by Glen Cooper, CBI, CBA, BVAL
There is a simplified method for appraising most businesses. And we are covering it in a five-part series of daily blogs and podcasts. This is part 4.
In part 1, we discussed the need for business appraisals. We noted that they can cost as much as $35,000 for just a normal business! We said that there is a better way for business owners to get the answers they need.
In part 2, we discussed how we arrived at a multiple of 3 to apply to seller’s discretionary earnings (SDE) for a business asking price. What the historical sales show is that small businesses tend to sell for between 1.5 and 3.5 times historical SDE, not including inventory and/or real estate.
The data is messy, however, so a multiple of 3x SDE is often used in business pricing. This multiple, which might be a little high for some businesses, is a good starting point for an asking price for a small business most of the time, perhaps especially now when stock and real estate investments are suffering by comparison.
In part 3, we discussed the adjustments that need to be made when calculating SDE. The expenses of the business need to be adjusted back to one owner/operator to make the business sales data we can find reasonably comparative to each other. That has already been done for us in BizComps®. But, we still have to do it for the subject business that we are trying to value.
In part 3, we also discussed that the tangible and intangible assets needed to run the business are included in the multiple-derived value, EXCEPT real estate, inventory for resale, accounts receivable AND, usually, the owner’s personal vehicle. Inventory for resale is valued at the lesser of cost or wholesale, and is added to any multiple-derived value. Accounts receivable are usually collected by the previous owner after the sale and during the transition period between owners, so they are NOT usually sold with the business.
The large item we haven’t yet discussed is the real estate occupied by the business.
Real estate is not included in the multiple-derived value of a business; so, if real estate is going to be part of the valuation, we need to add it to the business value that we calculate. But, if we do that, the expenses of the business must be adjusted to reflect payment of a reasonable “fair market rent” of whatever real estate is needed by the business.
It is not unusual to see an analysis that omits this step.
Business owners who own the real estate that their business occupies often fail to charge themselves rent. This creates the perception that the business is more profitable than it otherwise would be. Rental expense that is either too low or too high, for a business that occupies real estate, creates a distorted SDE.
To separate the real estate and business values is necessary, because real estate is usually a separate investment calculation. Commercial real estate derives its value from “Net Operating Income” (NOI). Annual NOI is scheduled rental income less vacancy and credit losses, less building operating expenses not paid by the tenant. NOI is capitalized to calculate the value of the real estate as a stand-alone investment.
What’s “fair market rent?” Well, fair market rent is what a willing tenant would otherwise pay for the space as rent. Or, in some cases, it might also be the rent that such a business that uses that type of space can afford, usually as a percentage of its annual gross sales. Industry associations often have such data.
For example, let’s say we have a modern, well-equipped and well-located pizzeria we own. And, we also own the free-standing building it occupies. Let’s say we have a 2,000 sq. ft. building right next to the area’s major shopping center with 50 seats doing $1,000,000 annual sales. So, what are the business and the building worth as a combined sale?
Such a pizzeria can afford about 6% of gross sales as rent, according to pizza industry data. If that is true at the time we’re valuing this pizzeria, then the pizzeria can afford $60,000 in annual rent. If we assume that the pizzeria expenses already include building taxes, insurance and maintenance (as they usually do when the owner of both building and business is the same), then that net rent of $60,000 is close to NOI for the building.
In our area, such a building would be worth about 10 times NOI, or $600,000.
If, after paying $60,000 in annual rent, our pizzeria still made $150,000 SDE for its owner/operator, the business should probably be priced at $450,000, with the building at $600,000, for a total of $1,050,000.
Would it sell for that? Well, it might, but negotiation would probably take it down to $300,000 for the business and $500,000 for the building in our market in 2009.
Inventory for resale in a pizzeria is minimal. Most pizzerias are supplied daily in most urban areas, keeping only a small inventory on hand, the value of which is mostly in alcoholic beverages if the pizzeria has such licenses.
If the owner were NOT paying any rent to himself, the P&L for the business might show an SDE of $210,000 and we would be greatly distorting the value of the business if we used a multiple of 3.
Now, we used industry operating expense ratios to determine fair rent. We should also check with local commercial real estate sources (appraisers, brokers, local government business development agencies) about fair market rent for similar properties.
$60,000 annual rent for 2,000 sq. ft. of retail is $30/sq. ft. /year. That’s about right in our market today for such a building.
In part 5 of this blog, we’ll summarize and tell you where you can get help with this process.
