How Are Businesses Valued?

Business valuation can be a difficult figure to obtain because there are so many variables. Business valuation models (methods) have been developed to make the process easier and more accurate. Some of the methods include :

• Return on Investment (ROI) method
• Market value
• Asset value going concern
• Asset value liquidation
• Net present value

The most appropriate method of valuing the majority of small businesses (up to $1 Million) is through the ROI method. The technique measures the return (i.e. profit before owner’s salary) received from an investment (i.e. purchase price) and is calculated by the following formula:

Price = net annual profit x ROI % (for that industry)

For example: if a business is making $50,000 profit and the accepted ROI for that industry is 30% then the price equals $166,667.

Here are example ROI’s for different industries (information provided by GMO Business Brokers – September 2009):

• Book Stores 20% to 25%
• Boutiques 75% to 80%
• Florists 70% to 100%
• Liquor Stores 22% to 28%
• Lotto Kiosks 22% to 28%
• Newsagencies 25% to 30%
• Restaurants (Fine Dining) 70% to 80%
• Lunch Bars 50% to 75%
• Manufacturing 25% to 38%
• Wholesale 27% to 35%

27 Questions You Should Ask Before Buying A Business

I met the husband and wife owners of a small retail shop recently. The business was running at a $65,000 (approx) annual loss.They had purchased the business over 12 months ago and had been steadily losing money. I looked briefly at their books and realised they had paid too much for the business. On top of that, both of them had no retail business experience and they had decided to cut out all of the advertising that the previous business owner had been running – due to cost reasons only.

I asked them how much research and due diligence had they conducted before buying the business. I was shocked by their response…

“We asked the solicitor who was performing the business settlement service if the business was a good buy.”

Talk about flushing $$$ down the toilet. Needless to say, they no longer have any available capital to invest in marketing or anything else. The outcome will be to close up shop and accept the loss, and the lesson.

So how do you actually avoid this type of business disaster?

Ask yourself these questions…

1. Why am I going into this business?

• For lifestyle (to work fewer than 40 hours per week, with the freedom to go on holidays whenever you choose)
• To make a profit by building the business up (increasing sales)
• To generate more cash-flow than than a 9-to-5 job.

If your reasons are not listed above – don’t buy the business. If you want to be involved in what the business does (manufacturing, retail, services, etc) out of personal interest, it’s much less stress and safer to be an employee.

2. What do I want from being in business?

3. What will be my exit strategy to get out of the business?

• Sell the business for a profit
• Sell the business to a major shareholder(s) and become a silent partner
• Pass the business down to a family member
• Franchise

4. What skills do I have that will make me successful in this business?

Please don’t think that all that is required to ‘improve’ the business is cosmetic – by changing some of the products, re-designing the store interior, etc. These ‘improvements’ won’t double sales.

Only very good marketing, a good sales team and good systems will increase sales significantly. Think MARKETING, SALES, DELIVERY of the product or service (using systems).

5. What skills will I have to “hire in”?

6. What cash flow do I need?

7. How much working capital do I have access to?

8. Will this business suit me i.e. hours, type of operation?

To ask the vendor who is selling the business…

9. How long has the business been operating?

10. How long has the current owner had the business?

11. Why is the current owner selling?

• Worn out from working long hours for little money?
• Couldn’t make the business work (perhaps in it’s current location)?
• Actual legitimate reasons such as retiring, moving to another state or country, or looking for another challenge in another business?

12. What is the Cash flow and Profit (Gross and Net) for the business?

13. What is the business owner paying him/herself?

14. What do the last 3 years of financial accounts show?

15. How has the business been valued?

16. Who are the key customers, suppliers, staff?

17. What are the terms and length of any leases?

18. Will the current owner stay on and assist for a period of time?

Ask them to put this period in WRITING!

19. What areas of the business are systemised?

20. Is there a business plan?

21. How many hours a week does the current owner work in the business?

22. When was the last time the current owner took a holiday?

23. What is the marketing systems like? Do they make money for the business?

Review all advertising material, the customer database, the POS systems (if applicable), any loyalty programs, special promotional material, etc.

24. What facts support the "story" of the business?

25. How secure is future income i.e. contracts with customers and suppliers?

26. How dependent is the business on the current owner?

27. What will it take to grow the business so I can sell it for a profit?

Before you make an offer

1. Get your accountant to check the financial accounts

Obtain actual lodged tax returns with the government, not the business owner’s printout or handwritten bookkeeping summary.

Your accountant will ensure that the business has cashflow and is not over-capalised.

2. Hire a solicitor who is experienced in buying businesses like the one you are looking at.

Your solicitor will ensure that the contracts with suppliers, the landlord, etc don’t have any surprises.

3. If you are spending over $250,000 on the business, or even if you want to be extra careful, pay for a business valuation.

Pay a licenced valuer to come in and audit the business. Even if you have to spend $7,000 for the valuation, it’s still much better than paying $50,000, $100,000 or more than you should have to buy the business.

You may even be able to ‘use’ the valuation to negotiate a better price.

The lesson

Homework always pays off in business. Taking shortcuts and buying a business on emotion often lead to regrets. Don’t let this happen to you.