Last week I told you about a reader who thought that he wanted to sell his business, but pretty quickly realized (after a bit of prodding from me) that he was really selling a product as he had not made any sales as yet.
So, this week, I wanted to cover the basic ‘street smart valuation’ methods for selling (or, part-selling) various types of businesses:
1. Professional Practices
These types of businesses (e.g. accountants, finance/insurance/stock brokers, doctors, attorneys, etc.) generally are the easiest to value as their sale price is usually governed by industry-standard formulas, often based on some multiple of fees rather than profits.
So, an insurance broker may sell for, say 2 x annual fees/commissions.
The easiest way to find out how to value your professional practice is to buddy up to a few of your peers and see what experience they have and to ask your industry association. It is also useful to see if your accountant (or another) has experience with any of their clients who may have bought/sold practices in your specialty.
2. Small businesses
Most other sole practitioner and/or small businesses sell for a multiple of their profit (per their most recent income tax returns); typically the business is bought/sold for a multiple of 3 – 5 times after-tax profits, but the range can vary widely.
Brad Sugars claims that his opening (and usually closing!) bid is zero … but, he may take the over the business’ leases (premises and/or equipment); since most small businesses lose money – barely paying their owners a ‘salary’ – this can be a surprisingly good deal!
Of course, if a large company (preferably one listed on a stock exchange) wants to acquire you – and, you can demonstrate a history of good profits – you may be able to negotiate a larger multiple … perhaps heading in the direction of the multiple that the public company itself is getting on the stock exchange (you can find a company’s P/E ratio on any good finance web-site).
Somewhere around 7 to 10 times after tax profits would be considered outstanding.
3. Venture Capital Ready
Let’s say that you have a small business and feel ready to take it to the next level, but you need some additional cash, effectively by selling them part of your business (i.e. trading some of their cash for a lot of your equity) … after watching Shark Tank you feel that you are ready to negotiate with some venture capitalists. What will they pay for a share of your business?
Well, you really need to know what sort of return they expect on their money:
If a company does have the qualities venture capitalists seek including a solid business plan, a good management team, investment and passion from the founders, a good potential to exit the investment before the end of their funding cycle, and target minimum returns in excess of 40% per year, it will find it easier to raise venture capital.
Think about it; a venture capitalist may invest in 10 businesses and lose their money on 7 of them, break even on 2, and rely on your business to make up for the other 9 duds 😉
If they could make (say) just 4% on their money just by letting it sit in the bank, then surely they’re going to need at least 10 times that return if they give it to you on a 10-to-1 failure:success ratio, aren’t they?
Now, 40% returns means that if they give you $1 million, they will expect to be able to get out in 5 years and walk away with well over $5.25 million!
So, here (in simple terms) is how they will make their offer to you (if you are still in self-delusional mode and think that you will be making the offer to them, watch some more Shark Tank!?):
1. Assess how much investment they will need to make in order to meet the growth needs of your business (this WON’T include giving you a pay-rise or any cash in your pocket … at least, not until THEY cash out first),
2. Decide how long they are prepared to wait to realize their investment (i.e. take their cash out by selling or IPO’ing the company)
3. Calculate the % and $ return they would need (in our example, this is the $5.25+ million that I mentioned above)
4. Assess what sale price the business is likely to get
5. Divide 3. into 4. and this is what minimum % of your company they will expect to get for their investment (in our example, this is $1 mill.)
So, if they think you have a $10 mill. business on your hands, they will want at least 53% of the company for their $1 mill. investment …
… and, I assure you, you will only get the $1 mill. if you are already doing really well 🙂
We are in the midst of obtaining a value on a Dental practice, for purposes of gifting it (for estate tax purposes)….and we actually got a valuation report estimate of 8 grand! Crazy right? Your method seems easy enough, its just whether the IRS will take the argument, AJC Said so lol
Thanks for this post, AJC. Now if only I had a business idea! A bunch of great ideas are already taken: http://www.webhostingsearch.com/blog/10-stupid-online-business-ideas-0360
@ Evan – … And, So It Was Written [by AJC] 😛
You’ll need a more authoritative estimate than that! But, for estate planning purposes are you looking for a higher or lower valuation 😉
@ Ill Liquidity – Somewhere in the dusty archives of this blog is a post listing the 10 dumbest sites to make $1m (Incl. the infamous Million Dollar Homepage and something to do with little red noses for your car’s radio antenna) … given the obviously low bar for million dollar ideas, surely a multimillion dollar one should be a snap for you?! 🙂
One of my in-laws recently tried to buy a retail store. The owner insisted on getting the book value of the company (assets less liabilities) plus a premium – around $500k or so. Problem was that most of the “value” in the book value was in improvements the guy made to the store – which are near worthless if you want to redo the store – and a bunch of really old accounts receivable (stuff he should have written off). Most importantly, the guy was only pulling an intermittent cash flow from the place after all expenses, non-owner salaries etc of $10-20k per year. Using your formula, my in-law should not offer more than $70-200k for the place – a far cry from the $500k the guy was looking for. Plus, $10-20k is not worth the time, risk it takes to own and run a business that requires you to be present 50-60 hrs a week…
Hmmm it all depends! If it is for estate planning purposes under the guise of a buy-sell higher might actually be the right answer. If it is for estate planning purposes for the IRS (or Aussie equivilent) we are looking for LOWWWWWWWWWWWWWWWWWWWWWWWw
@ Modder – … yet so many do [i.e. work for what amounts to ‘slave wages’ for the privilege to “own and run a business that requires you to be present 50-60 hrs a week”] 🙁
BTW: You CAN add to my ‘formula’ some amount for stock and other assets that the business may have, but you must value them realisitically (which usually has NOTHING to do with what the guy may have paid for them, some time before).
@ Evan – “it all depends” … indeed! 🙂
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Never thought about what my business is worth or to put a number on it. I will have to look into so formulas that are being used in real estate brokerage services. Very insightful topic going to have too do some research. I]m hoping 2x annual sales is light.