There is no doubt that running your own business can be one of the best ways to accumulate long-term wealth and free yourself from the grind of working for someone else. Two of the keys to making it work, however, is to do plenty of homework and to look carefully at what the business has to offer.
There are many different paths to entrepreneurial freedom, including starting a business from scratch and buying an existing business. Both approaches have their own unique advantages, but one of the most significant plusses to purchasing an existing business is that there is a clear track record to examine.
The existence of that track record means nothing on its own, however, and it is up to every potential buyer to carefully examine the business and determine its true value. A business that thrives under one owner can easily falter when a change of ownership occurs, so it is incumbent upon any potential business owner to carefully determine which factors have made the business a success and to determine how those advantages can be carried on when the business changes hands.
As with any type of sale, the seller of the business may have an inflated idea of its value. This can be particularly true if the business has been in the same family for a number of generations. In cases like this, the monetary value of the business and its emotional weight can easily become intertwined, and it is essential for the buyer to employ cold logic in order to come up with a true value.
There are a number of tried and true methods buyers can use to determine the true value of the business, free of any emotional baggage it may contain for the current owner. These methods include calculating the value of the underlying assets of the business (i.e., the book value), finding the liquidation value of the business, and calculating the future income potential of the business.
The Asset Valuation Method
The asset valuation method of determining the worth of a business seeks to determine the value of the assets owned by the business. This method can be valuable, but in many cases it is not sufficient to arrive at an accurate value, especially for a small business. The business may be rich in assets but generate little ongoing income. Conversely, the business may own very little but generate excellent cash flow. Potential buyers who choose to use the asset valuation model to evaluate a small business opportunity may want to also look at alternate methods of business valuation. The value of the assets can give potential buyers an estimate, but this method does not always present the true picture.
The Liquidation Value Method
The liquidation value method of determining value is similar to the asset valuation method, and some of the same caveats apply to this method as well. The liquidation value model simply looks at how much the business would fetch on the open market, without regard to the reputation of the business or its current owners. Despite its limitations, however, the liquidation value method provides a good benchmark for value and a good way for potential buyers to avoid paying too much for a going concern.
The Future Income Method
The future income method of business valuation uses the current cash flow and income stream of the company to make an educated assumption regarding the future potential income the business is likely to generate for its owners. When using this method it is important for the company to have a strong track record, preferably dating back at least several years. The more years of past income available, the more accurate projections of future earnings potential can be.
Video: Business Valuation St. Louis presents a summary of business valuation methods such as Income Approach and Discounted Cash Flow (DCF) Model.
When using the future income method to value a business it is important to be on the lookout for any factors that could affect the validity of the future projections. This caveat can be especially important when it comes to family businesses that date back several generations. In many cases, a family business and its owners will have established ties to the community that may not continue once the business is in new hands. It is important for the potential buyer to perform due diligence in order to arrive at a true picture of the business, its current income stream and its potential for future growth.
Related: Business Valuation Tool
As with many other business decisions, the best approach to accurately valuing a business is often a combination of several different methods. While any one method, used on its own, can provide an accurate view of the value of a going concern, the combination approach often works best.
For instance, the potential buyer of the business may want to use the future income method to get an idea of the potential return on investment that can be generated through the purchase of the business at various sale prices. That buyer can then use the liquidation value and asset value methods to compare the value of the business to the future cash flow it is expected to generate.
It is, of course, incumbent upon the buyer of any business to bring all of his or her negotiating skills to the table. Buying a business is a serious matter, and it is essential that it be given the seriousness that it deserves. While the current owner of the business may feel that his or her company is priceless, this is unlikely to be the case, and it is important for the potential buyer to arrive at a fair value for the purchase.
One way that buyers can evaluate the true value of a potential business purchase is to compare the asking price of that business with the selling price of similar businesses in similar locations and similar industries. While this method will not present the entire picture, it can provide a guideline and a helpful aid in the negotiating process.
And of course, it is a good idea for any potential business owner to enlist the help of skilled professionals when making such an important decision. A skillful business attorney can be a great help in determining the terms of the sales agreement, and a qualified accountant can help to untangle some of the more esoteric issues in the income statement. Financial documents can be difficult to unravel, and it is important to have the help of a skilled professional to avoid overpaying for assets and future income potential.
It is also essential to thoroughly research the history of the company in order to uncover any issues before they become unpleasant surprises for the new owner. This is especially important when dealing with a business that relies a great deal on its reputation for quality and customer service. From dry cleaners and car washes to grocery stores and computer repair shops, reputation can make or break a company, and it is important for the reputation of the company to be a good one. Purchasing a company that is not only a good value for the money but a good business is a great way for the new or experienced entrepreneur to get off on the right foot with his or her new enterprise.
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