How Much to Pay For a Business

The methodology outlined below is a simplified approach and as purchasing a business is a very significant step and every individual’s circumstances are different, I strongly recommend that you speak with a professional advisor familiar with your personal situation and needs before entering into any binding contract.

VALUING A BUSINESS: CRITICAL POINTS

  1. There is no right or wrong amount – There is only what you are prepared to pay and what the seller is prepared to accept – nothing else is relevant.
  2. How much to pay is based on what CASH you can realistically expect to generate from the business in future years – (There are many valuation methods available from complicated mathematical formulas to a simple percentage of sales. These methods make a good cross-check to the method suggested below).

HOW MUCH TO PAY – THE METHODOLOGY

STEP 1: NORMALISED PROFIT

Calculate a “normalised” annual cash profit (before tax) the business is likely to earn next year based on its past history. This is usually done by beginning with Last Year’s annual profit and making adjustments for items

  • incurred last year but won’t be incurred next year
  • to be incurred next year but weren’t incurred last year
  • Non-cash items

Examples of items you could adjust for

INCREASE PROFIT BY

  • Any wages or benefits paid to the business owner (or people related to the business owner) who will not be continuing when you own the business. This is not just wages but superannuation, medical benefits, motor vehicles, non-business (or slightly business) travel etc.
  • Interest Paid and any Other Finance Costs (that you will not be responsible for)
  • Depreciation and any other Non-Cash Items
  • Any Non-recurring expenses that occurred in the prior year (e.g. legal fees on a case which is now resolved)
  • The expected annual profit of any new (major) customers not included in the past year’s sales

DECREASE PROFIT BY

  • The market wage & benefits payable to you and any partner/relation that will work in the business (the amount is what you would be paid if the business was owned by a 3rd party and not necessarily what you will actually be paid)
  • Any expenses that will be incurred in future years, which are not included in last years’ profit (e.g. the business moved premises 3 months ago into a more expensive site – decrease the profit to reflect the new rental for the next 12 months less what was paid last year)
  • Any revenue earned last year that would be considered abnormal or not likely to occur next year (e.g. a large client was lost to a competitor, a “special” job which won’t occur again)
  • If there is likely to be significant capital expenditure (new equipment) over the next 3 to 4 years then an adjustment should be made (usually the cost of the equipment divided by the estimated years it will be used in the business)

At the completion of this stage we will have a value which represents the NORMALISED CASH PROFIT. This is the amount of profit before income tax that the business is expected to earn next year if it continued to run as it has done in the past.

STEP 2: SELECT AN APPROPRIATE MULTIPLE

There have been books written on what multiple to select and why, but here’s a RULE OF THUMB which has served me well through many purchases. There are 2 ranges

  • Smaller Business (Profit less than $100,000) 2 to 3
  • Medium Business (Profit $100,000 to $500,000) 3 to 4

(This methodology is not suitable for larger businesses)

STEP 3: CALCULATE THE VALUATION RANGE

Multiply the NORMALISED PROFIT calculated in Step 1 with the MULTIPLES in Step 2.

E.g. If you had a normalised profit of $150,000, the valuation range would be $450,000 to $600,000

STEP 4: NARROW THE VALUATION RANGE

To narrow the range further compile a list of factors which either improve or detract from the certainty that you will earn the normalised profit amount calculated in Step 1. Each factor that improves the certainty will support paying a higher amount in the range, each factor that detracts from the certainty supports paying a lower amount in the range. Based upon the number and importance of the factors in each category will allow you to tighten the range to either the lower, middle or upper portion of the range calculated above.

Examples of factors include

1. Age of Business

A business that has existed for 20 years is likely to have more certain earnings and be more established in a market than a business that has existed for 2 years

2. Size of Business

Generally the larger the business the more likely the business would survive any negative events

3. Certainty of Revenue Stream

There are many items that might improve or detract from revenue including

  • Does the revenue naturally occur each year (e.g. an accounting firm which would usually see the same clients to do their tax returns each year) V’s carpentry business which receives most of its clients from internet or yellow pages advertising
  • Is the revenue made up of a lot of smaller clients V’s a few larger clients? Whilst larger clients may be more profitable, they have a higher risk to the business should they take their business elsewhere.

4. Working Capital Required

The larger the working capital required (Debtors + Inventory – Creditors), the less you want to pay. Compare 2 identical businesses, the first requires you hold $200,000 worth of inventory, the second has an arrangement with suppliers to ship directly to customers. At the very least, you save interest on $200,000, plus the extra staff required to receive, pack and ship the stock, do stocktakes etc.

5. Economic Factors

What is the outlook for the next 2-3 years – if the economy or industry is likely to worsen then your valuation should be more conservative.

6. Market Position/Competitors

How secure is the business – are there are a lot of competitors in the industry(many competitors drive down profit margins), are there any new competitors and how difficult is it for a new competitor to enter the market, what impact would a new competitor have on the business.

7. Industry

Is the market growing or declining?

E.g. there are 2 businesses earning identical profit, one sells mobile telephone technology, and one sells facsimile machines. The mobile phone business is likely to have the stronger growth in the future and therefore you’re likely to pay more than you would for facsimile machine business which is old technology and declining sales.

These are only a selection of the factors and there may be others which are very relevant, (perhaps specific to your deal) and these should also be taken into account.

FACTORS THAT YOU SHOULD NOT INCLUDE

There are 2 special factors, which you may be tempted to include but shouldn’t

1. How you will improve the Business

Perhaps you have a special skill, contacts, or insight that will generate more profit than what the business is currently earning. Surely that will allow you to pay more for the business – Yes… and No

Yes, it will increase the profit and add to the value of the business…

No, you should not pay more for the business because of it. This is the extra profit that you are generating for the business, why should you pay the current owner for it? – he hasn’t done anything. The value you add to the business, is what you should receive when you SELL the business, do not pay this to the current owner.

2. Future Opportunities for the Business

The owner has explained to you how the business has many wonderful opportunities for additional sales but he hasn’t had the time or money to pursue.

This will increase future profits so you could pay more – WRONG!

  • it hasn’t happened yet and it might not happen for many reasons, even if it does it’s never as easy as the current owner tells you (if it was, he would have found a way, and he wouldn’t be selling the business)
  • if it does happen – you will be the one who makes it happen – why should he receive anything for this

OTHER TIPS

  • Don’t get into a conversation with the seller about how you arrived at the purchase price. This will spiral into you shouldn’t add back this, did you include that, and the multiple should be higher… this is not helpful. You have calculated a price that you will pay and that’s all the seller needs to know. Of course, there is likely to be a negotiation process so leave yourself some room to go up from your first offer).
  • Get an accountant to assist with the due diligence
  • When apportioning the purchase price amongst the assets, in most countries the best tax outcome will be to put the maximum value to assets in the following order
    • Inventory
    • Equipment and other depreciable items
    • Goodwill (as low as possible)
  • For the seller it is usually best in reverse and I have seen deals where the contract is left blank in this area, and each party fills in their own values later – check with your solicitor
  • Deduct any accrued employee entitlements from the purchase price (e.g. annual leave, long service leave)
  • Whilst it always preferable to have the previous owner to stay in the business for a handover period, if you are taking over their role, in practice it is usually best to let them go as soon as you are comfortable with the business

DISCLAIMER: Many of the comments in this publication are general in nature and anyone intending to apply the information to practical circumstances should seek professional advice to independently verify their interpretation and the information’s applicability to their circumstances. The author expressly disclaims all and any liability and responsibility to any person, whether a purchaser or reader of this publication or not, in respect of anything, and of the consequences of anything done by any such person in reliance, whether wholly or partially upon the whole or any part of the contents of this publication.