How much is a business worth? It depends on what you’re buying
When it comes to buying a small business, the big question is: how much does it cost?
“Several different methodologies can be used to value a small business, but ultimately the beauty is in the eye of the beholder,” says Chartered Professional Accountant Deborah Rosati who has helped many entrepreneurs purchase and operate businesses. “What that means is: the business is worth what a buyer is willing to pay for it. A buyer should look at much more than just the business’s latest financial statements to determine how much a business may be worth to them.”
Here are some questions potential buyers of a small business should ask in order to determine what the business may be worth to them.
- Why is the current owner selling the business? The reason the current owner is selling the business may be an indication of its future prospects. Perhaps the owner cannot continue the business due to age, health or death and no family member is able to carry on the business. On the other hand, if a young entrepreneur hasn’t got a convincing reason for selling profitable company with a good outlook that may be an indication of hidden problems. “If the owner’s reasons for selling the business aren’t clear or if there is undue pressure being placed on the buyer to close the deal, it’s time to take a step back,” Rosati advises. “Talk to customers, employees or other stakeholders to get their perspective on the business and its prospects.”
- How well do you understand the company’s business and its industry? The better the buyer understands the company, its business and its industry, the more likely he or she will be able to replicate its revenues. “If the buyer doesn’t have the expertise or availability to operate the business, he or she may need to hire a management team,” says Chartered Professional Accountant Don McKinnon of KPMG in Waterloo. “Those buyers will need to factor in the cost of those salaries when deciding how much they are willing to pay for the business.”
- What about goodwill? In most owner-managed businesses, goodwill is usually attributable almost entirely to the owner through his or her personal contacts with suppliers, customers and other stakeholders. Transferring that goodwill to a new owner is always challenging. “Usually the former owner is contracted to stay with the business for a period of time after the sale, to help transition customers and other contacts to the new owner,” says Mike Redden, a Chartered Professional Accountant with Good Redden Klosler in Simcoe, Ontario. “It’s also advisable to require the seller sign a non-competition agreement. The last thing you want, when the transition period ends, is to have the former owner open up a new business in competition with you.”
- Are there key employees other than the current owner? Businesses that rely on a few key employees, such as a key salesperson, can be highly vulnerable during an ownership change. Buyers need to figure out how to keep these employees with the
business and keep them motivated. “That’s often particularly challenging in the early days after an ownership change when the business may be short of cash,” McKinnon says. “If the business cannot afford to pay employees at a rate that satisfies their wishes, the owner will have to figure out other incentives in order to retain those key people.”
- What is the condition of the machinery and other equipment? Often business owners postpone repairs and maintenance to machinery and equipment prior to selling the business. Technology can be of particular concern since it can quickly become outdated. “The nature of the business, how machinery- or technology-intensive it is, and the extent of the capital expenditure needed to upgrade or maintain that equipment should be important considerations for buyers,” says Redden.
- Where does the business generate its revenue? How wide and deep is the business’s customer base? Does it generate solid revenues across all areas of the business, or does it derive most of its revenues from a limited number of contracts? “Buyers need to carefully review existing contracts and agreements, including their key terms and conditions, renewal options, expiry dates and assignability,” McKinnon says. “It may be beneficial to meet with these parties to determine whether they will carry on the agreement with a new owner.”
- How reliable are the financial statements? Not all financial statements are prepared for the same purposes or provide the same information. Audited financial statements would disclose sales to related parties, for example, while unaudited ones may not. “Because there are so many variables with financial statements, potential buyers should have the company’s last five years of historical financial information reviewed by a professional adviser,” says Rosati. “A chartered professional accountant will be able to spot weaknesses or areas where greater investigation is needed.”
- Are you buying shares or assets? For tax reasons, sellers usually want to sell the shares of the business while buyers would prefer to buy its assets. Purchasers may also want to buy assets in order to avoid assuming any existing corporate liabilities. “Ultimately, most business sales are share transactions, unless it is a small sale when the increased legal and accounting costs may outweigh the benefits of selling shares,” McKinnon says. “As a buyer, it’s important to understand the differences between an asset transaction and a share transaction and the effect that will have on what the buyer may be willing to pay for the business.”
- Does the acquisition make sense to you? After carefully reviewing all aspects of the business and the terms of the purchase agreement, buyers need to decide whether or not the purchase is a good one for them. “At the end of the day, as a buyer it all comes down to whether you’re comfortable with what you’ll pay for the business, the time and effort you’ll have to put into running the business, and what you can expect to get out of it,” Redden says.
Category: Personal Finance