What is a Business Worth?
Using Valuation Guidelines and Rules of Thumb in Appraising a Business
by William Bruce, ABI, SVA
Nothing causes company owners or the buyers and sellers of privately held businesses more anxiety than the problem of business valuation. In a transfer of business ownership, the question of selling price haunts both parties to the transaction. The seller doesn't want to price his business too cheap and “leave money on the table”. On the other hand, the buyer of the business is afraid he’ll pay too much and not get the best possible deal. The appraisal of privately held businesses is not an exact science but there are guidelines and rules-of-thumb that can be used for a close approximation of value. Plus there have developed in recent years fairly extensive databases of completed transactions which business appraisers can search for comparables.Certain situations require a formal business appraisal including the larger merger-acquisition transactions, SBA loan applications, management performance tracking, estate planning, divorce -- or the most dreaded of all -- IRS issues. After all, a professional, fully documented appraisal certainly takes the guesswork out of the situation. However, what we will discuss here in this article is not a formal appraisal but rather the informal methods of quickly approximating the value of a business entity. All of the guidelines we’ll quote are averages derived from thousands of completed transactions reported to national and regional databases.Let’s First Define What We’re Appraising
Most small business transfers are asset sales and the appraisal guidelines that follow assume an asset sale. This means that the buyer of the business buys certain assets of the business – usually the furniture, fixtures, equipment, inventory, the business name, and goodwill. These assets are transferred to the buyer at closing free and clear of any encumbrances. Generally not included in an asset sale are the cash on hand and the accounts receivable. These two assets are usually are retained by the seller of the business.The opposite of an asset sale is a corporate stock sale. In this case the purchaser buys the outstanding shares of stock in the corporation, thereby taking control of all the assets and debts of the business. And a basic word on business value might be in order here. An on-going business entity that is earning a profit is worth more than the sum of its tangible assets. What is really being transferred in the sale of a business is an income stream. Business appraisers seek to put a value on that income stream.The Two Appraisal Guidelines
There are two formulas for business appraisal guidelines. The first one -- and the easiest to use -- says that a business should be worth a certain percentage of its annual revenue. The other formula uses a multiple of the cash flow that the business produces. These guidelines assume all furniture, fixtures, equipment needed to do business. However as stated above, the sellers of most small-to-medium size businesses do not include in the sale any cash or accounts receivable. Hence, the guidelines do not include these items. Also, in most cases, the value of inventory, at cost, is added to the formula results.Nor do the guidelines include any allowance for real estate. The guidelines assume that the business is in a leased location at a competitive lease rate. If real estate, cash or accounts receivable are to be included in the sale of a business, their value should be added to the guideline results.And these guidelines assume that the business is making a net profit percentage that is within the average range for the type of business. If the business is above or below average in profit percentage for its category, the resulting values would need to be adjusted accordingly.Value as a Percentage of Annual Revenue
First, almost all privately held businesses with annual sales under $5 million are worth somewhere in the range of 20% to 80% of the company’s annual revenue plus inventory at cost. In one large database, the average price in the year 2000 of 3,8000 transactions was 44% of revenue. Exactly where in this range of 20% to 80% of revenue the value of a specific business falls depends on the kind of business. The range in valuation percentages is reflective of the many differences in the various categories of businesses. For example, some types of businesses require more expensive equipment that others. And some categories of businesses historically take a higher percentage of total revenue to the bottom line as net profits. This is why convenience stores, for example, are at the low end and dry cleaners are at the high end of the range when business value is expressed as a percentage of total annual revenue.If you’re looking for an auto parts retail store, as another example, you should expect to pay about 45% of revenue to purchase the business. Let’s say you are looking at a tire store with auto service. You should be able to buy it for somewhere around 40% of sales. Other examples: dress shops sell at around 20% of sales, coin laundries at 75%, franchised fast food outlets at 50%, print shops at 50%, vending routes at 65%, video stores at 55% and restaurants at somewhere between 25 to 35% of sales depending on type. Manufacturing operations sell for somewhere in the neighborhood of 65% of revenue depending on the product and other factors.Value as a Multiple of Cash Flow
The other set of guidelines seeks to approximate the value of a business by applying a multiple to the annual cash flow that a business generates. This second guideline states that most companies will sell for between one to six times the discretionary cash flow produced by the business. Exactly where in this range that a specific business falls, again, depends on the type of business.Cash flow IS NOT the same thing as the net profit that you show Uncle Sam on your tax return. It needs to be calculated by an experienced professional.From the database of completed transactions, we know that an air conditioning/heating contractor would sell for somewhere around 1.5 times cash flow. Beauty salons go for about 1 times cash flow. Day care centers that are licensed for 100+ students sell for around 4 times. A hardware store is worth approximately 1.2 times. Other examples: Home health care is 3 to 5 times, janitorial services are 1.5 times, jewelry stores are 4 to 6 times. Manufacturing operations will sell for between 3 to 5 times, depending on size and quality. Wholesale distributors in general can be bought for 1.5 to 2 times cash flow.But You Are the Ultimate Judge of Value
However, you as the owner, seller or buyer of the business are the final arbiter of what the business is worth to you. Remember, these guidelines are only averages. And the guidelines certainly don’t take into account any special considerations or any future plans that an owner might have for the business. What a particular business might be worth to you may be more or less than it’s worth to the next person who looks at it.One final observation: There is little geographic deviation in the value of businesses. A gift shop in Alabama is worth about the same as a similar one in California. What really counts more than anything is how well the business is performing financially.This article originally appeared in the Alabama Chamber of Commerce monthly magazine.
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William Bruce
Business valuation appraisal or worth using rule of thumb guidelines. Business worth with multiple percentage guidelines.
