The key is to first understand how business valuation works so let’s start this discussion with business valuation methods…
There are many different approaches to determine the value of a business for sale and selection of the best method depends on what you find in front of you. For example, you will find some businesses for sale that are worth nothing more than what you would get if you closed it and sold off all the assets. In these cases, value is simply the sum of the fair market value of the assets if you were to hold an auction. But, these are not the kind of opportunities that will interest the entrepreneur seeking to acquire something to operate and grow, obviously, so let’s set that valuation approach aside.
When it comes to a healthy, ongoing business that produces cash flow, you will take a different approach. Simply put, in these cases the value is what you would pay today for the all of the future cash flows that the business for sale will generate. So we have to estimate those future cash flows first, then determine what they are worth today by taking into account the likelihood that they will actually happen. You are predicting the future. And that’s tough, because who knows what will happen tomorrow much less next year or the next five years? But, we can look at the past to get an idea of what the future might bring.
The simplest and most common approach to value a business involves three basic steps:
- Analyze the past profits – this is proof of what actually happened.
- Adjust those profits to eliminate the effect of any past expenses that will not continue into the future under your ownership plus the effects of any investing the company must do to maintain operations (replacing equipment periodically, etc.).
- Choose a multiple that expresses what the market is willing to pay for those adjusted profits going forward.
So let’s start with the current and past profit performance. By examining the past three years of financial reports, you can see trends in revenue, profitability, consistency of performance and ultimately how cash moves in and out of the business for sale. You’ll be looking for changes over time in the key areas of revenue, gross profit, overhead and profit, as well as accounts you will find on the balance sheet like assets and working capital. Understanding the reasons behind these changes, positive or negative, will help you judge the likelihood that the profits will continue into the future from which you can estimate a base profit going forward.
Let’s move to adjusting the profits. Most business brokers will help their sellers compile a list of “add-backs” that adjust the profits up. An “add-back” is an expense that happened in the past operation of the business for sale, but that theoretically will not happen going forward. An example would be the expense for an automobile used by a spouse who does not work in the business. While such an expense might be on the books (to reduce the tax bill), it is clearly not a legitimate business expense and should be added back to the profit to reflect what would be earned when this practice is discontinued under new ownership. Another example of an “add-back” would be a one-time expense, such as a settlement of a lawsuit that will not reoccur each year going forward. You’ll find some add-backs that should be questioned. It’s understandable that the seller will be aggressive in finding them since each one increase value.
If the business for sale requires significant capital expenditures to maintain operations, that needs to be adjusted out as well.
The third step is choosing a multiple. So after adjusting the baseline profit with legitimate add-backs, you arrive at what we will call adjusted EBITDA. Now we have to apply a multiple to the adjusted EBITDA to arrive at a business valuation – one number that expresses a multitude of judgements including the uncertainty of the future, the risk of losing a key customer or key supplier, the quality of the management team, systems, marketing, owner-dependency, and many more factors.
There are some industries that have typical multiples that can be thought of as a rule of thumb. Regardless, there is no substitute for making your own judgement to account for the fact that every business for sale has unique characteristics. Start with the median multiple for the size of business for sale in question (probably 3 or 4) and adjust it up or down for all of the risk factors. This will produce a range of values and it’s usually the high end of the range (or sometimes more) that gets chosen as an asking price.
Before you buy a business, it’s important to run your own numbers as well as understand how the seller arrived at theirs.
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