Rough guide for what to pay when buying a business?

Question

Is there a rough guide for how much to pay when buying an existing business? Say, three times annual net income?

Answer 1

When you buy an existing business you have to make assumptions about the income.  In most cases everyone assumes that the total sales and income will continue at the same rate.  If you are buying you want to look for trends.  For example, if the sales and profits have been declining assume they will continue to decline and factor that into your decision to buy and the price you are willing to pay.

Another factor to look at in determining how much to pay is the return on investment.  After all if you can't get more profit than you would get if you purchased CDs there is no sense in buying the busineoss.

I haven't seriously considered buying a going concern for several years.  When I did I found that most of the owners were willing to sell for an amount equal to 1 years profit plus the value of the inventory.  As far as I am concerned I would not be willing to pay more than that for a going concern.  But, then things may be different today and things may be different where you are located.  (One way to tell is check out business broker web sites to get a feel for pricing vs. profits.)

You may find the following useful in determining/verifying the profits of a business you are considering.

The way you would determine the profit is as follows. It is a two step process. Step 1 is to calculate the Cost of Goods Sold. Step 2 is to determine your profit/loss.

Step 1: Cost of Goods Sold is equal to the sum of the cost of the beginning inventory plus purchases minus the cost of the ending inventory. When calculating the cost of inventory inbound shipping and handling are considered part of the cost.

Inventory valuation can be based on FIFO, LIFO, average cost or actual cost. (Look up the alternatives on Wikipedia if you don't know what I am talking about.)

Step 2:

Profit/Loss is equal to the sum of your income minus the sum of the Cost of Goods Sold plus your expenses (including out- bound shipping and handling charges).

Hope this hellps

Jerry-the-bookkeeper

Answer 2

There are a number of ways to value a business:

The most common method used by business brokers is OCF.  Owners Cash Flow. This is the amount of money that the owner of the Small business enjoys from the business.  This is the most telling way to understand the amount of money that the business generates.  The Broker then uses a formula  and compares the business to other ones in the general market to help find value.

OCF equals:

1. Net profit.  If there is a net profit shown on the tax return.  Many small business do not show a large net profit.  Yet they have been in business for many years.  (You ask yourself:  How do they do that?)

Simple.  For tax reasons.  The less profit you show, the less taxes you pay.  So how does the owner make a living? The answer is how does he take the money out!

2. Officers Salary:  This is the amount of money that he reports to the IRS as personal income. This may include the salary that is being paid to the spouse who is also an officer of the comany.  In many cases the children are also being paid by the business.  These amounts also count as OCF.

3.  Interest that the business earns on money that has been deposited in the bank is part of OCF.

4.  Depreciation of Capital Equipment and Capital investments are also a part of OCF. Depreciation lowers the taxable income of buisness.

5.  Owners Benefits.  Such as health & life insurance being paid for by the buisness.  

6.  Vehicles & related expenses.  As the owner of the business, he may have a company vehicle.  So may the spouse and even the children.  Company vehicles expenses are paid for by the company. Thus making it a part of the OCF.

7.  There are other ways that a owner of a business may hide income.  Checks may be cut to pay for lease of equipment that the owner owns personally.  This creats cash flow to owner threw that business.  Being the owner of the company and the owner of the equipment means that he can lease the equipment to who ever he wants and can charge the compoany what he wants.  All very legal. However he must claim the lease income on his personal income taxes.(it is a much lower rate then what is being paid by the business)

8.  There is personal travel that is written off through the business that is called business trips.  The trip to Vegas where the trade association is meeting or the trip to Aspen for that "Work Shop" is being held are excellent examples of how this is done.

9.  Also there is the old trick of cutting checks to the owners or whomever and calling the check a "Reimbursement" for services rendered and accounting for as an expense. (Personal Credit Cards)

10.  CASH is always under reported.  Most cash sales are not reported depending on the kind of business it is.  A cash heavy business never ever reports all it cash.  In very general terms, most cash heavy business only reprot from 1/3 to 1/2 of their cash income.

11.  There a bunch of other factors that come into play when valuating a business.

Good Business Brokers have been trained, educated and have expertise to help them valuate business.  A common mistake is to look at Net Profits.  I do know how many times I had to teach a potenial buyers about OCF.  Profit does not equal value!!!!!!  

The amount of money that the owner takes out of the business is what is important.

Now another way to valuate a business is to take OCF + FFE + Inventory + Lease Hold improvements or real estate if the real estate is apart of the deal = value.

Of course you need to look at ROI Retrun on investment.  How much money can you make on investing your money in this business vs placing it into another vehicle.  ROI should be about 3 to 1 in general terms.

There are many ways to valuate a business.  These are some of the most common ways.  

Please let me know if you have further questions or what to talk further.