How to value a small business for purchase?

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DoingHomework
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Re: How to value a small business for purchase?

Postby DoingHomework » Tue Nov 16, 2010 6:34 am

Spammy but raises a legitimate question.

I'd pay between $800k and $1M. Book value is meaningless for a small business. Value should be based on cash flow and sales.

kombat
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Re: How to value a small business for purchase?

Postby kombat » Tue Nov 16, 2010 7:16 am

I'm not an entrepreneur, but I've heard that a good rule of thumb is that a business is worth 2 years of net income, plus the value of assets, minus outstanding debts.

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Re: How to value a small business for purchase?

Postby MossySF » Tue Nov 16, 2010 8:29 am

The rules of thumbs are a good starting point. There's one more factor that becomes a multiplier and that's owner involvement.

If you absolutely have to be there everyday or the business goes under, 2 x annual profit - debt. A good example would be a small coffee shop where you have to be behind the counter at all times.

If the business is completely hands off with a team of competent managers and employees doing all the work, 10 x annual profit - debt.

There's a wide range in between requiring some owner oversight -- and you'd pick a multiplier in between.

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Re: How to value a small business for purchase?

Postby DoingHomework » Tue Nov 16, 2010 11:17 am

kombat wrote:I'm not an entrepreneur, but I've heard that a good rule of thumb is that a business is worth 2 years of net income, plus the value of assets, minus outstanding debts.


Twice sales is not too bad for a solid business. Companies like Proctor and Gamble sell for about that multiple. There you are paying a lot for the brand equity. For a small business I would completely ignore brand equity and focus only on sales or cash flow. But as Mossy said, there can be a lot of factors.

The reason book value is meaningless is because it can be very deceptive. Let's say the business is a candy maker. They might have a bunch of old machines that are fully depreciated but function extremely well and are in excellent condition. Book value would be zero. Now, let's say the candy maker was formed last year and has all new machines. Book value would be very high. But, except for maintenance and the need for replacement neither situation is inherently good or bad and neither would necessarily affect the price of the business. Maybe the old candy machines are well built and extremely reliable or maybe they are in serious need of replacement. You don't know that from book value.

Now, I don't have a problem with adjusting the price for assets-liabilities in principle, but again, the real story can be hidden. What if the asset is the real estate where the factory is and the liability is a noncallable, long term mortgage. The impact of the mortgage will be seen in cash flow. The value of the asset is meaningless unless it might be sold.

If I were to consider buying a business like that I would look very closely at the books and not focus on one simple metric.


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