Establishing the Value of a Business is not a Science

One of the more contentious issues in helping business owners sell their business is determining a probable sales price. It can be like brining up religion and politics at a gathering of people you don’t know. Sometimes it’s even worse if it’s with people you do know. Everyone seems to have an opinion, and often is can be off base.

Entire books have been written about business valuations, and so many variables are involved (and many of them are subjective) that different “experts” looking at the same company could formulate different recommendations.

Motivated by wishful thinking and unrealistic promise, owners, advisors and even brokers unfortunately often set inflated prices and terms that discourage qualified buyers from seriously considering purchasing the business.

Since the value ultimately will depend on both the buyer and the seller agreeing on a price, one of the most effective methods is known as “cash flow”. A business’ cash flow is determined by allowing the seller to paint a picture of their business’ true profitability.

By recasting the seller’s financials, a business that is paying taxes on a net profit of only $20,000 may actually have a cash flow of $200,000. By “adding back” to the seller’s net profit traditional expenses such as the owner’s salary, interest and depreciation, plus nonoperational expenses (i.e. personal auto lease, medical experience, membership, etc.) a seller will get a much clearer picture of the business’ real profitability. As part of this process, the seller will need to get their financial statements in order to make sure they have supporting documentation for these “add backs.”

Prospective buyers will typically want to see a minimum of two years of tax returns and income statements. Sellers should have their accountants review these documents to ensure accuracy and they will need to be ready to answer questions about gross sales, profits, expenses, etc.

Buyers are typically comfortable with the case flow method because at the end of the day, although they are buying a company, what they are really buying is its cash flow.

With an understanding of a business’ actual cash flow, different multipliers can be applied to determine a fair market range of value for the business. Once this range has been established, the owner can choose to price it at the high end, the low end, or in the middle of the range, depending on their motivations.

Establishing the asking price is only the beginning. Other important financial components include the down payment amount and the annual debt service when there is a promissory note involved. These amounts sometimes can be more important than the actual sales price.

This is just one area where a reputable business broker can assist an owner is creating a total sales package which will be attractive to qualified and motivated buyers.

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