What Price is the Right Price to buy a Small Business
If you decide you want to buy a business you need to prepare yourself for the rather inconsistent pricing methodologies used for setting the asking prices for small businesses.
You shouldn’t confuse the asking price with the value of the business….to you. There are many ways to compute the value of a small business. The results can be wildly different and all correct. The issue isn’t “what is a business worth?” as much as “what is it worth to you?”.
In this post we will discuss the elements that create value in a small business. As Business Brokers we have these discussions with buyers but more importantly we have the same discussions with business sellers.
Here are key elements that drive the value of a business up or down:
- Stability of Earnings. A business with consistent earnings is worth more than a business that has wild swings in it’s profits year to year. The reason is a business can never pay it’s bills with next year’s profits (unless you add debt or spend prior year profits). If you buy a business with consistent profits you will be able to borrow more to finance the purchase and therefore you can pay more.
- Customer Concentration – A customer with 100 customers all doing 15 of the revenue is worth more than a business with one customer doing 70% and 3 others doing 10%. If the 70% customer leaves the business is in the tank.
- Business has a high barrier to entry – Not many businesses have this but it it does it’s worth a lot. Barrier to entry could be patents, highly recognized brands, special equipment not easily duplicated, exceptional location, etc. But beware, if the business has one of these it will be reflected in the business by delivering higher profit margins.
- Management/Employee responsibilities – The less the owner of the business is involved the more the business is worth. In his book Built to Sell author John Warrilow describes how this characteristic creates value. Also, Michael Gerber has written a great book E-Myth that talks about applying these principals to small business. If you are serious about buying a business I would highly encourage you to get both of these books and read them before you begin your business search.
Now here’s a simple pricing model you might use. When looking at a business take each of the 4 elements above and score them on a scale of 0 – 4, with 4 being the best.
Let’s say you’re looking at a widget shop. The Widget Shop has seller’s profits of $100,000 per year. You score the business this way on the above 4 categories 3,2,2,3. The average of those is 2.5.
Then simply multiply the business profits of $100,000 times 2.5 and you get $250,000. Using the above assumptions $250,000 is a reasonable value of the Widget Shop.
As you might imagine there are many resources to help you value a business.
If you decide to look a buying a business you need to have some information and knowledge so that the asking price isn’t the only reference point.
Remember, it’s not what you pay relative to the asking price that’s important, it’s what you pay relative to the value to you that’s important.