Buzz Harris: 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 bringing 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 it can be way off base.

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

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

Since the value ultimately depends on the buyer and the seller agreeing on a price, one of the most effective methods is known as “cash flow.”

A businesses cash flow is determined by allowing the seller to paint a picture of their business’ true profitability. By recasting the sellers’ financials, a business that is paying taxes on a net profit of only $20,000 may have a cash flow of $200,000.

By “adding back” the seller's net profit, traditional expenses such as the owner’s salary, interest and depreciation, plus non-operational expenses (i.e. personal auto lease, medical expenses, memberships, etc.), a seller will get a much cleaner picture of their business’s real profitability.

As part of the process, the seller will need to get their financial statements to make sure they have supporting documents for these “add backs.” Prospective buyers will typically want to see a minimum of two years 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 cash 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’s actual cash flow, different multipliers can be applied to determine a fair market range of value for the business. Once this range hasn't 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 can sometimes be more important than the actual sales price.

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