Tag Archives: cash flow

How To Buy A Business

Sometimes entrepreneurs ask us how to buy a business. We tell them the best way is to enlist the help of a professional service to help you with the transaction. Below are some of the checklist items we discuss with our clients.

Review their financial documents. Determine how much cash flow you can expect in the near term after giving yourself a modest salary. Divide the cash flow by your cash investment to get your return on investment. Is the ROI acceptable for your perceived risk? If it is, make an offer. Rely on the process work and you’ll find the business that’s right for you.

Get expert advice – It’s always a good idea to speak to an accountant and a lawyer, before you buy a business. For instance, you may want to make sure the seller cannot open another similar business just around the corner. Don’t forget, mistakes made now may come back to haunt you in the future. Get advice about issues such as:
•  The expected return on invested capital.
•  Valuation of stock and work in progress.
•  Inspection of the seller’s accounts, tax returns, wages books, and any statements that must be given under the law, etc.
•  Find out why is the business being sold – Sellers will offer any number of apparently legitimate reasons to explain the sale of their business. But it is worth asking anyway, and attempting to judge how comfortable the seller is in releasing information. Sometimes the seller wants to sell the business for a reason that should discourage you from buying (eg it’s not making money!). Make sure an accountant looks at the business’ accounts.

• Determine what is a fair price – Usually a business that is a going concern is sold with a certain payment for “goodwill”. This is the price the buyer pays for the business’s “good name” that has been earned over the period of operation. An accountant can help you establish an appropriate figure for goodwill by examining the business’s financial accounts.

What are the sales prospects? Among other things, you should know:
• The sales figures for each month of the year.
• The profiles of buyers (eg their age, spending patterns).
• Who the suppliers are and what their relationship with the business is.
• What the stock figures are, including average costs and turnover.
• If the stock is realistically valued.
• Profits and expenses

Make sure the profit figures offered by the seller are analyzed by your accountant. For instance, it is important to know whether the business will generate enough profits to cover your financial needs and support your lifestyle. Make sure the seller’s figures presented as expenses are realistic and are also looked at by an accountant. For instance:

• Are the expenses listed in full?
• Are there hidden costs?
• What are the depreciation costs?
• Are there any cost increases likely in the future?
• What are the terms of the lease of premises?
• What is the cost of borrowings for the business?
• What is the business’s credit rating?
• What are the total costs of employees?
• What are the liabilities that will carry over with the sale?
• Are there likely to be any rental or leasing increases?
• Are there any outstanding maintenance costs that must be met?
• The assets – Make sure you understand what assets are included in the sale price. For instance:
• Are they priced at a fair value?
• What are the depreciation costs?
• What are the leasing costs?
• What is the cash flow?

Legal help – A lawyer can help with the following issues:
• Whether the business structure is suitable for your needs.
• Agreements with the seller to ensure they don’t compete in the same geographical area or the same market.
• The terms of the purchase agreement.
• Whether the purchase agreement should be subject to finance.
• Whether there should be a trial period built into the purchase agreement.
• Looking at existing leasing agreements.
• Whether the purchase agreement says what you think it does.
• Searching the council and other agency records to ensure there are no plans or council orders that could disrupt the business or lead to a drop in sales.
• Checking the zoning regulations.
• Drafting any restraint of trade requirements of the seller, including dealing with prior customers and conducting a similar business.
• Transfer of business names, trademarks, etc.
• Information to be supplied by the seller (eg a list of current customers and suppliers).
• Any agreement for the seller to work in the business for any length of time.
• Any specific requirements of legislation

Let an Exodus Business Solutions professional help you find the most appropriate business opportunity. Click here to learn more.

Business Valuation Formulas

Exodus Business Solutions can help you determine a fair and accurate valuation for your business.

The best results are produced by an in-depth analysis of many factors. Exodus is very experienced at assembling an accurate picture and executive summary. However, from time to time we are asked: “Isn’t there some kind of rule of thumb short formula for businesses?” The answer is that, yes there are short formulas, but these are generally inaccurate.

business-valuation-formula-list

 

Even though that is the case we are sharing with you what some people think are various rule of thumb valuation methods for specific types of businesses.

 

Sample Business Valuation Methods

Below are some sample business valuations and methods.

Capitalized Earning Approach – A common method of valuing a business is called the Capitalization of Earnings (or Capitalized Earnings) method. Capitalization refers to the return on investment that is expected by an investor. There are many variations in how this method is applied. However, the basic logic is the same. To demonstrate the capitalization method of valuation, let’s look at a mythical and highly oversimplified business. Pretend the business is simply a post office box to which people send money. The magic post office box has been collecting money at the rate of about $10,100 per year steadily for ten years with very little variation. It is likely to continue to collect money at this rate indefinitely. The only expense for this business is $100 per year rent charged by the post office. So the business earns $10,000 per year ($10,100-$100). Because the PO box will continue to collect money indefinitely at the same rate, it retains its full value. The buyer should be able to sell it at any time and get his initial investment back. A buyer would look at this “minimum risk” business earning $10,000 and compare it to other ways of investing his or her money to earn $10,000 per year. Let’s assume a near no risk investment like a savings account or government treasury bills currently pays about 8% a year. At the 8% rate, for someone to earn the same $10,000 per year that the magic PO box earns, an investment of $125,000 (125,000*8%= $10,000) would be required. Therefore, the PO box value is in the area of $125,000. It is an equivalent investment in terms of risk and return to the savings account or T-bill. Now the real world of business has no magic PO boxes and no “no risk” situations. Business owners take risks and have expenses, and business equipment can and usually does depreciate in value. The higher the perceived risk, the higher the capitalization rate (percentage) that the buyer will use to estimate value. Rates of 20% to 25% are common for small business capitalization calculations. That is, buyers will look for a return on their investment of 20% to 25% in buying a small business. However, as we’ll see below, some businesses have value to some buyers for reasons that have little to do with the amount of money they are earning. Finally, it is important to point out that the above example does not include a fair salary for the new business owner. If the owner must devote time working to realize a profit, he or she must, in theory, be paid a fair value for that work. The owner’s fair and reasonable salary must be separated from the return on investment computations. For example, if the magic PO box produced $30,000 per year but required a manager with a fair market salary of $20,000, the income for valuation purposes is $10,000, not $30,000. The fair market value for salary is the important number to use, not the actual salary to the current owner.

Excess Earning Method – This method is similar to the capitalization method described above. The difference is that it splits off return on assets from other earning (the excess earnings). For example, let’s suppose Mr. Owner runs a business that manufactures novelty products. His company has Tangible Assets of $300,000. Further let’s suppose that Mr. Owner pays himself a very reasonable market value salary– the same amount that he would have to pay a competent manager to do his job. After paying the salary Mr. Owner’s business has earnings of $120,000. The financially rational reason for owning business assets is to produce a financial return. Let’s say that a reasonable return on Mr. Owner’s Tangible Assets is 15% per year. A reasonable number here should be based on industry averages for return on assets adjusted to current economic conditions. For example, Mr. Owner or his advisors may have looked up industry standards for novelty manufacturing shops and found that the current average return on assets was 14%. (An alternative approach to finding an industry appropriate return on asset figure is to use a rate 2 to 3 points above the current bank rate for a small business loan, or about 5 points above the current prime rate).

So $45,000 of Mr. Owner’s profits are derived from the tangible assets of the business ($300,000 x 15%= $45,000) The other $75,000 ($120,000-$45,000=$75,000) in earnings are the excess earnings). This $75,000 excess earning number is typically multiplied by a factor of 2 to 5 based on such factors as the level of risk involved in the business, the attractiveness of the business and the industry, competitiveness, and growth potential. The higher the factor used, the higher the estimate of the business will be. A typical number is 3 for a solid, profitable company. That is, a good business that is judged to be average in terms of the level of risk involved, the attractiveness of the business, the industry, competitiveness, and growth potential would use three as a multiplier. The actual factor used is a mix of opinion, comparison to others in the industry, and industry outlook. Let’s suppose that Mr. Owner’s business is a bit better than average in these factors and assign a multiplier of 3.6. Therefore, the value of this business can be determined as follows:

A. Fair market value of tangible equipment $300,000
B. Total Earnings $120,000
C. Earnings attributed to Tangible Assets
($300,000 x 15%=$45,000) -$45,000
D. Excess Earnings
($120,000 – $45,000=$75,000) $75,000
E. Value of excess earnings
($75,000 x 3.6=$270,000) $270,000
F. Estimated Total Value (A+E) $570,000

The capitalization methods work for businesses that derive their income primarily from tangible assets such as a utility (such as gas or electric companies). In the case of most small businesses that earn only a small part of their revenues from tangible assets, the excess earning method is probably a better method to use.

Cash Flow Method – Buyers often look at a business and evaluate it by determining how much of a loan the cash flow will support. That is, they will look at the profits and add back to profits any expense for depreciation and amortization but also subtract from cash flow an estimated annual amount for equipment replacement. They will also adjust owner’s salary to a fair salary or at least an acceptable salary for the new owner. The adjusted cash flow number is used as a benchmark to measure the firm’s ability to service debt. If the adjusted cash flow is, for example, $100,000, and prevailing interest rates are 10%, and the buyer wants to amortize the loan over 5 years, the maximum a buyer is willing to pay for the firm would be $392,211. This is the amount that $100,000 per year would support over 5 years. Therefore, when using this method, the value of a company changes with interest rate conditions. It also changes with the terms a buyer can obtain on a business loan. From a buyer’s perspective this may make sense, but from a seller’s perspective it introduces a sort of arbitrariness into the process.

Tangible Assets(Balance Sheet) Method – In some instances, a business is worth no more than the value of its tangible assets. This would be the case for some (not all) businesses that are losing money or paying the owner(s) less in total than a fair market compensation. Selling such a business is often a matter of getting the best possible price for the equipment, inventory, and other assets of the business. It is generally best to approach other firms in the same business that would have direct use for such assets. Also, a company in the same business might be interested in taking over your facility. This would mean your leasehold improvements (modifications to space, etc.) would have value and the equipment would have value as “in place” plant and equipment. In place value is higher than the value on a piece by piece basis such as at a sale by auction.
Cost To Create Approach (Leap Frog Start-Up) Sometimes companies or individuals will purchase a company just to avoid the difficulties of starting from scratch. The buyer will calculate his or her start up needs in terms of dollars and time. Next he or she will look at your business and analyze what it has and what it may be missing relative to the buyer’s start up plan. The buyer will calculate value based on his or her projected costs to organize personnel, obtain leases, obtain fixed assets, and cost to develop intangibles such as licenses, copyrights, contracts, etc.). A reasonable premium of above the sum of projected start up costs may be offered because of the effort and time being saved by the buyer. The more difficult, expensive, and/or time consuming startup is likely to be, the higher the value would be based upon this method.

Rule of Thumb Methods – One of the most common approaches to small business valuation is the use of industry rules of thumb. While most financial analysts cringe at the use of these approaches, they do have their place, which we believe to be as adjuncts to other methods. One industry rule of thumb says an Internet Service Provider company is worth $75 to $125 per subscriber plus equipment at fair market value. Another says that small weekly newspapers are worth 100% of one year’s gross income. The problem with these and all rule of thumb formulas is that they are statistically derived from the sale of many businesses of each type. That is, an organization might compile statistics on perhaps 100 small weekly newspapers that were sold over a two year period. They will then average all the selling prices and calculate that the average paper sold for 100% of one year’s gross income. The rule of thumb is thus created. However, some newspapers may have sold for twice one year’s gross while other may have sold for half of one year’s gross. The rule of thumb averages may be accurate for those businesses whose performances are right about at the average. The business with expenses and profits that are right on target with industry averages may well sell for a price in line with the rule of thumb formula. Others will vary. To apply the rule of thumb to a business that varies significantly from the average is not appropriate.

Value of Specific Intangible Assets – This is an often overlooked approach to valuation. Yet in some cases it is the only appropriate approach that will result in a sale. The approach is based upon the buyer’s buying a wanted intangible asset versus creating it. Many times buying can be a cost efficient and time saving alternative. For example, we recently sold a temporary employment agency. This agency specialized in placing health care assistants (such as nurses aids) in hospitals and nursing homes. Because there is a shortage of these workers in the area where the selling company did business, placing workers was not difficult. However, finding qualified workers was very difficult. We approached firms in the same and related businesses. Through our research, we calculated that recruiting a qualified worker cost at least $200 for an agency. Therefore, we were able to obtain a price of $170.00 for each worker in the pool of available employees by showing a competitor that this would save them money. In fact, this not only saved $30.00 per worker, but it also cut down on recruiting time to recruit. The overhead of the selling company was not an issue because the buying company already had the system in place that the overhead expense was paying for (offices, computer system, phones, etc.). In fact, whether the seller was making or losing money was of little consequence to the buyer. The value to the buyer was the value of buying a qualified worker versus recruiting a worker through the more traditional method of advertising, interviewing, etc. A common application of this method is the acquisition of a customer base. Customers with a high likelihood of being retained are valuable in most industries. Examples of industries where companies are bought and sold based upon the value of the customer base include insurance agencies, advertising agencies, payroll services, and bookkeeping services. In practice the buyer will often ask for a credit for each customer that is not retained for a stated period of time. For example, a firm may offer $100 per customer, with a pro-rated credit for each customer lost during the twelve months following the closing of the sale. Pro-rating is based upon the time the customer is lost– if the customer is lost after 6 months, for example, half of the $100 would be returned to the seller.

Conclusion – There is no surefire way to value a company for buying and selling purposes. The true value is the perceived value to a buyer who is ready, willing, and able to buy it. However, there are a number of approaches to estimate value; some of those are discussed above. It is not unusual for a buyer to ask for the logic behind an asking price. Having a good answer to that question will enhance your chances of selling your firm for the desired price.