Author Topic: Evaluating the value of a business (for possible purchase)  (Read 4232 times)

jo552006

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Evaluating the value of a business (for possible purchase)
« on: October 06, 2014, 09:44:19 AM »
Recently I found a business that I would actually LOVE working in.  The prospect of loving going to work in the morning was something I never thought I would find.  I asked the owner if he needed help and his response was that he doesn't need help, but that I can buy the whole business.  I have seriously been talking with my wife, and she thinks we should try to buy the business.

Now here's the problem, I estimate that AT BEST, the business assets are maybe worth 150k.  This includes existing contracts, existing stock, everything that has value currently.  The business has lots of potential, and the owner has at least 2 great ideas that I agree COULD earn a lot of money.  The owner has really used the business as more of a "hobby to pay the bills" so the returns have been MUCH lower than they could have been over the last few years (aka. historically, this business has only made ~50-70k profit per year, because that's all the owner needed the business to make...he's 61 years old).  The owner wants 425k for the business because of the the potential it has, and the couple of ideas he has.  This would include training for new owners for 6+ months, and the use of his shop until the business could be moved.

I am wondering if anybody has any experience in evaluating the real worth of a company.  Links are always helpful.  My wife and I are serious enough to consider giving him a retainer, but I don't believe the business is worth anywhere near what he wants, and am keen to walk away if I can show him math and he remains firm on numbers.  Is this the type of thing where you higher somebody to do the evaluation for you?

All we want is a business that will sustain itself and employ myself, and eventually my wife and possibly a couple of family members.  So how about it, are the "potenial, instruction, and ideas" worth a premium, or is the business only nominally worth more than the value of all current assets?

retired?

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Re: Evaluating the value of a business (for possible purchase)
« Reply #1 on: October 06, 2014, 09:54:34 AM »
I've never done this, but I can think of a company I might have bought from the owner (older and also really worked as much as he felt like) when I was an employee.

This was services firm (consulting), so no stock and no real long-term contracts.  The value was the relationships and the firm's reputation.  That said, I would have valued it based on the CF stream it had generated.  Don't count your own pay since you want to value as a business and that is a cost (in case you had a manager run it). 

Put some probabilities on the success of each of the ideas and how much additional they would generate.  Use a high discount rate to reflect the risk (am thinking NPV of cash flows).  Anticipate extra costs to implement the ideas, etc.  Include a scenario where the firm or its services become obsolete...if that is a possibility.

Not much to go on, but thought I'd throw out that perspective.  Seems worth more than $150 if regularly generating net income of at least $50k.  Would you pay $150k for a stream of annual $50k?

AlexK

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Re: Evaluating the value of a business (for possible purchase)
« Reply #2 on: October 06, 2014, 09:58:43 AM »
I would place no value on the potential for the business to grow. You are paying for what the business is, not what the owner could have done with it. It sounds like you could start your own competing business for much less than what the owner is asking.

retired?

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Re: Evaluating the value of a business (for possible purchase)
« Reply #3 on: October 06, 2014, 10:00:04 AM »
to be clear, if the 50-70 is what he pays himself, don't call it profit.  A theme in some of the blog posts of MMM is to be sure to include the value of your work (one was re investing in real estate and valuing as tho 100% financed).

in my case, the firm generated about 500k in revenues, the owner paid himself 75k.  As a twist to evaluating, he always paid out bonuses and bought equipment at the end of the year AND contributed to the ESOP so net income was zero....thus taxes zero.  Makes it harder to value, but..........

The pure business value is what it would return to you if you had to do nothing, i.e. hired others to run it.  If nothing, then it is worth nothing.

retired?

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Re: Evaluating the value of a business (for possible purchase)
« Reply #4 on: October 06, 2014, 10:03:51 AM »
I would place no value on the potential for the business to grow. You are paying for what the business is, not what the owner could have done with it. It sounds like you could start your own competing business for much less than what the owner is asking.

a childhood friend had the saying "if If's and But's were chicken and nuts, we'd all have a Merry Christmas". 

Is this a services business or goods?

pksr

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Re: Evaluating the value of a business (for possible purchase)
« Reply #5 on: October 06, 2014, 10:37:44 AM »
Ditto AlexK's sentiment - you pay for what he's done, you get to keep what you're going to do with the business.

One excellent reference book I have is "The Entrepreneur's Guide to Finance & Business" by Steven Rogers. It's a great, very practical book. It does seem to be out of print with an exorbitant price ebook pricetag on Amazon, but if you can find a copy, it would have very appropriate advice.

Selling the business makes total sense for him (otherwise it's going to wither as he retires), and buying it makes total sense for you (since it'll jump start your entry into this industry, versus trying to start from scratch).

The problem is in valuation, and I'd recommend exploring two angles that could bridge the gap. First, try to get 100% seller financing. He probably wants a check so he can head to the fishing hole with no worries, but seller financing would keep him strongly interested in the business performance and keep you from tapping assets for the purchase.

Second, there should be some concept of an earn out. In this situation, a low (very low, given the circumstances and his limited options) initial price that could then increase based on sales targets (or, if he's naive, profit targets) being met in future years would make him want to see his great ideas through - he'd have a lot of skin in the game and may stay on as a strategic advisor of sorts. That may be a pain for you to manage if he can't let go, but I'm just introducing it as a concept. If he's the kind of guy who might want to stay in the game (for free, more or less), it could be worth the trouble.

But if he's firmly anchored anywhere near $425K, I think you should use your discussions with him to find out as much as you can about the business and then start a competing enterprise. No calculation by an expert is going to knock him off of what he thinks his "baby" is worth.

Can you give a general indication of the industry and customer base? If it's a good (non commodity) industry with a lot of recurring revenue, buying from this guy may start to make more sense.

Cheddar Stacker

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Re: Evaluating the value of a business (for possible purchase)
« Reply #6 on: October 06, 2014, 10:56:43 AM »
I've dipped my feet into valuation over the last two years. A few thoughts:

-You should talk with a professional about this. Valuation, Tax, Legal. You could overpay for the business, or expose yourself to unwanted liability or tax if you don't buy it properly.

-Valuation methods: Asset approach, Market approach, Income approach.

Asset - you pay FMV for all the assets. If there aren't many assets, don't use this approach.
Market - look for similar businesses that have sold recently and apply those sales prices to your situation. Typically tough to find a good match.

Income Approach - this is likely the approach you would use since you have contracts/future earning potential. For this approach you project future EBITDA/cash flow and calculate the risk in earning that cash flow. You do this by analyzing past performance as well as non-financial factors such as market share, ease of entrance into the industry, existing competition, projected growth, etc. If you project the business will generate $75K in cash flow to the owner and the industry calls for a multiple of 5x EBITDA, fair value would be $375K. This means it would take you 5 years to recover your initial investment. If that's too long or risky for you, use a lower multiple, but the seller will obviously want a higher multiple.

That's a very high level description and if there are other valuations specialists out there I'm sure they could pick it apart. There is much more to it. I wouldn't consider spending $200K on a business without first spending $5-10K on a proper valuation and some legal/tax advice.

The problem is in valuation, and I'd recommend exploring two angles that could bridge the gap. First, try to get 100% seller financing. He probably wants a check so he can head to the fishing hole with no worries, but seller financing would keep him strongly interested in the business performance and keep you from tapping assets for the purchase.

Second, there should be some concept of an earn out. In this situation, a low (very low, given the circumstances and his limited options) initial price that could then increase based on sales targets (or, if he's naive, profit targets) being met in future years would make him want to see his great ideas through - he'd have a lot of skin in the game and may stay on as a strategic advisor of sorts. That may be a pain for you to manage if he can't let go, but I'm just introducing it as a concept. If he's the kind of guy who might want to stay in the game (for free, more or less), it could be worth the trouble.

^ This is very good advice, consider it. A seller financed buyout also allows to the seller to realize the tax gains slowly.

lakemom

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Re: Evaluating the value of a business (for possible purchase)
« Reply #7 on: October 06, 2014, 11:04:13 AM »
A quick rule of thumb is 2.5X earnings plus value of hard assets. 

Have you discussed the possibility of him holding a note for the business.  With a decent down someone who truly believed in the value of the business going forward (and your ability to maintain and grow it) should have no problems holding the note for at least 5 years.

Papa bear

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Re: Evaluating the value of a business (for possible purchase)
« Reply #8 on: October 06, 2014, 11:16:44 AM »
Absolutely talk with an accountant or lawyer.  There are many ways to value a business and there are a lot of things you need to look into from a legal standpoint.  Do your due diligence on the business.  You may be purchasing all of his obligations, debt, liens, etc.


Trede

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Re: Evaluating the value of a business (for possible purchase)
« Reply #9 on: October 06, 2014, 12:00:11 PM »
Lots of people on the right track here, although it's hard for me to offer specific advice without knowing the type of business we're talking about.

- Agree with the valuation rule that your goal is to pay for what is, not what could be.  Of course the seller's goal is to get you to give him part of the value of what could be.  I am assuming that his ideas for the future don't involve anything patentable and thus worth consideration from a valuation perspective.
- In buying companies or assets of companies (there are reasons to do one over another... as a buyer I always want an asset deal and leave any liabilities in the shell company I don't take, but sellers often have reasons to want to sell the company and not just its stuff), I have financial advisors who can audit the company's books.  A multiple of EBITDA gets to a good rule of thumb valuation, but the multiple does depend on the industry, and you'll want to look at multiple years so the valuation is not based on a particularly good or bad year.  A better assessment is discounted cash flows if the company has a backlog of business and a means of projecting future contracts.  Mostly I like to use multiple valuation methods.  The more they agree, the more you feel like you are setting a fair price.  The less they agree, you gain insight into the risk of the business.
- Although I am assuming we're talking about a small, privately held business, the basic concepts of acquisition are really the same.  Looking up at my bookshelf, I see "Mergers & Acquisitions for Dummies."  Yes, really.  Not all of it is relevant to a small, privately held business deal, but even from a subject matter perspective it's worth a look, including "What's a company worth?" (Chapter 12 in my edition). 

jo552006

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Re: Evaluating the value of a business (for possible purchase)
« Reply #10 on: October 07, 2014, 08:22:19 AM »
The business is a laser engraving/etching business.  There are 2 machines valued at 100k new, but today are realistically worth somewhere in the 50k range (maybe more, maybe less).  There is some existing inventory, blanks as well as completed works that have value.  There is also art work.  The art work is worth more than the rest of the business assets.  There is also time involved converting the artwork to an output the laser will read, which has already been done and has a tangible value.  Over all I would expect that a rigorous evalutaion of existing assets would come in approximately the 150k range.  I DO believe this gentleman that there is a HUGE amount of potential.  I have many ideas myself, and he had ones as well.  There is a value to him training me as the new owner, using his shop until I can set up my own, and being able to purchase 1 day and start producing a product the next day. (Selling the product...much harder).  I would DEFINITELY need to get a business evaluation by a professional, but I am confident it would come in FAR under what he is asking for the business unless I am missing something.  Lets say best case a business evaluation come in at 1/2 what he's asking if he is firm near 425k, there's no need to go any further, and I'd rather save myself the cost of the evaluation if he's not willing to come down.

Cheddar Stacker

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Re: Evaluating the value of a business (for possible purchase)
« Reply #11 on: October 07, 2014, 08:29:39 AM »
The business is a laser engraving/etching business.  There are 2 machines valued at 100k new, but today are realistically worth somewhere in the 50k range (maybe more, maybe less).  There is some existing inventory, blanks as well as completed works that have value.  There is also art work.  The art work is worth more than the rest of the business assets.  There is also time involved converting the artwork to an output the laser will read, which has already been done and has a tangible value.  Over all I would expect that a rigorous evalutaion of existing assets would come in approximately the 150k range.  I DO believe this gentleman that there is a HUGE amount of potential.  I have many ideas myself, and he had ones as well.  There is a value to him training me as the new owner, using his shop until I can set up my own, and being able to purchase 1 day and start producing a product the next day. (Selling the product...much harder).  I would DEFINITELY need to get a business evaluation by a professional, but I am confident it would come in FAR under what he is asking for the business unless I am missing something.  Lets say best case a business evaluation come in at 1/2 what he's asking if he is firm near 425k, there's no need to go any further, and I'd rather save myself the cost of the evaluation if he's not willing to come down.

Yep, you need to have this conversation with him if you haven't already. Don't pay thousands if there's no chance he'll sell for what you're willing to buy for. You two should establish a rough range of your preliminary estimates. If you're worlds apart, a valuation likely wouldn't change either of your minds.

If you purchase based on FMV of assets (the asset approach) you don't actually pay FMV. There would be a large discount (20-40%) for lack of marketability. This is a privately held business with a limited pool of potential buyers. So $150k*80%=$120K.  Good luck.

pksr

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Re: Evaluating the value of a business (for possible purchase)
« Reply #12 on: October 07, 2014, 10:45:10 AM »
The business is a laser engraving/etching business.  There are 2 machines valued at 100k new, but today are realistically worth somewhere in the 50k range (maybe more, maybe less).  There is some existing inventory, blanks as well as completed works that have value.  There is also art work.  The art work is worth more than the rest of the business assets.  There is also time involved converting the artwork to an output the laser will read, which has already been done and has a tangible value.  Over all I would expect that a rigorous evalutaion of existing assets would come in approximately the 150k range.  I DO believe this gentleman that there is a HUGE amount of potential.  I have many ideas myself, and he had ones as well.  There is a value to him training me as the new owner, using his shop until I can set up my own, and being able to purchase 1 day and start producing a product the next day. (Selling the product...much harder).  I would DEFINITELY need to get a business evaluation by a professional, but I am confident it would come in FAR under what he is asking for the business unless I am missing something.  Lets say best case a business evaluation come in at 1/2 what he's asking if he is firm near 425k, there's no need to go any further, and I'd rather save myself the cost of the evaluation if he's not willing to come down.

It feels like you're down a very detailed path in some regards, but a lot of it is anchored around this guy's specific operations / assets.

Since you are planning some significant changes / expansions and will, by necessity, be changing quite a bit from what was done before, I think you need to develop a comprehensive business plan (if you haven't already).

This is a good reference for what you should have within in: http://www.sba.gov/writing-business-plan

I'd focus particularly on the Market Analysis - laser engraving, to this layperson, seems like an area that could be at severe risk for disruption - either through technological advancements or vicious competition as local players become global ones. Plus, any product / service that seems a little commodity-like and involves big upfront investment in assets is scary.

A business plan doesn't need to be 100 pages, but it does need to cover all of the key sections. The business plan should also flesh out how critical acquiring this guy's operation and knowledge is going to be to your business. And that's the point - I can't believe this guy has some super secret/proprietary knowledge, so you should design a business plan to do laser engraving, and doing a deal with this guy would be ONE way of executing that plan.

lemanfan

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Re: Evaluating the value of a business (for possible purchase)
« Reply #13 on: October 07, 2014, 02:08:06 PM »
A lot of good things said above.  If you have an hour to spare, this podcast might be of use:
http://eventualmillionaire.com/ace-chapman/