How to value a small business is often a confusing and subjective issue for both business vendors and prospective purchasers.
Many small businesses are valued for sale based on standard industry style valuation methods that have been developed within different industries. The advantage of these industry methods is that they ensure consistency of valuation between similar types of businesses.
However, most of these valuation techniques do not consider the buyer’s desired rate of return on investment for a specified risk profile. Many industry standard valuation techniques result in the overvaluation of small business enterprises. This often leads to purchasers paying too much goodwill for a business resulting in a high level of business failure.
Business valuations must take into account the risk profile of the going concern and the return on investment commensurate with the amount of risk of business failure.
Only a qualified Accountant is educated enough to understand business valuation methodologies regarding tangible and intangible assets. Accountants are trained to understand the complexity of goodwill and taxation issues regarding purchasing and selling a business. Financial advisors, business advisors & brokers are usually inadequately educated and often do not understand how to correctly value a small business. Unfortunately, advisors and brokers are only trying to earn a commission for the sale of a business. Just like real estate agents, business brokers don’t care about the sale price or business valuation as their commission is paid by the business vendor.
What is a Small Business?
A small business is typically a business with a small group of owners that are usually relatives or friends. The owners typically operate the business themselves and employ a small number of staff. The majority of businesses in an economy are small, family operated business that employ less than 25 staff.
A small business can be a sole trader, partnership or a private company. These businesses cannot raise funds from the public and cannot trade ownership shares with the public.
Why Operate a Small Business?
The primary reason to purchase or commence a small business is for financial gain.
However, there are many other reasons to operate a small business:
- Provide employment for yourself and others
- Work without a boss
- Control your own destiny
- Work in your industry of choice
- Work non-regular or shorter hours
- Leave a legacy for your family
- Earn more money than a job
- Build a business asset that can be sold
What to Consider When Purchasing a Small Business
There are many things to consider when deciding to purchase a small business.
- What are the reasons for sale of the business?
- How long has the business operated at a profitable level?
- Is the current location suitable for continuing a profitable business?
- What are the projected sales, cashflow and profits for the next year?
- Does the business have strong positive cashflow?
- How was the business funded and the impact on profitability?
- How are you going to fund the purchase of the business?
- Is the product or service market growing or shrinking?
- Does the business have a seasonal sales cycle?
- Are you going to earn profits consistently throughout the year?
- Are you able to develop and add value to the business?
- Does the purchaser have the ability & aptitude to operate the business?
- Can the business be easily re-sold if it doesn’t work out for you?
- Is the customer list really worth the value per customer?
Goodwill: How to Value a Small Business
Goodwill is an intangible asset of a business. It represents the premium price paid for the business over the value of the net assets. An amount of goodwill is paid for the benefit of acquiring an existing business with established customers and suppliers. The goodwill could include amounts for intellectual property such as patents, trademarks or registered designs. This intellectual property may give the business competitive advantages over other business in the same industry.
Starting a new business requires finding premises, sourcing suppliers, hiring and training staff, advertising to attract customers and many more initial activities. A new business takes time to establish a normal level of trading and profitability.
Many people would prefer to pay an amount of goodwill for an established business rather than try to start a new business. Starting a business is always an expensive and time-consuming activity with hidden costs and issues. And there is no guarantee that a new business will be successful.
The amount paid for goodwill is always negotiable between the buyer and seller. Sellers generally overstate the value of their business to try to achieve a maximum selling price. There is no simple calculation for goodwill as it really comes down to how much a seller wants for their business.
Business buyers have to correctly evaluate the real value of the business based on actual earning capacity and return on investment.
What is a Going Concern?
A business is a going concern when the business will continue to operate in the future under existing or new ownership. There must be assets that will produce future cash inflows and profits.
Any assets that are not likely to produce future benefits must be written down or written off. One of the most commonly overvalued assets is goodwill, trademarks or capitalized research and development expenditure. After a business is purchased, the goodwill must be written down in accordance with the earning power of that intangible asset.
Small Business Valuation Methods
Generally, there are two valuation methods for determining how much to pay for a small business.
Asset Based Valuation Methods
These valuation methods determine the value of a small business based on the value of the net assets. Assets can be valued by historical cost, written down cost, replacement cost or fair market value.
One of the most common methods for valuing a small business is fair market value of the tangible assets plus an amount of goodwill for the established business. The amount of goodwill is highly subjective and negotiable between vendor and buyer.
Disadvantage of Asset Based Methods
Asset based business valuation methods do not take into account the earning power of the assets. The actual earning power of the assets may be greater than the asset value generating positive goodwill. Or the earning power of the assets may be low causing the assets to be devalued or written off.
Earnings Based Valuation Methods
Earnings based methods of valuation are more appropriate to value a small business. It is more important how the assets of the business earn income and profits than the value of those assets.
Would you rather invest $10,000 to make earnings of $10,000 per year, or invest $1million to earn $100,000 per year? The first example makes a 100% return on investment, whereas the latter makes only 10% ROI.
Earnings based valuation more correctly reflects the value of a service-based business. The income and profitability of service-based businesses is more dependent on returning customers rather than the value of assets employed in the business. For example, an accounting practice has few tangible assets. The real value and goodwill of the business is the customer list. These customers return every month for accounting & taxation services.
Another example is a lawn & gardening business. The vendor wants to sell a trailer equipped with lawn mowers, grass cutters and other equipment. The value of the equipment is trivial in comparison to the value of the recurring customer list. Acquiring a customer would have incurred advertising and acquisition costs in excess of the one-off earnings for a customer. Every month the customers generate earnings for the business so the customers are worth many times the monthly earnings.
Industry Standard Earnings Based Valuation Methods
Many industries have developed a standard method of valuing a business based on sales turnover, income, gross profit or net profit before tax.
Goodwill is usually based on a multiplier of earnings but this does not reflect the desired rate of return on investment. It does not take into account other factors such as current loan interest rates or increased leasing and staffing costs.
News Agency Shop
A goodwill payment of 2 times the annual gross profit.
Assume an average annual gross profit of $200,000.
Goodwill will be $400,000.
However, what is the net profit before owners’ salaries?
Shop leases and hiring staff is very expensive. There won’t be much profit left for owners after covering the overheads. The net profit before owners’ salaries may be around $50,000 per year.
Would you pay goodwill of $400,000 for an established business that earns you $50,000 per year? Or just get a normal job.
Management Rights for Apartment Building
An apartment building homeowner association (body corporate) pays a manager an annual salary of $80,000 for caretaking and cleaning.
The value of the management rights is 5 times the annual salary.
The business value is $400,000.
$80,000 / $400,000 = 20 % return on goodwill
Most building managers borrow the funds to purchase the management rights.
Assume the interest rate is 10% on $400,000 = $40,000 per year interest payments.
Salary $80,000 less $40,000 interest = $40,000 real salary.
Would you borrow & pay $400,000 for a job that pays you $40,000 per year?
Most people can get a job that pays $40,000 per year with no investment.
Older persons, who have the capital and don’t need to borrow funds, like to purchase these businesses. They like to believe they are getting 20% return on their investment. But they forget that they have to do the work and often employ others to work for them. They could invest their capital elsewhere and work a normal job to make a similar net return.
Insurance Brokers
The industry standard amount for goodwill is twice the annual broker earnings.
For example, pay $200,000 goodwill for a business that earns $100,000 fee income.
A buyer needs to carefully consider whether they will make an adequate return on the investment.
Types of Business Risk to Value a Small Business
Prospective business purchasers must consider industry, business and acquisition risks associated with taking over the ownership of an existing business.
Acquisition risk means will a change in the ownership of the business make any competitive advantage or disadvantage to the business. Does the existing owner’s persona drive sales to the business? Will customers remain loyal to the business with a new owner?
Business risk relates to how competitive and profitable the business is compared to other businesses in the same industry. Does the business have any sustainable competitive advantages over competitors? What happens if new competitors enter the industry?
Industry risk relates to how the industry is operating within the economy. Is the industry likely to continue into the foreseeable future or is the industry in decline? Is the number of competitors increasing or decreasing? Are there technological changes to the industry? Are other larger businesses trying to consolidate or take over the industry? Is the industry moving offshore to a cheaper economy?
Conclusion: How to Value a Small Business
There is a high incidence of business failure among new business owners who purchase an existing going concern business. The main cause for new business operators failing is paying too much goodwill for an overvalued business. Often the owner funds the goodwill with debt finance which is unserviceable.
Standard industry accepted valuation methods are too simplistic, generalized and often misleading when applied to a small business for sale. There are many other factors to consider when purchasing a business as well as the basic financial numbers. The prospective purchaser must perform an analysis of the business’s strengths and weaknesses in the current economic environment.
Most business valuation methodologies do not take into account the level of business and industry risk and the purchaser’s desired rate of return on investment. New owners trap themselves in a business that makes money but at a rate of return below what is required to service debt and provide adequate owner’s wages.
There is no point purchasing a business, taking on the risks and rewards of ownership, to make the same or less earnings than working a normal job. There must be a rate of return on capital that is way in excess to working a standard job.
Prospective business purchasers must invest in consulting with a qualified Accountant who has experience in small business valuation and negotiation. This will save you from paying too much for a business and potentially making a huge financial mistake.