are not prepared.

Negotiate for a Good Price

Never forget that the seller's asking price is just a starting point for negotiation.

According to industry data from business brokers, businesses typically sell for between 15 percent and 25 percent below the business seller's initial asking price.

If you pay the asking price, there's a strong chance you are overpaying for the business.

The key is to figure out what you are willing to pay and keep your emotions out of it. If you can't get your price, just walk away and don't look back.

Anna Lempereur is a freelance writer interested in writing about small business. She is currently a Journalism major at the University of Albany in New York.

http://www.gaebler.com/Factors-to-Consider-When-Buying-a-Business.htm

Three Principles of Business Valuation

Buying a Business


Three Principles of Business Valuation
Written by Bobby Jan for Gaebler Ventures

Valuing a business is an art form as much as it is a science. This article introduces three basic but important principles of business valuations to help you get started.

Are you an entrepreneur and looking for a business to buy?
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If you are, it is very important to understand how to value a business correctly. This article introduces three basic but important principles of business valuations to help you get started.

The Principle of Alternatives

The Principle of Alternatives states that each party always has an alternative to consummating a transaction. This seems like a no brainer but this is one of the fundamental principles of business valuation.

This principle is profound in many ways. For example, as you negotiate to buy another business, never get into the mentality that you just have to buy that business. Many companies and individuals grossly overpay as they get tunnel vision.

The Principle of Substitution

The Principle of Substitution tells us that the value of something tend to be the price paid for an equally desirable substitution. As a profit maximizing agents, we all try to minimize cost, all else equal. The value of a business, therefore, is the smallest price paid for substituting the business with something equally desirable.

Example 1: If a business could be replicated for X amount of dollars (by purchasing and operating the exact assets that a business has), then the Principle of Substitution tells us that it is the business is worth at most X amount of dollars.

Example 2: In this example, you want to determine the value of business A. Business A costs $5 million to replicate exactly. However, another equally desirable but different business could be acquired for only $2 million. The Principle of Substitution tells us that business A is worth at most $2 million dollars.

The Principle of Future Benefits

Unless you are buying a company only to liquidate instantly, you care a lot about the future benefits of owning that business. The Principle of Future Benefits tells us the economic value of a business reflects (anticipated) future benefits.

Although you shouldn't buy a business solely based on the past, the past could sometimes be an indicator of what is to come. The Principle of Future Benefits is why a fast growing company sells for much more than a slow growing one. The principle also explains why an industry might experience a surge in business valuations when a favorable has been passed.

Cheng Ming (Bobby) Jan is an Economics major at the University of Chicago who has a strong interest in entrepreneurship and investing.

http://www.gaebler.com/Three-Principles-of-Business-Valuation.htm

How to define the economic value of a business

Economic Value
Written by Bobby Jan for Gaebler Ventures

If you are looking to buy a business, it is important to understand how to define the economic value of a business. By looking at how much the business is worth through various business valuation lenses, you can determine what price you might be willing to offer.

If you are looking to business, it is important to determine the value of the business.
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Value comes in many different forms.

Some people buy certain businesses to increase their social standing while other run businesses as a hobby. Most entrepreneurs, however, are concerned with the economic value of a business.

There are many subtypes of economic value. This article will introduce some of them.

Book Value

The book value is the value of a business or a portion of a business that is stated in financial statements and accounting records. This value is often lower than the market value of a business due to tax considerations.

Fair Market Value or Market Value

Market Value often defined as the price the owner is willing to accept and that the buyer is willing to pay. There are many methods for determining the market value of a business. The most commonly used method is the discounted cash flow methods.

Going Concern Value

Going concern value is the value of the business as a whole and not the sum of its parts.

Goodwill Value

Goodwill includes:

The value of a business that is in excess of the total capital invested in the business.
The intangible assets of a business such as its brand name. For example, the Coca-cola brand name is worth billions.

Replacement Value

The replacement value of a business is determined by how much it will cost to replace the assets of a business.

Liquidation Value

The liquidation value is the net proceeds from selling a business. It is important, however, to take into account how the business will be liquidated. Namely, how much time does the business owner have to sell the business?

Cheng Ming (Bobby) Jan is an Economics major at the University of Chicago who has a strong interest in entrepreneurship and investing.

http://www.gaebler.com/Three-Principles-of-Business-Valuation.htm

Why Understand Business Valuation

Why Understand Business Valuation
Written by Bobby Jan for Gaebler Ventures

What is my business worth? It's a common question for entrepreneurs, and there are several occasions when you might need to be able to answer the business valuation question. This article introduces some of reasons for determining the value of a business.

Any entrepreneur worth their salt must understand something about business valuation as it is important for buying and growing businesses.
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The following are some of reasons for determining the value of a business.

Selling and Buying Businesses

Don't simply leave valuation to the professionals. Serious entrepreneurs must be able to recognize a good or fair deal. Value should be the most fundamental consideration when it comes to buying and selling businesses.

To Borrow Money

When you borrow money, sometimes a portion of your business must be offered as collateral. It would be wise to understand the value of your collateral to ensure that the terms of the loan reflect its true value.

For Insurance Purposes

Business valuation is important when determining the insurable value of assets. It is also important for obtaining fair settlement from insurance companies.

Designing Buy-Sell Agreements

Since buy-sell agreements often specify a price or a procedure for determining price, a working knowledge of business valuation is essential.

Employees Stock Ownership Plans

Employees Stock Ownership Plans, or ESOP, has many benefits over cash payments. Correctly pricing stocks, which comes from correctly valuing a business, is essential for an effective ESOP.

Cheng Ming (Bobby) Jan is an Economics major at the University of Chicago who has a strong interest in entrepreneurship and investing.

http://www.gaebler.com/Why-Understand-Business-Valuation.htm

Price Versus Value When Buying a Business

Price Versus Value When Buying a Business
Written by Bobby Jan for Gaebler Ventures

If you are an entrepreneur and looking to buy a business, there are a few concepts worth understanding. This article covers the concepts of price, value, and cost.

Wondering how to value a business?
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Warren Buffett once said, "Price is what you pay, value is what you get."

Business valuation is difficult and too many people use price as the signal for value. The price for value confusion can be costly.

Price is the amount of currency paid to acquire an asset. Cost is the total amount of one or more commodity to acquire an asset.

These commodities could be anything from time, natural resources, currency, etc. Cost and price are closely related and are often interchangeable. However, in many cases, the price paid for an asset and the cost of acquiring it might be significantly different.

Without getting philosophical, value is the intrinsic economic worth of an asset. Value refers to the true worth of an asset as according to some standard. For example, you an asset's value might be how much it can produce another product.

Often, the value of an asset is ultimately how much it contributes to the bottom line of a business. The goal of business valuation is to determine the value of a business.

Paying attention to price instead of value caused many personal and social tragedies in history. Investing based on price is responsible for the Tulip Mania in the 17th century, the Great Depression in early 20th century, and most recently the dot.com bubble in the late 1990s

On the other hand, buying based on value has made many individuals very wealth, including the richest man in the world, Warren Buffett.

Cheng Ming (Bobby) Jan is an Economics major at the University of Chicago who has a strong interest in entrepreneurship and investing.

****Buying & Selling a Business: Determining The Value Of A Business

 

Buying & Selling a Business:
Determining The Value Of A Business
Source: Small Business Management

 

The most difficult step in buying or selling a small business is probably determining what the business is worth as a going concern.

 

Many judgment decisions must be made. Yet before negotiations can continue successfully, a value must be established. The value must be acceptable to both buyer and seller, or further negotiation is fruitless.

 

It must result from the logical and objective efforts of all the parties involved.

 

Valuation Methods
There are two basic methods of determining the value of a business. 

• The first is based on expectations of future profits and return on investment. This method is preferable by far. It forces the buyer and seller to give at least minimum attention to such factors as trends in sales and profits, capitalized value of the business, and expectancy of return on investment.
• The second method is based on the appraised value of the assets at the time of negotiation. It assumes that these assets will continue to be used in the business. This method gives little consideration to the future of the business. It determines asset values only as they relate to the present. It is the more commonly used, not because it is more reliable, but because it is easier. The projections needed to value the business on the basis of future profits are difficult to make.

 

Looking Ahead

 

Whichever method is to be used to value the business, the buyer should ask the seller to prepare a pro-forma, or projected, statement of income and profit or loss for at least the next 12 months. For this, the seller will prepare a sales estimate for this period along with a matching estimate of the cost of goods sold and operating expense.

 

The projected statement will reflect the net profit the seller believes possible. The buyer should then make his own estimate of sales, cost of goods sold, operating expenses, and net profit for the next year at least, and as far into the future as possible.

 

In preparing these statements, the buyer should start by analyzing the actual statements of profit and loss for at least 5 years back. He should be sure that the past and projected statements provided by the seller are correct and are consistent with the buyer's proposed future operation. He should also study general and local economic changes that will affect future business. This includes competition.

 

If the buyer is not qualified to prepare projected financial statements, he should consult an independent accountant. This will involve some expense, but the cost will be small compared to the loss he might incur if he invested in a small business with a doubtful future.

 

Financial statements and their analysis and market analysis are discussed elsewhere in this section.

 

Forecasting Sales
The most important projection to be determined in the projected income statement is the sales figure. After this number has been established, the cost, expense, and profit figures are easier to acquire. The data for projecting sales will come from past sales records of the business. The more accurate and systematic these records are, the more confidently they can be used in estimating future sales.

 

How long a forecast? A basic question is this: "Over how long a period of time is it necessary or possible to forecast sales?" Any forecast is uncertain, and the farther a forecast is projected into the future, the greater the uncertainty. While it may be possible to exercise at least reasonable control over the internal operation, the external economic and market factors make forecasting difficult because of lack of control.

 

Perhaps the best way to approach the length of the forecast is in terms of the expected return on investment. Suppose it is estimated that the business should bring a 20 percent return on initial investment. The investment, then, should be returned in 5 years. At this point, the owner would just break even on his original investment. It seems logical to project sales and profits over a span of time comparable to that estimated for return on investment - in the above illustration, 5 years.

 

Any such forecast, however, should give careful consideration to expected changes either in the economy or in the industry market that might affect the pattern of sales change. Mathematically, it is possible to forecast sales with some precision. Realistically, however, this precision is dulled because vital market and economic factors cannot be controlled.

 

Methods of forecasting sales.
There are numerous methods by which sales forecasts can be made. Most of them take their lead from the past sales performance of the company. For establishing trends or averages, 5 years of sales history is better than 3, and 10 is better than 5.

 

Perhaps the simplest method is to assume that the percentage increase (or decrease) in sales will continue and that no market factors will influence sales performance more in the future than in the past. Suppose, for example, that the rate of yearly average increase for the past 5 years has been 4 percent, and that each year has shown about this rate of increase. Then it might be assumed that sales for the next year will be 4 percent greater than the current or most recent year.

 

But what about the year following? The year after that? Can it be assumed that these years will also increase at about 4-percent level? Each additional year into the future reduces the certainty of the predictions.

 

If these negative influences limit the accuracy to such an extent, why try to forecast beyond the immediate future (1 year)? Because such a forecast forces the person making it to give at least a little attention to economic and market factors that might influence the future operation - that might, in fact, indicate that the purchase or sale of the business would not be wise.

 

With forecasts covering more than 1 or 2 years, a more detailed forecasting technique is needed. Such technique should be designed to weight out extreme variations in year-to-year sales and to give a trend or level of sales change that is more realistically oriented to probable future sales patterns.

 

No method of forecasting can set any value on external market conditions, because there is no guarantee that these conditions will carry over into the future with the same relative significance. Nevertheless, their possible influence should be considered.

 

Risk and Return on Investment
If a buyer wants to invest money in a business that is being sold, he should be concerned about receiving a fair return on his investment.

 

Many businesses can make a profit for a short time (1 to 5 years) ; not so many operate profitably over a longer period of time.

 

From the buyer's point of view, what is a fair rate of return from an investment in a small business? The rate of return is usually related to the risk factor - the higher the risk, the higher the return should be.

 

The buyer of a small business should try to determine the risk factor of the new business, though this is difficult at best and in many cases impossible. In attempting to assess the risk factor, the buyer should project the profits of the business as far into the future as possible. He should ask himself how high the risk should be normally and look for conditions that would be likely to affect the sales and profit-making capability of the business.

 

In any event, he should consider carefully the minimum return on investment that he is willing to accept. This concept of risk is important in valuing the business by capitalization of future earnings.

 

Valuing the Business by Capitalizing Future Earnings
The price to be paid by the buyer should be based on the capitalized value of future earnings. Instead, however, in most small business buy-sell transactions, price is based on the purchase and sale of assets, Profits are made by utilizing assets, of course, but actually the assets purchased are only incidental to the future profits of the new business.

 

Capitalized value is the capital value that would bring the stated earnings at a specified rate of interest. The rate used is usually the current rate of return for investments involving a similar amount of risk. The capitalized value is found by dividing the annual profit by the specified rate of return expressed as a decimal.

 

Assume for the moment that the future profits of a business have been projected for the next 5 years and are estimated to average $20,000 a year. (This is in addition to compensation for the services of the buyer and any members of his family.) What should be the sales price for the buy-sell transaction?

 

If this investment were as safe as Government bonds that yields 6 percent, the buyer should be willing to pay 333,000 ($ 20,000 / 0.06 ). If the investment is considered as safe as an investment in an excellent corporate stock that earns 10 percent in dividends and price increases, the buyer should be willing to pay $200, 000 ( $ 20,000 / 0.10 ).

 

Very few small businesses, however, have as low a risk factor as these two investments. What rate, then, should be used in capitalizing the earnings of a small business? Usually, 20 to 25 percent is considered adequate. This means that the buyer should pay between $80,000 and $100,000 for this business. If it earns the projected $20,000 a year, the buyer will recover his initial investment in 4 or 5 years. This time will be extended by income taxes to be paid on the income, but this would also be the case for most alternative investments except nontaxable securities.

 

In using a computation such as this, the importance of long run profits should be kept in mind. Unless profits are possible over a long period of time ( 10 to 15 years), investment in a small business may be a poor decision. The trend of profits is also important. If all other factors are the same, a company whose profits are declining is worth less than one whose profits are increasing.

 

Valuing the Business on the Basis of Asset Appraisal
The majority of buy-sell transactions are based on a value established for the assets of the company. This approach is not recommended, but if it is to be used, the suggestions that follow should be considered. A most important point is to find out early in the transaction just what assets are to be transferred. Usually, the seller has some personal items that he does not wish to sell. Prepaid insurance, some supplies and the like, in addition to cash, marketable securities, accounts receivable, and notes receivable usually are not sold. If the buyer does purchase the receivables, the seller may guarantee their collection, but such a guarantee should be established.

 

The assets most commonly purchased in a small business buy-sell transaction are merchandise inventory, sales and office supplies, fixtures and equipment, and goodwill.

 

Evaluating goodwill. One of the assets that must be considered in a buy-sell transaction is goodwill. Goodwill, in a general sense, arises from all the special advantages connected with a going concerns good name, capable staff and personnel, high financial standing, reputation for superior products and customer services, and favorable location.

 

From the accounting point of view, goodwill is the ability of a business to realize above-normal profits as a result of these factors. By above-normal profit is meant a higher rate of return on the investment than that ordinarily necessary to attract investors to that type of business. The value of goodwill can be computed in either of the following ways :

 

1. Capitalization of average net earnings. As explained above, the amount to be paid for a business may be determined by capitalizing expected future earnings at a rate that represents the required return on investment. The difference between this amount and the appraised value of the physical assets may be considered the price of goodwill.

 

This method uses only earnings in computing the price to be paid for the business, For that part of the calculation, it ignores the appraised value of the assets.

 

2. Capitalization of average excess earnings. This method recognizes both earnings and asset contributions. It starts with the appraised value of the assets and computes what would be a fair return on that value. If the estimated future earnings are higher than this "fair return," the difference between the two figures - the "excess earnings" - is capitalized at a higher rate, and the amount thus obtained is considered the goodwill value. This figure is added to the appraised value of the assets to give a price for the business.

 

Payment of excess earnings is often stated in terms of "years of purchase" instead of in terms of capitalization at a certain interest rate. Capitalization of average earnings at 20 percent is the same as payment for 5 years' excess earnings.

 

As the above discussion shows, the determination of goodwill usually reflects the value of profits that will be realized by the buyer above the normal rate of return; that is, the excess profits. But most small businesses that are for sale do not have excess profits. They usually show nominal profit or none at all. Often the seller makes an offer that seems quite good, but the buyer must be able to eliminate the seller's emotions and reduce all facts to workable relationships.

 

If there are excess profits, goodwill is usually valued by capitalizing them at a fixed percentage established by bargaining between the seller and the buyer. The capitalization percentage needs to be high because profits higher than a normal return are difficult to maintain. Excess profits of $4,000 capitalized at 10 percent will give a goodwill value of $40,000 ( $4,000 / 0.10 ). Capitalizing the same excess profits at 20 percent gives a goodwill value of $20,000 ( $4,000 / 0.20 ).

 

Though goodwill valuation is the first asset valuation to be discussed here, it is normally the last to be computed. Since few small businesses being sold are producing excess profits, the problem of goodwill value is not a pressing one in most buy-sell transactions.

 

Merchandise inventory.
In a service business, placing a value on the inventories is a minor problem; but in distributive and manufacturing businesses, the inventory is likely to be the largest single asset. A manufacturer, for example, has three inventories - raw material, work in process, and finished goods - and each of them presents different problems in valuation. The distributive company has only one inventory, called merchandise inventory.

 

The financial statements presented by the seller will probably reflect an inventory value different from the one assigned in a buy-sell transaction. Inventories are usually carried on the books either at cost or at the lower of cost or market. Market is defined as the current replacement cost to the seller.

 

In determining the value of inventories, the seller has to chose a method of arriving at cost. The most common costing methods are first-in-first-out (FIFO), last-in-first-out (LIFO), and average cost. These methods may give very different values and the buyer and seller must arrive at some value agreeable to both. The most common methods used in valuing inventories for buying and selling small businesses are cost of last purchase and current market price.

 

The quantity of the inventory is usually determined by a physical count. The physical inventory procedures should be decided before the count, and each inventory team should include one representative from the buyer and one from the seller. It is easy to omit items from the inventory count, and here the seller is usually in a more vulnerable position than the buyer. There is more danger of omitting items from the count than of double counting them.

 

It may be that some items of inventory are not to be sold. If so, these items should be segregated before the count begins. Another problem is determining what quality of items are to be included in the inventory. The buyer needs to be cautious when examining the inventories - in most buy-sell situations there is some inventory that is not salable. This is one reason why the buyer should employ as his representatives on the inventory team individuals who are acquainted with that type of inventory. If the buyer and the seller disagree on the value of certain items, the seller will remove these items from the list of inventory for sale.

 

When the inventory is being priced, be very careful in matching price to quantity. Be sure that the units in which the quantity is recorded and the units priced are the same. The physical count should be recorded in duplicate so that buyer and seller can each make separate extensions after all prices have been listed. After independent extensions, the two inventories should be reconciled.

 

Manufacturer's inventory.
When a manufacturing company is being exchanged, the raw materials inventory is taken and priced like the merchandise inventory of a distributive business. The work-in-progress and finished-goods inventories may present a problem. Usually, there is no market price or cost of last purchase to relate to these inventories; consequently, the seller’s cost is generally used for establishing prices.

 

If the seller has unused plant capacity or if his plant is inefficient, his costs may be inflated. Such a situation requires the help of an accountant with a good knowledge of cost accounting.

 

Store supplies and office supplies.
These two items are usually quite small. They should present no problem, though some of them may have no value to the buyer if the name of the company is to be changed. After the usable supplies have been determined, a physical inventory should be taken and priced as in the case of the merchandise inventory.

 

Property assets and accumulated depreciation.
The property-asset account normally reflects the cost of the assets reduced by a provision for depreciation. In many small business buy-sell transactions, no real property is exchanged, because the plant site is leased. The problem of establishing a value on real estate is not as acute, anyway, since the market value for real property does not fluctuate as widely as the market value for personal property, It is customary to have an independent appraiser establish a value for real property. Appraisers' findings on real property are usually more acceptable to both parties than personal-property appraisals - the real property may have multiple uses, whereas personal property consists of single-purpose assets. The book value of real property will be close to the appraisal value unless the property has been held for a long period of time or unusual circumstances have caused sudden and drastic changes of real-property values.

 

Personal-property assets.
The buyer may feel that he knows going values of the personal property and decide not to retain an independent appraiser. In addition, many individuals believe that cost or book value is a good place to begin negotiations for personal property. However, because of the many methods of computing depreciation and also because of conflicting ideas about capitalizing costs, the cost or book value may not reflect a value that is agreeable to both parties.

 

It is difficult to assign a value to personal property equipment because these assets have little value if the company is liquidated. Therefore, a going-concern value should be determined. The price to be paid for this equipment should be somewhere within the range of the cost of new equipment or the cost of comparable used equipment. For this reason, an independent appraiser can be useful, particularly if he is acquainted with the type of equipment being sought or sold.

 

The seller should realize that he may own assets that do not appear on the fixed-asset schedule. Many companies have a policy of not capitalizing any assets below some arbitrary amount ($200 or $300). A complete physical inventory should be taken.

 

If the assets are numerous and geographically dispersed, the seller may be asked to prepare a certified list of the assets giving description and location. The buyer can then test the list by verifying only selected assets at the time of the sale, but with plans to verify all of them within a certain period of time.

 

The value of personal-property assets is usually decided after considerable bargaining. It is better to assign values to individual assets rather than to make a lump-sum purchase of assets. In a lump-sum purchase, there is more chance of overlooking some asset values.

 

The buyer should try to determine the condition of the assets as well as repair and replacement requirements. If he doesn't establish the condition of the assets individually, repair and possible replacement costs may create an unexpectedly heavy drain on his working capital.

 

Income Tax Consequences
Income tax consequences of the buy-sell transaction may be an important bargaining issue if the buyer and seller are aware of them. The seller should be concerned about the amount of tax he will have to pay on his gains from the sale. The buyer should be concerned about the tax basis he will acquire as a result of the transaction. These concerns almost inevitably lead the buyer and seller into conflict in valuing the business.

 

The income-tax laws are highly technical, and the possible variations in a buy-sell situation are infinite. Because of this, a discussion specific enough to be really helpful is impossible here. Both buyer and seller should study the applicable tax laws ; and if an important decision in the buy-sell agreement is to be based on income-tax consequences, the advice of an income-tax expert should be sought. The key to tax savings is tax planning before the buy-sell contract is closed.

 

The seller should keep in mind that he must report any income-tax liability he incurs by selling a going business. Reinvesting the sales proceeds in another business will not enable him to avoid or postpones his income tax liability.

 

A Valuation Example - the Regal Men's Store
This example will help to bring the factors discussed about into better focus. It is not intended to show what should be done but to give some idea of what might be done.

 

The buyer and the seller. Joe Critser is interested in buying a men's clothing store. He has had nearly 25 years' experience in the men's clothing trade - first as a salesman in retail stores and more recently as a sales representative for Sentinel, a major manufacturer of men's clothing. Now 45 years old, Critser is interested in having a store of his own.

 

In February, Critser learns that the Regal Men's Store is for sale. James Rombaugh, owner and operator of the store, is now 67 and wants to retire, he says. He has no heirs, and no employee of the store is financially able to purchase the business. Rombaugh started the store in the late sixties and has been the sole owner since than.

 

The store. Critser's early investigation convinces him that the store has the kind of possibilities he is looking for. Although it has been operated conservatively, it has a good reputation in the community and a creditable standing in the clothing trade. The store has never been particularly aggressive in advertising, the owner has relied on repeat patronage and word-of-mouth advertising.

 

Critser suspects that part of Rombaugh's desire to sell is due to competitive pressure from more aggressive stores in the community. Sales have continued to increase about in proportion to the market in general, but gross margin and profit have been reduced because of lower overall maintained markup and increasing costs of operation. Rombaugh owns the inventory, fixtures equipment, and operating supplies and leases the building at 5 percent of net sales, with a minimum payment of $ 1,000 a month. The current lease will expire in about 4 years.

 

The preliminary discussion. Rombaugh has been well impressed with Critser and agrees to furnish necessary financial information. In their discussion to date, Rombaugh has stated that he feels the business is worth about $100,000 for the purchase of inventory, fixtures, equipment, and goodwill. He will retain all accounts receivable, but he is willing to allow the new owner an 8 percent fee for outstanding accounts receivable collected after the transfer of ownership has been completed.

 

He also wants to keep a few assets for which he has a sentimental attachment, such as a massive roll-top desk purchased when the store was first opened. Rombaugh will assume responsibility for payment of liabilities outstanding at the time of sale.

 

Critser, on the other hand, feels that the business is worth somewhat less than $ 100,000. It is obvious to him through casual inspection that some of the inventory is worth less than the original purchase price, and he doubts the value that Rombaugh would place on goodwill. He also notes that some of the display equipment is outmoded and needs replacement.

 

Before accepting or rejecting Rombaugh's price, Critser suggests that he be permitted to make his own evaluation of the business on the basis of past financial records and an appraisal of the assets. Rombaugh agrees. Following are the major elements of Critser's investigation and appraisal :

 

Past sales

 

XXX1 - $220,000

 

XXX2 - 228,800

 

XXX3 - 238,000

 

XXX4 - 247,600

 

XXX5 - 257,600

 

Forecast sales - XXX6

 

$265,000 - Critser's estimate of sales, which includes a somewhat smaller increase than the average of 3.2 percent per year between XXX1 and XXX5.

 

$268,676 - Rombaugh's estimate based on the average.

 

Five-year operating statement

 

XXX1 XXX2 XXX3 XXX4 XXX5

 

Sales $220, 000 $228, 800 $238, 000 $247, 600 $257, 600

 

Cost of goods sold 139, 980 146, 432 159, 260 160, 940 167, 440

 

________ ________ ________ ________ ________

 

Gross margin 80, 020 82, 368 78, 740 86, 660 90,160

 

Operating expenses* 62, 420 66, 352 62, 674 70, 566 74, 704

 

________ ________ ________ ________ ________

 

Profit 17, 600 16, 016 16, 066 16, 094 15, 456

 

* Includes owner's salary.

 

 

 

Projected operating statement for XXX6

 

CRITSER ROMBAUGH

 

(Buyer) (Seller)

 

Sales $265, 000 $268, 676

 

Cost of goods sold 172, 250 174, 640

 

________ ________

 

Gross margin 92, 750 94, 036

 

Operating expenses* 76, 850 75, 766

 

________ ________

 

Profit 15, 900 18, 270

 

* Includes estimate of owner's salary.

 

 

 

Balance sheet of Regal Men's Store as of January 31, XXX6

 

Assets

 

Cash on hand and in bank $20, 000

 

Accounts receivable $32, 000

 

Less estimated un-collectible 4, 000

 

________

 

28, 000

 

Merchandise inventory 49, 214

 

Sales and office supplies 1, 920

 

Fixtures 20, 000

 

Less estimated depreciation 5, 600

 

________

 

14, 400

 

Equipment 19, 000

 

Less estimated depreciation 8, 600

 

________

 

10, 400

 

Miscellaneous assets 1, 280

 

________

 

Total assets $ 125, 214

 

Liabilities

 

Accounts payable $ 11, 000

 

Payroll and sales tax payable 1, 300

 

_______

 

Total liabilities $ 12, 300

 

James Rombaugh, capital 112, 914

 

Net worth

 

________

 

Total liabilities and net worth $ 125, 214

 

Salable assets

 

Inventory at current book value $49,214

 

Sales and office supplies 1,920

 

Fixtures, current depreciated value 14, 400

 

Equipment, current depreciated value 10, 400

 

________

 

Total salable assets $75, 934

 

Valuation of inventory and appraisal of fixed assets

 

CRITSER ROMBAUGH

 

Inventory by physical count $47, 514

 

90 percent valued at current prices $42, 762

 

5 percent valued at 75 percent of current prices 1, 782

 

5 percent valued at 50 percent of current prices 1,188

 

________ ________

 

Inventory - appraised value 45, 732 47, 514

 

Usable office supplies 1, 680 1, 680

 

Fixtures - appraised value 13, 600 13, 600

 

Equipment - appraised value* 9, 400 9, 400

 

________ ________

 

Total assets-appraised value $70, 412 $72,194

 

* Independent appraiser. Excludes assets to be retained by Rombaugh.

 

How much to pay?
If Critser feels that his return on investment should be capitalized over 5 years, his offering price, based on anticipated profits for the year ahead, would be $79,500 (5 years=20 percent per year; $15,900 / 0.20=$79,500 ). If, on the other hand, the purchase was based on the appraised value of assets only, the purchase price would be $70,412 plus any provision for goodwill.

 

Since both of these figures are well below the suggested price of $100,000, negotiation will be necessary. Here are some questions that might arise :

 

1. In light of future sales and profit possibilities, are the assets worth more than the sale price?

 

2. Is the risk less than Critser anticipates? To pay $ 100,000, he would have to reduce his risk level to between 6 and 7 years.

 

3. Is Rombaugh's price too high in the light of future sales and profit possibilities under new management?

 

4. How much confidence does Critser have in his ability to realize an acceptable return on his investment?

 

5. Is the actual value of this business as a going concern closer to $68,000, $80,000, or $100,000?

 

6. How much is the goodwill of this business actually worth to Rombaugh? To Critser?

 

7. What kind of compromise might be satisfactory to both the buyer and the seller?

 

 

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