CB: Let’s start with the basic question: Is there an easy way to figure out a fair price to pay for an existing business?
MM: Yes — but only if you have all the right information. What you’re talking about is a “business valuation” — and there’s a whole accounting industry built around doing this for big businesses.
CB: When they’re looking to buy out an existing business?
MM: Yes — but also when they’re selling, so they can get some help in setting a price. You’ll also see this when a firm is raising capital or when there are lawsuits or divorces among the partners . . . things like that.
CB: Should you always have a professional valuation done before buying a business?
MM: I’m sure most of the so-called “experts” would say so, but I disagree. If you’re going to buy a business, you should already know enough about it to figure out what it’s worth. If you’re going to buy something you don’t understand, you would certainly need outside help. But then you’re buying a pig in a poke — not a good way to invest, in my opinion. Use experts for a second or third opinion but trust your experience most of all.
CB: I did some research, and apparently there are lots of different ways to value a business: looking at assets, earnings, revenues, combinations of those things . . .
MM: Yes, it can get complicated . . . but it doesn’t have to be. Every business lends itself to a certain type of evaluation. The businesses I specialize in — publishing companies that market their products directly to customers — are best valued by either earnings or the value of their mailing lists, to give you one example. Other businesses, such as restaurants, may be better valued on a gross-sales basis.
CB: Let’s say we’re talking about buying a small, local service-based business. Do you start by considering paying the asking price?
MM: Are you kidding? The most important rule is to give that no credence at all. Sellers have emotional investments. They want to get paid back for all their time, their worries, etc. But that has nothing to do with what the business is going to do for you . . . so just ignore it. For most businesses most of the time, the No. 1 thing to consider is earnings. You need to figure out what the earnings of the business are and make an offer that’s based on them. Earnings, by the way, is the same thing as profits — what you end up with after the business has paid all its expenses, including your salary.
CB: So how do you make an offer that is, as you say, based on earnings?
MM: The price you offer should be a multiple of earnings. You might, for example, be willing to pay three times earnings or five times earnings or even 15 times earnings, depending on a number of factors.
CB: Such as?
MM: Such as the way the business is managed, the industry outlook, profitability trends, and so on. Looking at all these factors gives you different ways to ask one critical question. CB: Which is? MM: How stable and predictable are the earnings of the business?
CB: And why is that important?
MM: Let’s say I have a grocery store that you want to buy — and, last year, it made $50,000 in profits. You’d want to know how reliable that $50,000 figure is going to be in the future. If you knew that you could count on it year after year, you might be willing to pay five, six, even 10 times that amount ($250,000 to $500,000) for the business. But if you suspected that the $50,000 was a one-time thing — that the following year the business might make $25,000 and the year after that only $10,000 — you certainly wouldn’t be willing to bid anywhere near $250,000. In that case, you might offer just $100,000.
CB: That makes perfect sense. So, how do you predict the stability of a business’s earnings?
MM: The first thing you do is consider not just one year’s worth of earnings but several. Most of the deals I’ve done have been based on the three most recent years. Three is a good number to start with. But you’ll want to throw out any extraordinary years. For example, if you’re buying a travel agency and one of the numbers you’re dealing with is for a year when the Olympics were being held nearby, you’d eliminate that year. Consistent numbers are always better than numbers that are all over the place.
CB: How else can you determine the reliability of the profits?
MM: You look at the profitability of the industry as a whole. Is it trending up or down? Another thing is the locale. How is this particular business likely to do in this corner of the world? Another consideration is the sales and marketing apparatus of the business. Is it stable and self-running . . . or does it depend on something or someone that won’t be there after the business is sold?
CB: You need to be sure that the business’s human resources are not lost.
MM: I hate that phrase, but the concept is correct. It is the same for top management. You have to take into account the importance of the owner to the success of the business. Suppose you want to buy “Crazy Eddie’s Stereo Sales.” Everyone in town buys there because Eddie is on television and he’s a fun, whacky character; there are free hot dogs and balloons at the showroom on Saturdays and he has great deals. But if you buy that business and Eddie retires, you may find that the magic is gone . . . and so are the profits. On the other hand, if you’re buying Mayfield Appliances, which has been around for 100 years and has a reputation as the best store in the state, that’s a different story. Because people feel good about Mayfield Appliances, not just one figurehead — and the goodwill (the reputation) stays with the firm when you take over.
CB: It sounds like you’re saying that if you own a small business, you should actually make yourself less important as time goes on if you want to be able to sell it easily.
MM: Absolutely. And a lot of people don’t do that. Ego can be a killer in business — but that’s a separate discussion. Now, you might try to buy Crazy Eddie’s and give Eddie a contract to stay on as a consultant. But you can run into a lot of problems doing that. Eddie is used to being the owner and the boss, and he might not like taking orders from you. It’s also a bad idea to buy a business where the present owner has unique skills that you won’t be able to reproduce.
CB: Such as Philippe Petit’s Tightrope-Walking Academy.
MM: Right. Or Clancy and Evans’ Fine Jewelry Repair. Do the customers insist on doing business only with Clancy and Evans? Do they think that Clancy and Evans have some special magic? If the answer is “yes,” your answer should be “no.”
CB: Let me see if I have this right. You begin by looking at the profitability of the business. You determine how reliable the earnings are by taking at least a three-year average and then accounting for anything that might affect those profits in the future. Once you’ve determined how much you can expect to make from the business, year after year, you can come up with a reasonable purchase price by calculating a multiple of that number.
MM: Exactly. The more reliable the profits and the less they will depend on key individuals in the future, the higher the multiple you can assign to it.
CB: Any other considerations?
MM: Yes. You must add or subtract any numbers that don’t represent an arm’s-length business transaction.
CB: Like? MM: Let’s say the owner had his wife and kids on the payroll but you are pretty sure they didn’t actually do anything. Their salaries could be imputed (see “Word to the Wise,” below) as profits.
CB: Making the value of the business higher. MM: Exactly. On the other hand, the owner might be underpaying himself. Maybe he’s a marketing genius or his own top salesman and yet he isn’t paying himself an “arm’s-length” salary for doing that job. In such a case, you’d need to figure out what it would cost you to pay someone to do it and subtract that amount from the projected profitability. CB: Because that’s what you will have to do.
MM: You’re catching on.
CB: Anything else?
MM: If there is any real estate or some other major physical asset involved, deal with that as a separate transaction. In fact, you often don’t want to actually buy the entire old business; you want to buy just the parts of it that are going to make you money in the future. You don’t want to get stuck with old baggage that could involve lawsuits, hidden liability . . . those kinds of things. And don’t forget the final factor — the effect your involvement will have on the business. You could foul things up. Or you might make the business much better. You won’t know exactly what is going to happen until you actually do it. But you should be prepared for either possibility.