by Glen Cooper, CBI, CBA, BVAL
Buying a business is the right thing to do for some people.
In this series of five blogs/podcasts, I am discussing all of the major issues about buying a business, especially in today’s opportunity-filled market.
When you and the seller finally trust each other enough to tell the truth, then a good deal is possible. You’ll begin to see the real opportunity a successful transaction offers each of you. You will get the business you want and it will likely be a good deal for both of you.
So, you ask, what’s a good deal? What, after all, is the business worth?
In a previous blog/podcast series, we titled, “Appraising A Business in 60 Minutes,” we covered a lot of territory. In fact, on our website, there are several articles – past and present – that we offer in this category that will be subjects of future blogs and podcasts.
Right now, however, let talk about “rules of thumb.”
Rules of Thumb Are Dumb!
Business valuation experts agree: rules of thumb are dumb.
But we use them anyway!
The most common rule of thumb for what a small business is worth is three times owner cash flow. It comes up all the time because it is often a good general measure of what might make sense. It is sometimes used just to explain why more than three times owner cash flow is too much. Owner cash flow, by the way, is just one of many ways to measure the profitability of a small business.
The rule sounds a little too simple, as well. For example, one could ask: Is that this year’s owner cash flow, last year’s owner cash flow, next year’s projected owner cash flow, or what?! How do you define owner cash flow?
For that matter, how do you define small business? Does a value calculated using this rule of thumb apply to all types and sizes of businesses? Does it include furniture, fixtures and equipment? Does it include inventory? Does it include real estate?
Besides that, how does any rule of thumb take into account all of the other things that matter besides profit?
Is there any way to measure the attractiveness of a business? What about location of the business? What about the stability? What about the systems and the skilled employees? What about seller financing? How do these things impact a rule of thumb?
A rule of thumb, however handy it may seem, is an obvious simplification of a much more complicated reality.
Future Benefits Create Value
The truth, of course, is that only future benefits offer value. Business value is a function of the future benefits the business offers its owner. Future benefits are measured in many ways.
There are cash flow benefits, to be sure. But there are also benefits that relate to an owner’s ability to realize his/her dream. The personal growth and lifestyle and legacy benefits are almost always just as important as cash flow. Companies that acquire other companies often experience synergistic benefits.
Who says so? Well, buyers, of course.
There are, at any one time, at least 500 active business buyer prospects (individuals, companies and groups) roaming around Maine with a variety of wishes and needs. They have their financial limits, of course, but they are almost always looking for a unique business that matches the dream they have in their mind’s eye, or gives them that synergistic fit with the company they already own.
A business buyer might pay three times annual cash flow for a business if his/her goal was purely a 33% pre-tax annual return on investment. But if another buyer wants it for non-financial reasons of growth, lifestyle, legacy and/or synergy, and can live with only a 20% pre-tax annual return, they might pay five times annual cash flow to get it.
The day-to-day reality of business buying and selling is negotiating all these terms and taking into account the many and varied motives of buyers and sellers.
Because individuals, companies and groups measure and define all of these terms a little differently, the range of what people will pay for a small business is usually pretty broad.
Nobody Really Knows
It might shock you to know that no one knows what a business is worth.
Even those of us who are veteran business brokers and appraisers don’t really know. Ultimately, only the person who is making the buying decision can determine value. And the value that they (you) determine is only good in that one moment and may be unique to them (you).
To really figure out what a business is worth takes in-depth knowledge of that specific business. You can’t “drive by” and figure it out.
Even if you know some of the data—like annual gross sales and annual cash flow to the owner—you still can’t figure it out. You must know more than just facts. You must know the subtle nuances of why the business is what it is. You will even need to guess where it is going! Where, indeed, can it go under new ownership?
To understand a business takes in-depth study of its markets. You must know the customers and clients the business serves, and their reasons for buying from this particular business. You must know who the competitors are, and what they offer. You must know how the whole industry works.
To fully understand how a business works, there is a need for long talks with an owner that trusts you. Yes, if the seller of a business does not trust a buyer, the information given to that buyer will never be good enough.
Buyers, don’t bother to buy from people who don’t trust you. Sellers, don’t bother to sell to buyers you don’t like. If the chemistry is not right between a buyer and a seller, it takes an earthquake to get a good negotiation going!
Finally, AFTER you have figured out how the business works, how the markets work, how the industry works and determined whether or not you can get along with the owner, then—and only then—is it time to get busy with the numbers crunching!
Strategy: You’re in Control!
If you need to value a business—yours or someone else’s—there is a process.
It starts with YOU taking control. You need to read at least a few “how to” articles about small business valuation. You need to research the business. You need to study the industry and its markets.
If you are buying a business, all of this starts with a long talk with the owner of the business. Remember though, that if you don’t like the business owner—or the business owner obviously doesn’t like you—then move on to seek another opportunity.
Life is too short—and the odds are too long—to waste your time trying to do the very intimate work of buying or selling with someone on the other side of the table that you don’t like.
In part 5 of this series, I will tell you what NEGOTIATION STRATEGY you must adopt to get your best deal and keep you legally safe.
I would also point my readers, again, to Richard Parker’s BizQuest blog at http://blog.bizquest.com/2009/04/buying-a-business-tips-and-updates.html. He provides many nice tips on buying and selling and I’m happy to link with him.
Two sources of easy-to-find pricing data are BizComps and the annual Business Reference Guide:
BizComps Business Sales Statistics
BizComps is a market data study based upon thousands of small business sales transactions in the U.S., updated annually, but containing data for the last ten years. The study is available on disk or in printed report format. There is also a free BizComps user guide. Data can be ordered from www.BizComps.com or www.BVMarketData.com.
2009 Business Reference Guide
This annual guide, now in its 19th year, is the essential guide to pricing businesses with updated “rules of thumb” for over 500 types of businesses.
Pricing data contains rules of thumb, tips from industry experts, benchmark comparison data, financing facts and industry resources.
Order from http://www.businessbrokeragepress.com/
