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There is an inherent danger in using Rules of Thumb, when considering the Fair Market value of a business. 2 + 2 does not always equal 4.

The first consideration when working with a potential seller, is establishing the sellers expectation of what the business is worth. “My CPA said my business should be worth 3 – 4 times my earnings. We topped $1,000,000 last year so we are looking for 3 to 4 million as a purchase price.”

I have to be the bearer of bad news, educating the seller that the “earnings” your CPA was talking about was “net income”, or maybe EBITDA (Earnings Before Interest, Taxes, Depreciation, & Amortization), or maybe EBIT (Earnings Before Interest & Taxes), or maybe SDE (Sellers Discretionary
Earnings); certainly not sales revenue. I must then encourage the Seller
to acquire a business valuation so that he or she understands how the industry and lenders will consider the company on the open market.

The Business Valuation of a company is not always calculations based on a
multiple of earnings. If Buyers have been looking at business opportunities in
that manner, they may have missed several key components of the actual fair
market value of the business they are considering purchasing. As an example; are accounts receivables included in the price or excluded; and the inventory; is inventory included in the valuation or an addition to the asset value of the company? Is the business managed or will the owner be significantly involved in the day-to-day operations? These are all factors in the calculations and considerations of market value for the business opportunity.

Another basic rule of thumb we hear often in business brokerage or mergers and acquisitions, is “an average of the last three years”; not always the case. In pricing a business there is also a consideration of the history of the company; are the revenues and profits of the business growing, has the income flattened out, or are sales declining. In a declining revenue situation where the company owner might have had a health issue, it would be unfair to the buyer to average the last three years of profits and revenues. The value would calculate higher than a buyer should pay due to downward trend of the businesses income. In a situation where revenues and profits are the same year after year after year, averaging three years of financial
performance would be applicable; in a situation where there is growth or significant growth, it would be unfair to penalize the seller for marketing the business correctly, maximizing profits by taking the average of the last three years of income and revenues. We might average the last two years plus a projected year. The bottom line is: how are lenders looking at the business? They all will say “we put more weight on the last year and the interim financials than what the seller did two or three years ago”.

Another consideration; is the business managed vs. unmanaged. Say you were looking at two different companies to purchase, their revenues are close to the same and their net cash flow to the buyer is the same, say $330,000 a year as an example. It would be easy to say “three times cash flow = $1,000,000”. Upon closer review; one of these businesses is managed by a general manager, requiring little time of the new owner on a day to day basis. The second business; the buyer will work in the company 65 to 70 hours a week, sweating over production and delivery of products and services. There is a value driver called “opportunity cost”. The opportunity
to buy a business where the buyer will not be significantly involved daily is worth far more than a business where the buyer will be the owner / operator and greatly involved in the earnings of the company.

Lastly; there are several methodologies to consider in the calculation of value; income approach, market approach, asset approach…  Are we applying multiples to SDE or EBITDA, or EBIT?

To all you Buyers out there; if you have passed on some opportunities because you thought the business was overpriced; that could be true as according to the IBBA, only 12% of businesses on the market will sell because the other 88% are generally overpriced. However, when Buyers analyze one of those businesses for sale in the 12% range, he / she should understand that there are more ways to look at fair market value or a business valuation than using a general “Rule of Thumb”.

You can find related information on my website; https://murphybusiness.com/dallas/services/business-valuation/

So… If you are buying or selling a business in Dallas or anywhere in Texas; find me at rgadberry@murphybusiness.com and let me help you understand the true fair market value of the opportunity you are reviewing.