Article provided by Fedgroup
Owning one’s own business can be a fulfilling experience and certainly one that is far removed from working for a boss. Many people thrive in this environment where the business stands or falls as a result of the decisions they make on a daily basis.
There are two broad ways of going into business for oneself. You could either start from scratch or purchase an existing business. Starting from scratch has the advantage of shaping the business exactly as you want it. Purchasing an existing business also has advantages, such as an existing location that is often hard to find, and a track record of proven performance.
Business owners who start from scratch have to do many months of preparations to ensure that the business idea can indeed turn a profit. However, those who purchase an existing business should apply this same diligence to ensure that a fair price is paid and that no nasty surprises are hiding around the corner.
Calculating the value of a business is a tricky exercise because there are so many variables that should be taken into account and the help of a professional is recommended. However, there are a few basic principles that prospective business owners can keep in mind to get the negotiations ball rolling.
Most people enter into business for themselves to fulfil a particular passion or to be their own boss. Although these are the main driving factors, everyone does so with the expectation that the business would pay them while fulfilling this passion. The easiest way to find out whether the business can afford its new owner is to look at its cash flow. This figure also makes a big contribution to the price the seller is going to ask.
Although businesses can generate cash flows from investments or by extending credit, the cash flow most pertinent to the health of the business is the operating cash flow. Operating cash flow is simply the money paid to the company by customers (its revenue or turnover) minus the money paid to suppliers. Operating cash flow is therefore the money generated by the company’s core operations.
A company’s cash flow statement is different from the income statement and balance sheet because it does not factor in cash coming into or leaving the business in the future. While the balance sheet and income statement calculate the company’s net earnings, it is the revenue recorded on the cash flow statement at is all-important in determining the health of a business.
A company might show huge net earnings without being able to pay its bills. If a company records high earnings growth but little growth in cash flow, it is usually because it has sold the product or service on credit. In other words, there are many people owing the company money. While debtors are good for business, they can be bad for cash flow. If these debtors turn bad, the company could be in serious trouble.
The cash flow statement gives a good indication of future revenue through its recording of past performance. Therefore, if a person is looking to buy a business and renovate it, the cash flow statement gives a good indication if there is enough money available to pay for any plans that the new owner may have.
When the price of a business is calculated, many professional valuators use the average cash flow of the previous three years when they do their calculations. The previous year is given a weight of 70% in this average, the year before that 20% and 10% is allocated to the cash flow three years ago. Although this formula can give a good indication of average cash flow, it is also prone to oversimplification. It is important to take into account how old and established the business is, and whether it is on a high-growth path.
Because of the recent economic downturn, the weighted average cash flow may be lower than usual, which means that some businesses currently up for sale are more affordable than usual, provided that the recession has not placed their survival under threat. One should also look at the percentage of growth year-on-year (there may even have been a decrease). This will indicate trends in the future cash flow of the business.
As a general rule of thumb, businesses usually tend to be sold for two or three times their annual revenue, while franchises go for three or four times annual revenue. Any price higher than this is usually not considered good value for money.
Free cash flow
One of the disadvantages of only looking at cash flow to determine the sales price of a business is that it does not include capital outlay for fixed assets. Capital outlay is any expenditure on assets that is paid off over a term longer than a tax year.
Capital outlays can vary dramatically from industry to industry. Compare, for instance, the heavy machinery that has to be purchased by manufacturing companies, with the rent of an office and an IT infrastructure for some services industry companies.
The cash flow that is available after provision has been made for capital outlays is called free cash flow.
Increasingly, free cash flow is being factored in to determine the asking price of a business.
Some companies that report massive cash flows have little free cash flow because of the expensive equipment used in manufacturing the product.
When a company reports its earnings on its income statement, it is possible to prop up the final figure through clever accounting. This is much harder to do with free cash flow, which is why it is an effective tool to determine how much the company generates for its stakeholders.
Another calculation often used to determine the business price is earnings before income and taxes (EBIT). This figure is the operating revenue plus the non-operating revenue, minus operating expenses.
This calculation allows the owner to know how much money can be taken from the business as a personal salary. After the money the owner wishes to take out of the business is subtracted from the EBIT, the money that is left should be around 25% of the asking price of the business.
For instance, if the business generates R1 million a year and you or the manager requires a salary of R400 000 for the year, what is left of the earnings before interest and tax for the company comes to R600 000. A good price for this business would therefore be R2.4 million, because R600 000 is 25% of this total.
The earnings before interest and tax of a business is a broad tool and differs considerably in practice. In general, the higher the price of the business, the higher the percentage of EBIT left after subtracting the owner’s salary would be. The age of the business would also determine the EBIT, with more established businesses able to command a higher percentage. Businesses that operate in a riskier space should charge a lower percentage.
EBITDA is another ratio that is often used to valuate companies. It is the EBIT, with depreciation and amortisation also added back to the figure. This figure shows the profitability of the company, regardless of the way its operations are financed, through credit or cash, for instance.
This figure shows whether a company is able to service debt in the long run, and is therefore an especially popular valuation tool for companies that own expensive equipment that must be paid off over a long period. EBITDA is therefore a good indicator of the company’s profitability, but not its cash flow.
The general rule when valuing a business is that five to seven times EBITDA is a reasonable price. There are, however, many factors that should be kept in mind and larger, well-established companies tend to be sold for higher multiples of EBITDA.
EBITDA can also be used as a bargaining tool. If other companies in the same market space have been selling for lower multiples of EBITDA, then it stands to reason that prices are lower under current economic conditions.
The value of the assets owned by a business plays a major role in determining the sale price of the business. Many business owners do not wish to part with every asset in the business when they move on. It is therefore important to receive a list of every item that forms part of the transaction and not to simply assume that all business assets are included in the price and will automatically be transferred to the new owner.
The assets of the business can be divided into the following categories: merchandise, supplies, goodwill and equipment.
The standing of a business in a community is a definite asset if the company has become known as an ethical operation that goes the extra mile for its clients. This goodwill can be one of the company’s biggest assets and could have a bearing on the price of the sale. Also included in goodwill is the staff members of a company. If they are to stay on and they have been trained in managing the company’s operations or equipment, this expertise will also be included in the purchase price. Although the new owner would have to fork out more for a business that comes with a competent staff complement, their presence does provide a measure of certainty that the transfer to new ownership could occur smoothly.
When the business price is determined, a financial value has to be ascribed to the company’s goodwill. This is the amount above the average that the company is earning because of the goodwill factor.
Do not let the formulas do all the talking
The aforementioned ratios are some of the ones used most often to arrive at a good selling price. There are many more than these available, and volumes have been written on how to determine business value, with intricate and confusing formulas being used by people with master’s degrees in economics. While these calculations can go a long way to provide a clear-cut value, the human element should not be disregarded.
A prospective business owner who is serious about making a success of the business about to be purchased should not be afraid to break a sweat when analysing the value of the business. This means not only perusing the financial statements of the business, but to actually be up to speed with every inch of the physical premises and the employees that will still be there when the owner departs.
By visiting a company, one can get a feeling for the strengths and weaknesses of the business that may not be apparent from the financial statements alone. One gets to see the managers in action, as well as being able to gauge the demographics of the average client.
Many businesses, especially fast food enterprises, that are profitable become less so due to location. Some businesses become gridlocked and it becomes extremely difficult to access the premises during peak traffic. A visit to the site during these periods can provide an indication of whether there is a danger of this happening in the future.
If a business owner intends to expand, the premises must also be scrutinised to ensure that increased operations are indeed possible, especially with regards to the ability to house more equipment or accommodate more clients. If there is little space for future growth, the sales price should be considerably lower.
Although an overly emotional approach can lead to the breakdown of a price negotiation, at least some of the business evaluation should include a personal impression.
Am I taking over any additional expenses?
When a business price is negotiated, one should ask for proof that payments for amenities are up to date. If there is money outstanding on electricity, water or refuse removal, these costs should be settled by the old business owner before it is sold, or the cost should be subtracted from the final price. Some business owners have taken over a company without paying attention to this seemingly mundane detail, only to find out that the business owes the municipality thousands. If no provision is made for these costs in the sales contract, they are the new owner’s problem. Some owners only become aware of these problems when their water or electricity is cut off soon after acquiring the business. They are then incapacitated for however long it takes to reconnect, not to mention putting a dent in their cash flow to make this payment.
What the people add to the price
When calculating the value of the business, it is important to keep the human touch in mind and be honest with yourself. Every new business owner would like to believe that he or she brings a special personal touch to the company that can drive revenue. While this may be true, one should not bargain on it.
It may also be that the previous owner had some special touch or charm that attracted customers. It may therefore take some time to create the same customer loyalty and the business may not be able to afford the repayments until this is achieved. If the business price is calculated on the basis of the current cash flow and you are absolutely confident that you can add extra value through your own efforts, then the business purchase becomes a good deal.
Petrol service stations should be considered as passive income generators, as the revenue tends to stay reasonably consistent over time. Unless traffic routes change or margins are cut, there is little the business owner can do to affect revenue.
Some businesses have customers that are bound by contract to use the products or services of the business in the foreseeable future. These customers guarantee revenue for the new business owner, which creates peace of mind, but the previous business owner may also use these clients to justify a higher price.
How much work must I do?
Despite the fact that a business owners are their own bosses, there are certain instances where they should still reason like employees. No employee would work long hours for a putrid salary and a business owner should follow the same approach. The business should pay the owner for the amount of work that it requires.
If the business is a passive income generator, then a higher price is in order, because the business can continue to pay for itself with minimum inputs from the owner, who might even have enough time to run a second business. Sometimes, all a business needs to run properly is the appointment of a decent manager. However, if the business takes long hours of work by the owner to function optimally, it had better pay enough to make it worthwhile. Some businesses’ budgets are so tight that they cannot survive unless the business owner works actively in the business, thereby eliminating an additional salary.
Cash flow determines the amount of employees that can be employed, as well as the level of their qualifications. The more qualified an employee is, the more he or she will cost the business. Many businesses require this expertise to survive. If the previous owner had this skill and is now leaving the company, a new person may have to be appointed. The cost of appointing this person should be considered when looking at the final price of the business. Some companies add millions of rands to the business price for each engineer in its employ.
The payment terms offered to clients are another consideration for price evaluation. Some small businesses with little leveraging power in the marketplace may be forced to give their debtors longer periods to pay their accounts. At the same time, they may be forced to accept shorter terms in which to settle their accounts with their creditors.
In this scenario, cash flow could be under pressure and this should be taken into account when the price is determined. A buyer should also look at outstanding debtors and creditors. If substantial debts are outstanding, it may indicate that clients are not honouring their commitments to pay their accounts, which could point towards a business in distress.
Business accounts also show how diversified the business is. If there is only one big client, then there is substantial risk associated with the business, because that one client could cancel at any moment. Even if a binding contract with a single client is in place, that client could still go bankrupt, taking the small business down with it. Businesses associated with this type of risk should sell for less.
What has gone before?
The history of the business is another important factor in determining the price. The old adage is that one should understand the business that one is purchasing very well. One way to achieve this is to know the track record of the business throughout all its life stages. Most businesses encounter crises and opportunities as they mature and the way these are dealt with or capitalised upon can tell the new owner something about the culture of the business and the space in which it operates.
These factors do not only tell the business owner whether the business space correlates with his own strengths or weaknesses, but also what a fair asking price would be. If a business has faced many threats in the past, it may mean that it is operating in a very volatile market space. Those companies that show a steady upward curve are safer bets, although they may also cost more.
Specialist stores may attract extra costs
If you are buying a business to operate in a marketplace where you have not been active before, it is important to ensure that there are no costs associated with that industry that you are not aware of, such as the price of a liquor licence for any business that sells alcoholic beverages.
Some companies that handle hazardous materials are obliged to take on more insurance or pay for particular permits. These subtract from the cash flow of the company and are not always considered when a fair price for the business is being calculated.
Taking care of these aspects takes extra time or even an extra employee, which should also be factored in.
One should be particularly careful when calculating the cost of a business that is sensitive to imports and exports or other fluctuating costs such as the fuel price. A company’s financial records might reflect earnings that were generated when the rand was strong. A deteriorating rand could therefore severely diminish the company’s profits. Therefore, the past performance of this business should not be the only benchmark. Generally, the more vulnerable a business is to these fluctuations, the bigger the risk. Increased risk should be factored into the final sales price.
How are franchises different?
Prospective new business owners may decide to go the franchise route. The advantage franchises hold over other businesses is that the support from management and a well-established brand name makes the transition from the old owner to the new go a lot smoother in general. This smooth transition means that cash flow may not be affected as much as would be the case when other businesses change hands.
Of course, a premium has to be paid for this certainty, which is why franchises sell for more than other businesses. However, this price can only be justified if the extra customers attracted by the brand name can pay for the higher price. One should also look at the added value that the franchise adds, such as marketing, training and technical support.
These add-ons differ from franchise to franchise and should be taken into account when the price is considered.
Why is the business in the market?
It is important to know why the person is selling his business and to be satisfied that nothing is hidden in the answer. This is especially true of deals that look too good to be true, because often the company may be in serious trouble. In these cases, business owners often try to hide one aspect of the business that is well below par, such as cash flow, by trumping up other factors such as profitability or the amount of assets owned.
In some cases, however, it may just be that the seller is looking for a new challenge or is emigrating, in which case a favourable price may be in the offing. However, if the owner is looking to sell for a nice profit, with the backing of a strong economy and lots of demand from clients, there may be a string of interested parties. In this instance, negotiating leverage diminishes significantly and the asking price may even be too steep to consider.
Close the deal
It is important to remember that no price asked by the seller of the business is final. Chances are the person selling the business has made the same calculations as the one interested in buying the business. The person selling the business makes calculations on the value of the business and tries to add a few rand extra to make it a good deal for him. The person buying the business would make the same calculations and try to pay slightly less than this total. When negotiating the price of the business, all this homework becomes useful to justify why a slightly lower price is in order.
Sellers of businesses would often try to inflate the value of the intangibles such as customer loyalty and goodwill. Insist on proof that these factors are as valuable as the business owner insists they are.
If there are not many interested parties and the owner wants to sell the business quickly, there is some room to push for a lower purchase price. In the current economic climate, there are not as many buyers in the market as a few years ago. This works in the favour of potential business buyers.
It is important to remove all emotion from business negotiations. Some businesses would be nice to own, but the asking price just does not justify the purchase. During the negotiations it is advisable to take one’s time and consider what the current owner is putting on the table. Be sure what factors are deal breakers and do not compromise on them.
It is also useful to keep in mind that sellers bring their own emotions to the table. Often, they built the business up from scratch and the decision to sell is not an easy one. They may therefore tend to overvalue many aspects of the business. Assure them that the business will be well taken care of, but do not compromise on paying for what it is actually worth.
Knowledge of different valuation methods is one way to ensure that the best price for the business is being paid. If the business owner only uses one method (asset value and cash flow are used most often) questions should be asked about the items that were not considered in the valuation. If a business owner prefers one method over another, it does not necessarily mean that he is wilfully trying to hide information about the business, but drawing attention to other valuation methods could be used to drive down the price.
Once the business deal is closed and the company changes hands, the value of the company should be jealously guarded. Everything should be done to ensure that the business can be sold for a lot more than what it was bought for.
If you did your homework during the valuation process, you will have a good idea of all the components that add value to the company. These components should then be looked after to ensure that they do not lose value over time to diminish the overall value of the business.
Building up the value of your business is not only important for when you in turn want to sell the business a few years down the line, but also because many of the ratios discussed here are also used by the banks to determine whether or not to extend credit to your business.