Often the most difficult step in buying or selling a small business is determining what the business is worth.
There are two basic methods of determining the value of a business. The first is based on expectations of future profits and return on investment. This is by far the preferable method, as it forces the buyer and seller to give at least some attention to such factors as trends in sales and profits, capitalized value of the business, and expectancy of return on investment.
The second method is based on the appraised value of the assets at the time of negotiation. It assumes that these assets will continue to be used in the business. This method gives little consideration to the future of the business. It determines asset values only as they relate to the present. It is the more commonly used method because it is easier, not because it is more reliable.
Whichever method is used to value the business, the buyer should ask the seller to prepare a pro-forma, or projected, statement of income and profit and loss for at least the next twelve months. This means the seller will prepare a twelve-month sales estimate along with a matching estimate of the cost of goods sold and operating expenses.
The statement will reflect the net profit the seller believes possible. The buyer should then make one of his or her own for as far into the future as possible, and then compare his or her statement with that of the buyer. If you are a buyer and ill qualified to prepare such a statement on your own, you can consult an independent accountant. The additional cost would be small compared with the loss you might suffer if you invested in a company with a shaky future.
The buyer should start by analyzing the actual statements of profit and loss for at least five years back. He or she should check that the past and projected statements provided by the seller are correct, and study economic changes and competition that would affect future business.
The most important figure to project is the sales figure, because determining this figure makes it far simpler to forecast the cost, expense, and profit figures. The sales figure is projected using data from the company's past sales records. Of course, the more accurate and systematic these records are, the more accurate the projection.
How long a forecast is necessary? Any forecast is uncertain, and the farther a forecast is projected into the future, the greater the uncertainty. Why? A reasonable measure of control over internal operations is to be expected, but external economic and market factors cannot be controlled and therefore will make the process of forecasting difficult. Such factors should just be anticipated to the best of your ability. It is possible to mathematically predict sales with some degree of precision, but outside factors will obviously leave room for error.
The best way to approach the length of the forecast, then, is in terms of the expected return on investment. It seems logical to project sales and profits over a span of time comparable to that estimated for return on investment.
Methods of forecasting sales. There are a number of ways to forecast sales, most of which depend upon the past sales performance of the company. When establishing trends or averages in sales, the more sales history studied the better.
Perhaps the simplest method is to assume that the percentage increase (or decrease) in sales will continue and that no market factors will influence sales performance more so in the future than they did in the past. For example, if the business has enjoyed a yearly average sales increase of 4 percent for each of the past five years, you might assume that trend will continue over future years. But with each passing year, the prediction becomes less certain.
So if the accuracy of your predictions is limited, why try to forecast beyond the immediate future (one year)? Because it makes you pay attention. It causes you to keep abreast of economic and market factors that could influence future operation"and might make it unwise to purchase the business at this time.
Sometimes a more detailed forecasting technique is needed, one that can factor in possible variations in year-to-year sales and some external factors. No method of forecasting can set any concrete value on external market conditions; you can't be certain such conditions will be significant several years from now. Still, it is wise to consider external influences as much as possible.
Risk and Return on Investment
If you invest money in a business that is being sold, it's only natural to hope you receive a fair return on your investment. It is not uncommon for businesses to turn a profit for the first few years, but you need to think long-term, too.
From the buyer's point of view, a fair rate of return from an investment in a small business is generally proportional to the risk factor"the higher the risk, the higher the return.
If you purchase a small business, try to determine its risk factor, even if it is difficult or impossible. Regardless of your success, you should consider carefully the minimum return on investment you are willing to accept.
Valuing the Business by Capitalizing Future Earnings
The buyer should be paying a price that is based on the capitalized value of future earnings. In most cases, however, price is based on the purchase and sale of assets. These assets are used to generate profit, sure, but they don't correspond directly to future profits.
Capitalized value is the capital value that would bring the stated earnings at a specified rate of interest. The rate used is usually the current rate of return for investments involving a similar amount of risk. The capitalized value is found by dividing the annual profit by the specified rate of return expressed as a decimal.
When using this computation, keep long-run profits in mind, because unless profits are possible over a period ten to fifteen years, investing in a small business may be a poor decision. And if all other factors are the same, a company whose profits are declining is worth less than one whose profits are increasing.
Valuing the Business on the Basis of Asset Appraisal
The majority of buy-sell transactions are based on a value established for company assets. This is not the recommended approach, but if you should use it, consider abiding by the following suggestions. Find out as soon as possible exactly which assets are to be transferred. There are often a few personal items the seller does not wish to sell, in addition to prepaid insurance, certain supplies, cash, marketable securities, accounts receivable, and notes receivable. The assets most commonly purchased in a small business buy-sell transaction are merchandise inventory, sales and office supplies, fixtures and equipment, and goodwill.
Evaluating goodwill. Goodwill, in a general sense, concerns all the special advantages of a business like a good name, capable staff and personnel, high financial standing, reputation for superior products and customer services, and favorable location.
From the accounting point of view, goodwill is the ability of a business to realize above-normal profits (higher rate of return on investment) as a result of these factors. Its value can be computed in either of the following ways:
Capitalization of average net earnings. As mentioned, a business's purchase price may be determined by capitalization. The difference between this amount and the appraised value of the physical assets may be considered the price of goodwill. This method uses only earnings in computing the price, ignoring the appraised value of the assets.
Capitalization of average excess earnings. This method recognizes both earnings and asset contributions. It computes the fair return on the appraised value of the assets, and if the estimated future earnings are higher than this "fair return," the difference between the two figures""excess earnings""is capitalized at a higher rate, and the result is considered the goodwill value. This figure, when added to the appraised value of the assets, gives a price for the business.
Goodwill usually reflects excess profits, but most small businesses that are for sale don't have any"only nominal profit or none at all. The buyer must disregard the seller’s emotions when computing and reduce all facts to workable relationships.
If there are excess profits, goodwill is usually valued by capitalizing them at a fixed percentage established by bargaining between the seller and the buyer. The percentage should be high because profits higher than a normal return are difficult to maintain.
Goodwill is generally the last asset valuation computed, and since few small businesses being sold are producing excess profits, the problem of goodwill value is not a pressing one in most buy-sell transactions.
Merchandise inventory. In a service business, placing a value on the inventories is a minor problem; but in distributive and manufacturing businesses, the inventory is likely to be the largest single asset. A manufacturer, for example, has three inventories"raw material, work in process, and finished goods"and each of them presents different problems in valuation. The distributive company has only one inventory, called merchandise inventory.
The financial statements presented by the seller will probably reflect an inventory value different from the one assigned in a buy-sell transaction. Inventories are usually carried on the books either at cost or at the lower of cost or market. Market is defined as the current replacement cost to the seller.
To determine the value of inventories, the seller chooses a method by which to arrive at cost. The most common costing methods are first-in-first-out (FIFO), last-in-first-out (LIFO), and average cost. These methods may each give very different values and the buyer and seller must arrive at some value agreeable to both parties. The most common methods used for small businesses are cost of last purchase and current market price.
The quantity of the inventory is usually determined by a physical count. Each inventory team should include one representative from the buyer and one from the seller, and inventory not to be sold should be separated before the count begins. Also, the quality of the inventory should be examined and satisfy the buyer. If you are the buyer, be certain there are people on your team who can properly evaluate it. If the buyer and the seller disagree on the value of certain items, the seller can remove these items from the list of inventory for sale.
When a manufacturing company is being exchanged, the raw materials inventory is taken and priced like the merchandise inventory of a distributive business. The work-in-progress and finished-goods inventories may present a problem, as there is usually no market price or cost of last purchase to relate to these inventories. That means the seller's cost is generally used for establishing prices.
Store supplies and office supplies. These two items are usually quite small. They should present no problem, though some of them may have no value to the buyer if the name of the company is to change. After the usable supplies have been determined, a physical inventory should be taken and priced as in the case of the merchandise inventory.
Property assets and accumulated depreciation.
In many small business buy-sell transactions, no real property is exchanged, because the site is leased. It is customary to have an independent appraiser establish a value for real property. Appraisers’ findings on real property are usually more acceptable to both parties than personal-property appraisals"the real property may have multiple uses, whereas personal property consists of single-purpose assets.
If the buyer is confident in knowing going values of the personal property, he or she may decide not to retain an independent appraiser. In addition, many individuals believe that cost or book value is a good place to begin negotiations for personal property. However, because of the many methods of computing depreciation and also because of conflicting ideas about capitalizing costs, the cost or book value may not reflect a value that is agreeable to both parties.
It is difficult to assign a value to personal property equipment because these assets have little value if the company is liquidated. Therefore, a going-concern value should be determined. The price to be paid for this equipment should be somewhere within the range of the cost of new equipment or the cost of comparable used equipment. For this reason, an independent appraiser can be useful, particularly if he is acquainted with the type of equipment being sought or sold.
The seller should realize that he may own assets that do not appear on the fixed-asset schedule. Many companies have a policy of not capitalizing any assets below some arbitrary amount ($200 or $300). A complete physical inventory should be taken.
If the assets are numerous and geographically dispersed, the seller may be asked to prepare a certified list of the assets giving description and location. The buyer can then test the list by verifying only selected assets at the time of the sale, but with plans to verify all of them within a certain period of time.
The value of personal-property assets is usually decided after considerable bargaining. It is better to assign values to individual assets rather than to make a lump-sum purchase of assets. In a lump-sum purchase, there is more chance of overlooking some asset values.
The buyer should try to determine the condition of the assets as well as repair and replacement requirements. If he doesn't establish the condition of the assets individually, repair and possible replacement costs may create an unexpectedly heavy drain on his working capital.
Income Tax Consequences
Income tax consequences of the buy-sell transaction may be an important bargaining issue if the buyer and seller are aware of them. The seller should be concerned about the amount of tax he will have to pay on his gains from the sale. The buyer should be concerned about the tax basis he will acquire as a result of the transaction. These concerns almost inevitably lead the buyer and seller into conflict in valuing the business.
The income-tax laws are highly technical, and the possible variations in a buy-sell situation are infinite. Because of this, a discussion specific enough to be really helpful is impossible here. Both buyer and seller should study the applicable tax laws; and if an important decision in the buy-sell agreement is to be based on income-tax consequences, the advice of an income-tax expert should be sought. The key to tax savings is tax planning before the buy-sell contract is closed.
The seller should keep in mind that he must report any income-tax liability he incurs by selling a going business. Reinvesting the sales proceeds in another business will not enable him to avoid or postpones his income tax liability.