Before making the commitment to buy a business, it is necessary to find out how much it is really worth. It is not prudent to rely only on the quote that is given by the person selling the business. It is always possible that the seller may be overstating the worth of the business to get as much as possible for it. In certain situations, getting a business appraised in order to establish its true value is a requirement. This is the case where a business is being bought in a merger or acquisition transaction or where a buyer has applied for a loan to buy a business and the lender needs to verify its actual value.
Apart from establishing the accurate value to avoid being overcharged, an appraisal will also be helpful later on for estate planning purposes and also for tracking the growth of the business as a viable venture from the time it is acquired. Also, an appraisal will include checks that ensure that the buyer does not buy a business with undeclared liabilities, such as unpaid taxes, which could cause problems later on.
It is important to engage an independent third party to verify the true value of a business that one is interested in buying. This service is offered by business appraisers. These appraisers may work independently, or they may be a unit in a business broker’s company that is concerned with finding businesses for clients who are interested.
Business appraisers may use two methods to establish the actual value of a business for sale:
- Applying a multiple to the cash flow of a business
This is considered the more accurate method. The aim is to establish the value of a business by applying a multiple to the its discretionary cash flow (DCF). DCF does not refer to the profit or loss records that are indicated on tax return forms. Rather, it is the total amount that is generated by a business in a year less the amount that is used to meet operating expenses. This amount may be different from the formally declared returns because business owners treat personal drawings differently. Some list every personal expense as a business expense, while others pay themselves a salary and use it to meet their personal expenses. Discretionary cash flow is so called because it depends on the discretion of a business owner. It is the amount that is available as the owner’s remuneration, which can be seen as a return on investment and can be used to pay off debts if there are any.
Most privately owned businesses have a multiple of one to five added to the DCF by appraisers. The exact figure depends on the type of business. For instance, one that deals with air-conditioning and heating appliance repair and installation will typically be valued at two times its DCF, a hardware store at three times, a home health care business at four times, a janitorial service company at 1.5 times and a jewelry store at five times.
- Applying a percentage to the yearly gross revenue of a business
This method is not considered as accurate as the first. For instance, a full-service restaurant that has a liquor license may have a value of up to 30% of its annual gross revenue on average, while a dry-cleaning business will have about 75% of its annual gross revenue. Weekly publications are often valued at about 100% of their annual sales.
Real estate not included
It is important to note that these two appraisal methods consider only the revenue generated by a business. If there is real estate value involved, it should be added on. This would be apply in cases where the business owner owns, rather than rents, the premises. The current cost value of the inventory that is available at the time of appraisal should also be added.
No fixed value
It is also important to note that the true and accurate value of a business is not fixed. Different appraisers may arrive at different values, depending on the multiples or percentages they apply. Also, the very same type and size of businesses may have different values based on factors like location, which determines how convenient it is for buyers to go to a particualr shop. Also, a business may sometimes be facing risks or disadvanatges that another is not, such as poor management practices which have compromised the performance and value of the business.
It is also good to know that there are other appraisal methods apart from annual gross income. Appraisers may use market valuation where a business is valued according to what has been paid for it in comparison with similar businesses for sale in the same location. For this reason, the quote one gets from a seller and the one that an appraiser may arrive at may be different. However, the difference should not exceed 10%. One can negotiate a buying price based on this margin. If an agreement is arrived at, due diligence should be followed in closing the deal.