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Best Buy

When purchasing a business, how do you determine a fair price?

Q. What is a good rule of thumb in determining the purchase price for a business? I have heard that a good formula uses the amount of profit times a multiple of 3. Is that true?

Lea Gionette

Via the Internet

Q. I have explored several small businesses in rural locations for possible purchase, but I keep coming back to the same two issues: First, I start by determining the cash flow (taking into account the cost of goods sold, depreciation, expenses, salaries, etc.). Then I divide the cash flow amount by a realistic capitalization rate. Why would the resulting amount be increased to account for assets when assets were already incorporated in determining the level of cash flow? Second, how can I reach an agreement with a business owner on the value range of the business if the owner is reluctant to use the services of an experienced business appraiser or business broker?

Dennis Pabich

Via the Internet

A. David M. Bishop is an attorney-CPA and a business appraiser with the Bishop Law Firm in Charlotte, North Carolina. He advises business owners on business transfer strategies and has valued or sold more than 100 businesses:

The overwhelming majority of small-business sales are asset sales using earnings-based valuation methods, and business brokers ordinarily assume an earnings-based valuation when quoting a selling price. That's because for most profitable businesses, the greaBODY value is in the earnings, not the individual assets (e.g., inventory, equipment). However, a company's individual assets are sometimes worth more than the company's annual earnings, in which case the price determinant would quite simply be the value of the individual assets. But think long and hard before purchasing a business based strictly on the individual asset value because the goal should be to buy an established business with proven cash flow.

The question on buying a rural business indicates you have made use of an earnings-based valuation methods; however, this method may be more appropriate for a medium-to-large-sized company than for the smaller situation you describe. In valuing the assets of a small business (revenues of $2 million or less), the Owner's Discretionary Cash method is the one I would recommend because it eliminates arguments over what amount represents reasonable compensation for the owner and what amount represents true income.

Owner's Discretionary Cash is an amount equal to the sum of pretax net income, owner's compensation, interest expense, depreciation, owner's perks, extraordinary losses and discretionary expenses less extraordinary gains and income. Among the other types of earnings bases are net income, gross cash flow, net cash flow and earnings before interest, taxes, depreciation and amortization (EBITDA). Both the Owner's Discretionary Cash method and the EBITDA method indicate values for the "operating" assets (all assets less cash, accounts receivable and nonoperating assets). Your reluctance to increase the resulting value by the value of individual assets is well-justified, unless the assets are nonoperating, such as marketable securities not used in the business.

While an appropriate market multiple for the EBITDA method is currently 5, a common mistake is to mismatch an earnings base such as EBITDA with the average market multiple for the Owner's Discretionary Cash method, which is 21|2 to 3. Begin by properly matching the earnings base to the market multiple.

Before blindly applying a multiple to the earnings base, however, consider other factors that justify a higher or lower multiple. For example, if a business depends on a handful of customers, a key employee, or a contract that could be terminated, the company may be riskier than the average business and therefore a lower multiple should be used. Also consider whether the business is so connected with the owner that it can't be transferred. In that case, the multiple should be very low to reflect the risks associated with transfer. Are you buying stock (and thereby assuming all the liabilities of the business)? Again, making the appropriate adjustments in the valuation process is critical.

Remember: The danger with rules of thumb is that people forget they're merely guidelines. The rule of thumb may not be appropriate if there is more than one owner, the business owns real estate or has erratic earnings. A word to the wise: Before buying any business, insist that you be given enough information to review with your business appraiser. Do-it-yourself valuations can be costly.

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This article was originally published in the August 1997 print edition of Entrepreneur with the headline: Best Buy.

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