How Much to Pay For a Business

The methodology outlined below is a simplified approach and as purchasing a business is a very significant step and every individual’s circumstances are different, I strongly recommend that you speak with a professional advisor familiar with your personal situation and needs before entering into any binding contract.

VALUING A BUSINESS: CRITICAL POINTS

There is no right or wrong amount – There is only what you are prepared to pay and what the seller is prepared to accept – nothing else is relevant.
How much to pay is based on what CASH you can realistically expect to generate from the business in future years – (There are many valuation methods available from complicated mathematical formulas to a simple percentage of sales. These methods make a good cross-check to the method suggested below).

HOW MUCH TO PAY – THE METHODOLOGY

STEP 1: NORMALISED PROFIT

Calculate a “normalised” annual cash profit (before tax) the business is likely to earn next year based on its past history. This is usually done by beginning with Last Year’s annual profit and making adjustments for items

incurred last year but won’t be incurred next year
to be incurred next year but weren’t incurred last year
Non-cash items

Examples of items you could adjust for

INCREASE PROFIT BY

Any wages or benefits paid to the business owner (or people related to the business owner) who will not be continuing when you own the business. This is not just wages but superannuation, medical benefits, motor vehicles, non-business (or slightly business) travel etc.

Interest Paid and any Other Finance Costs (that you will not be responsible for)

Depreciation and any other Non-Cash Items

Any Non-recurring expenses that occurred in the prior year (e.g. legal fees on a case which is now resolved)

The expected annual profit of any new (major) customers not included in the past year’s sales

DECREASE PROFIT BY

The market wage & benefits payable to you and any partner/relation that will work in the business (the amount is what you would be paid if the business was owned by a 3rd party and not necessarily what you will actually be paid)

Any expenses that will be incurred in future years, which are not included in last years’ profit (e.g. the business moved premises 3 months ago into a more expensive site – decrease the profit to reflect the new rental for the next 12 months less what was paid last year)

Any revenue earned last year that would be considered abnormal or not likely to occur next year (e.g. a large client was lost to a competitor, a “special” job which won’t occur again)

If there is likely to be significant capital expenditure (new equipment) over the next 3 to 4 years then an adjustment should be made (usually the cost of the equipment divided by the estimated years it will be used in the business)

At the completion of this stage we will have a value which represents the NORMALISED CASH PROFIT. This is the amount of profit before income tax that the business is expected to earn next year if it continued to run as it has done in the past.

STEP 2: SELECT AN APPROPRIATE MULTIPLE

There have been books written on what multiple to select and why, but here’s a RULE OF THUMB which has served me well through many purchases. There are 2 ranges

Smaller Business (Profit less than $100,000) 2 to 3
Medium Business (Profit $100,000 to $500,000) 3 to 4

(This methodology is not suitable for larger businesses)

STEP 3: CALCULATE THE VALUATION RANGE

Multiply the NORMALISED PROFIT calculated in Step 1 with the MULTIPLES in Step 2.

E.g. If you had a normalised profit of $150,000, the valuation range would be $450,000 to $600,000

STEP 4: NARROW THE VALUATION RANGE

To narrow the range further compile a list of factors which either improve or detract from the certainty that you will earn the normalised profit amount calculated in Step 1. Each factor that improves the certainty will support paying a higher amount in the range, each factor that detracts from the certainty supports paying a lower amount in the range. Based upon the number and importance of the factors in each category will allow you to tighten the range to either the lower, middle or upper portion of the range calculated above.

Examples of factors include

1. Age of Business

A business that has existed for 20 years is likely to have more certain earnings and be more established in a market than a business that has existed for 2 years

2. Size of Business

Generally the larger the business the more likely the business would survive any negative events

3. Certainty of Revenue Stream

There are many items that might improve or detract from revenue including

Does the revenue naturally occur each year (e.g. an accounting firm which would usually see the same clients to do their tax returns each year) V’s carpentry business which receives most of its clients from internet or yellow pages advertising

Is the revenue made up of a lot of smaller clients V’s a few larger clients? Whilst larger clients may be more profitable, they have a higher risk to the business should they take their business elsewhere.

4. Working Capital Required

The larger the working capital required (Debtors + Inventory – Creditors), the less you want to pay. Compare 2 identical businesses, the first requires you hold $200,000 worth of inventory, the second has an arrangement with suppliers to ship directly to customers. At the very least, you save interest on $200,000, plus the extra staff required to receive, pack and ship the stock, do stocktakes etc.

5. Economic Factors

What is the outlook for the next 2-3 years – if the economy or industry is likely to worsen then your valuation should be more conservative.

6. Market Position/Competitors

How secure is the business – are there are a lot of competitors in the industry(many competitors drive down profit margins), are there any new competitors and how difficult is it for a new competitor to enter the market, what impact would a new competitor have on the business.

7. Industry

Is the market growing or declining?

The Economic Importance Of The Home Based Business Industry

DEFINING THE HOME BASED BUSINESS

The home based business can be defined as a business whose primary office is in the owner’s home. The business can be any size or any type, as long as the office itself is located in a home.

In the USA, there are about 6.6 million home based businesses that generate at least 50% of the owner’s household income.(a)

“If one advances confidently in the direction of his dreams and endeavors to live the life he has imagined, he will meet with success unimagined in common hours.” – Thoreau

ESTIMATES OF THE TOTAL SIZE OF HOME BASED BUSINESS

“One study has estimated that the total number of people who run or are employed by home based businesses in South East England is in excess of 250,000 people, equivalent to 7% of the working population of the region.(c)

“While the average home entrepreneur business has two employees (including the owner), 39% have between two and five employees, and 10% have more than five. Using these average employment numbers, Emergent Research estimates that home entrepreneur businesses currently employ roughly 13.2 million Americans, including the owner.(a)

“To put these figures in perspective, let’s compare them to U.S. employment generated by two important industrial segments: venture-backed firms and the oil and gas industry. Analysis by the National Venture Capital Association shows that companies that received venture capital backing including such corporate giants as Intel, Microsoft, and Apple – employed 10.4 million in 2006.”(a)

THE IMPACT OF THE DEVELOPMENT OF THE INTERNET ON THE ECONOMY AND HOME BASED BUSINESS

The development of the internet has been and will be the big driving force in the development of the internet related home based business. Let us have a closer look at these developments. The following information is extracts from the McKinsey report.(b)

Two billion people are connected to the internet. This number is increasing by about 200 million per annum.
Almost $8 trillion exchange hands each year through e-commerce.
About one-third of small and medium-sized businesses extensively use web technologies.
The web has made possible new waves of business models and entrepreneurship. It has transformed industries.
The internet accounts for 3.4% of the GDP of the 13 countries that was part of the study. These countries represent 70% of the world GDP. The total contribution of the internet to the world economy is $1 672 billion or 2.9% of the total GDP.
The internet accounts for 6% of the GDP of countries like Sweden and the UK.
Over the past 5 years, the internet has contributed 21% of the GDP growth of the 13 countries that were studied. These countries represent 70% of the total GDP of the world.
This is a reflection of the small and medium-sized enterprises receiving a performance boost through the internet. These companies with a strong web presence grew more than twice as quickly than those with a minimal or no web presence.
The internet has become a very significant factor in the world economy and the growth of the economy. More specifically in jobs and wealth creation.
Online marketing represents 15% of total marketing worldwide.
The search requests by individuals on hard-to-find items or information was a total of 1 trillion requests during 2009.
In the USA, web surfers made purchases worth $250 billion in 2009; in the UK, it was $63 billion or 2.9% of the GDP. The average online shopper in the USA has spent $1 773 during the year. In the UK, $2 535 was spent on average.
The study concludes that the influence of the internet on the economic growth in the world, on job creation and generating wealth, is becoming more important and stronger.
For individual companies the internet lowers costs and increases revenue, productivity and profits. The internet helps these companies to accelerate growth in the export markets and to have access to new markets.
The introduction of broadband stimulates the development of the internet in those countries where it is being introduced. The internet stimulates growth in GDP, in job creation, wealth, and increases productivity.
In France, the internet has created a total of 700 000 jobs during the past 15 years.

The research of McKinsey indicates the growth in people connected to the internet, the importance of doing business via the internet, and the big influence that these new technologies have on the GDP of the world economies.

THE INFLUENCE THESE DEVELOPMENTS HAVE ON MY HOME BASED BUSINESS

Accurate research information is not available about the expected growth in the online home based business industry. I want to make some estimates based on the information discussed above:

The annual growth in people connecting to the internet is growing with about 10%.
The ability of the internet to:
Create new jobs. Give people an extra income stream. Have their own home based business and being self-employed. These changes create many new business opportunity.
The new technologies related to the internet will create new business models that will stimulate opportunities.
More and more trading and marketing is being done via the internet due to the development of new systems and technologies.
The improved communication systems and technology makes it cheaper, less risky, and more attractive to start a home based business.
The influence of the development of the internet on the growth in the GDP of the countries in the McKinsey study has been higher during the last five years than during the previous fifteen years. The trend is upwards. Many of the conclusions in this study indicate that the influence on economic growth in the future will be higher than in the past. Some developed countries like the UK have a more people using the internet than others, for example the USA. That indicates growth in many of the developed countries.
Due to the development and introduction of broadband in the less developed countries of the world, new trading and business opportunities will become available.