How To Establish A Business Valuation

By Author: Jamie Hanson
Total Articles: 3495
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Rather than starting a new business from scratch, many people choose to buy an existing business. With an existing business, you immediately have a customer base, cash flow, and established business processes. It can also be easier to obtain financing for buying an existing business.

When evaluating a business that you are considering buying, there are many factors to consider, including financials, legal considerations, staffing, customer base, reputation, and competition. Your business evaluation team should include your accountant, your attorney, and experts in the type of business you are considering.

Once you've completed your "due diligence," you will need to arrive at a fair valuation, or price for the business.

The seller will certainly have a price in mind for the business, but you'll need your own evaluation to determine if the price is reasonable, or if you should propose a lower price. Unfortunately, establishing the value of a business is not an exact process. In fact, there are several different approaches that may be used.

MULTIPLIER

The multiplier method is probably the most ...
... common method used to establish a general ballpark figure. In this method, the annual gross sales of the business are multiplied by a figure based on the type of business; often inventory value is added to the value after the multiplier is applied.

The multiplier figure is a customary, or "industry average" figure that varies from industry to industry. Multipliers may vary from about 1 to 3 or more.

The actual industry multiplier can be found in various financial publications, as well as analyzing sales of comparable businesses

Some valuation formulas start with pretax profits, rather than gross sales, and apply a multiplier ranging from .25 to 2 or more.

BOOK VALUE

Another very simple valuation method, book value is simple the difference between the business assets and liabilities. While this method may work well for some types of businesses, such as retailers or premise-based businesses, it may be very inaccurate for a consulting or service type business, where much of the business value is in the staff and business relationships.

RETURN ON INVESTMENT

A very common and effective way to establish a business value is based on expected return on investment, or ROI. Return on Investment is simply profit, after taxes and debt service, over the purchase price of the business.

A typical small business should yield an ROI of 15% to 30%. However, the expected ROI will vary based on economic conditions, and the interest rate on secured instruments and other forms of investment.

Note that depreciation of capital assets should not be included in ROI calculations; depreciation is usually considered a set-aside to allow for equipment replacement.

INTANGIBLE VALUATION

Small business sellers often attempt to assign a cash value to factors such as customer good will or business reputation. While these intangibles certainly have value, that value should already be reflected in more quantifiable business metrics such as sales.

Therefore, cash value should not be added for a factor such as good will, because it is already accounted for by the gross revenues and profits of the business.

There are other intangibles, however, that may have a bearing on business value. Patents, for example, may have actual market value (though it may be difficult to determine), and may legitimately be included in book value computations.

REAL WORLD VALUE

Each of the valuation methods above has advantages and disadvantages. It's wise to compute a value using each method, and see how they compare.

Sometimes, in the process of negotiation, a buyer may become attached to the idea of buying the business, and be persuaded to pay more than the business is really worth. It's therefore important for the buyer to use the results of formal valuation methods to establish a maximum price before starting negotiations.

The final "real world" price for a business is the price that a buyer and seller agree on.

The buyer and seller may also negotiate other aspects of the transaction that will have an impact on the final price. For example, the buyer may be willing to pay a bit more if the seller provides financing, or agrees to provide consulting services during a transition period as the buyer takes control of the business.

Ultimately, price is just one factor in determining whether or not the purchase of a business is a good investment.

For help buying a business or selling a business, contact Hub Synergies Inc, your Bay Area business brokers.