People are used to negotiating over price and trying to get the best price. In the case of a real estate investment where the mortgage costs are a large expense and based on the price paid, getting a good price is very important to making money on the investment. When buying a business, the price of the business is important, but buying a good business is more important and paying a little more to get one makes economic sense. Typically, the extra price paid is recouped in a relatively short time.
In a traditional business valuation, there are three approaches to determining the value. What the business assets would sell for in an orderly liquidation – the asset approach — is rarely the selling price of a good, profitable, business. The income approach uses return on investment or discounted cash flow to determine a value. However, buyers and sellers can differ on how much of a return is reasonable and a reasonable price for the business. The last approach, the market approach, looks at what businesses actually sell for. Common databases used are BizComps, the Institute of Business Appraisal, and Pratt’s Stats. If a buyer looks at actual sales, they will see a wide range of multiples – on sales or income — that businesses actually sell for. An astute buyer needs to compare how the business they are buying compares to the average business to determine a reasonable price to pay.
Here are some other factors that a business buyer should consider. These might not show up on an income statement or balance sheet, but will affect the future earnings of the business.
Profit Margin – How does the profit margin of the business compare to the average business in its industry? An above average profit margin, over the long term, will generate much more income. An above average profit margin can indicate a better business to buy. The buyer needs to evaluate why the profit margin is higher than average and be sure it is not because the business is skimping on expenses that will hurt it in the long run.
Risk – How risky is the business? This requires evaluating what risk factors the business is exposed to and the chance of each occurring. Can its product or service become obsolete? Can they be replaced by an Internet offering? Is the company dependent on a few key customers, or a key employee, or location? How many competitors are there? Are there barriers to entry for a competitor? The less risky the business, the more it is worth.
Quality of Assets – The most obvious are any equipment. Is it up-to-date or obsolete? Will it need to be replaced soon? Even more important are the people assets. Are any key employees leaving soon?
Financial Information – Unfortunately, many businesses – even large ones – can have poor financial information. It is worth something to get good financial information – tax returns, income statements, and balance sheets — that a buyer can rely on when buying a business.
When deciding how much to pay for a business, these are some of the factors that don’t show up on the financial statements that should be considered. Paying more for a better quality business usually pays off quickly.