This content was provided by Kip Moggridge, Business Broker at Arthur Berry and Company.
Every buyer asks the question “what’s it really worth”. To begin with, there can be several values for a business depending upon what it’s being valued for. Selling, re-financing or financial equity issues all have different values. The values run all the way from salvage up to enterprise value or net present values depending upon the required use. From a selling perspective you should know that most business asking prices are usually at the highest fair market value without consideration for future risks.
That asking price is established by using several methods from comparison of similar business sales to simple percentage of gross earnings figures. The best method is one that is a combination of the tangible assets at replacement or fair market values plus some value for the seller’s discretionary (net) earnings. The reason I like that latter method is because it describes exactly what you’re buying and places values on each of the components. Assets and earnings.
Getting a good description of both of these segments is your first step in figuring what a business is worth to you. Assets, at fair market values are usually the easy part. Just start with what the original cost to the seller was and discount that for depreciation and or obsolescence. A typical discount would be something between 20% of original cost (salvage value) and about 70% or original cost (replacement) values. Real estate will always require an appraisal so an “estimate”contingent on appraisal is appropriate.
Bank and financial institutions describe earnings as “ The Sellers Discretionary Cash Flow (SDCF)” which is a combination of these items right off the taxes or P and L’s (add these all up): Net, owners compensation, depreciation, interest and or capital expenditures, benefits to owners and any extra expenses you would not incur. Get comfortable with doing this with every business you look at. Takes some skills, but you can do it.
Next, you have to determine what your limit to a purchase is. Start with two independent variables (these don’t change). The first one is your personal salary needs might be for one year. It’s the minimum (not what you would like) amount of money you will require for the time you spend in the business. For some buyers, it is the total needed for you and your family to live on each year, to the penny. No vacations, just subsistence. Next, is how much cash do you have that you can invest safely and, if you lost it, your not in the poor house. Again, this should be a minimum number. Don’t try to impress someone with some huge, cash out your 401k, sell the home and boat, number. Just the real world amount you can invest today.
With those two, we can determine what you can afford. First, multiply the cash to invest by 10 and that’s the maximum selling price for any business you can afford. After you find a business that’s within that range, what do you look for first? (Were you paying attention?) Right, it’s the cash flow (discretionary) that is reported by the seller. If it covers what you needed in your first independent variable, you can look at this business.
Now for the final part, what is it worth to you.
To finance any business you have found, banks will require that the reported SDCF, after you take our first independent variable (remember what that was?) Right, your required salary. The balance of the “old” SDCF, after salary (first independent variable), must be 1.25 times greater than any new payments incurred. How that works is you start with a selling price and deduct your down payment. The new figure is what you finance. By example, let’s say that you offered $175k for a business and made your down payment of $20k using your (2nd variable). New payments annually are usually about 13% of what you borrow. So, borrowing $155k the payments should be about $21k a year. In that business, the old SDCF was just 40k (including a salary for the old owner) so lets say that you needed 30k a year to live on. With me so far? Great! So after you take out your salary from the $40k historic SDCF you are left with $10k to make the $21k payment on. You can’t buy or finance this business at these numbers.
To finance this business the adjusted or new, net cash flow (old SDCF minus your salary) has to be 125% greater than the payments. ? If it’s not, there is only one part of the overall formula that has to change. Do you know what has to change to make this come out? Remember you can’t change your independent variables. Right, it’s the price you pay. Lower you’re offering price to a point where the numbers do work. Offer at what works for you!
Here’s is another example that does work. Business B is offered for $200k, and has a cash flow of about $87k. You need $30k to live on so let’s see what works:
Selling Price: $200k
Down Payment: ($20k)
Old cash flow: $87k
Less your salary: ($30k)
Net Cash Flow: $57k
New Payments: $23.4k
Debt Coverage Ratio: ($57k/$23.4k) = 2.44
Return on Down payment = 244%
Can you buy and finance this business? Yes !
What happens when the cash flow isn’t there but you believe that you can take the business to the next level. Your energy, abilities and desires have a value and you may not want to just discount a business because the numbers are not presently there. In that scenario, you may have to offer less or obtain some seller financing to meet the obligations to finance but businesses do have “risks” and that’s the part of the formula that can’t be determined precisely. Buying an existing business gives you some idea of where you have to go based upon its history and I think that beats the heck out of starting from scratch.
It takes courage to be a small business owner but it must be ok because look around and you will see countless examples of successes and failures but sometimes you just have to try. Remember what Kipling said in his poem, “If……if only I had tried.”
That’s all there is to figuring value to you, the buyer…
Contact Kip Moggridge at Arthur Berry & Company:
9095 S. Federal Way, Boise, ID 83716 – 208.639.6169 – firstname.lastname@example.org