Council Post: Buying A Small Business? Here’s How To Make Sure You Don’t Overpay

By Trent Lee, the recipient of the award as the #1 Business Broker in the country by the IBBA (International Business Broker Association).

As a business appraiser and business broker, I see a lot of small businesses for sale. When it comes to valuing most small businesses, or what are called “main street” businesses, there are a couple of quick litmus tests you can apply to make sure you don’t overpay for a business you are looking to purchase.

This almost goes without saying, but a business appraiser can and should be part of your acquisition team. Business valuations can get quite complicated and you’ll need an experienced professional to help represent you, but as a general overview, these methods will give you a good foundation and head start to determine the fair market value of any small business you may be considering.

Rule Of Thumb No. 1: Buying Yourself A Job

Some small businesses are no more than a one- or two-man job. These are tricky to value because the likelihood that they have much in equipment value is typically low, so the only valuation driver is to look at the reported net profit of the business. Notice I mentioned reported net profit. If the business owner is pocketing unreported cash, this should not be part of the valuation.

Let’s assume you are looking at a marketing agency that is primarily a one- or two-man operation. The business brings in a reported net profit of $150,000. Let’s assume that if you were to purchase this business, you’d need the skill set and time to take over as a full-time job. If the average market wage for this type of position were $80,000, deduct $80,000 from $150,000, which leaves you $70,000.

From there, two simple math formulas are required. Anything less than the market wage of $80,000 is a multiple of 1 and anything between $80,000 and $150,000 is a 1.5 multiple. Here is what the valuation math looks like:

• $80,000 x 1 = $80,000

• $70,000 x 1.5 = $105,000

• Collective total = $185,000 for the fair market valuation of the company.

This should give you a quick and easy way to determine how much you should pay for a business that has few to no employees.

Rule Of Thumb No. 2: A Small Business With Employees

A business with employees means leverage and higher value — leverage because the owner can leverage the time and talent of employees to generate revenue. They are no longer a one-man show that is totally dependent on their own time and energy to generate revenue.

There are a few steps required to calculate the fair market valuation for a small business with employees. First, calculate what is called sellers discretionary earnings (SDE); next, look up the market multiple for the particular industry or niche business you are looking at.

First, you need to understand SDE. (I cover this topic in greater detail in my last article.) If the seller/owner pays themselves $35,000 per year on W-2 wages and has the business cover their family health insurance, car, gas and auto insurance payments, you’ll want to add these all together. You’ll also want to calculate how much in depreciation, interest and retirement contributions the business made on behalf of the owner. These expenses are all added back to the reported net profit of the business. This process is called recasting the financials.

Here is what the math may look like:

• Net profit: $100,000

• Owner’s salary: $35,000

• Add-backs: $50,000 (these must be documented and verifiable)

• SDE: $185,000 ($100,000+$35,000+$50,000)

Next, you’ll need to have access to look at market multiples for businesses within the same industry and size and what market multiple they sold for. This is where the help of a business broker or business appraiser will come in handy.

For now, let’s use a general average. According to BizBuySell data, average cash-flowing businesses sold for 2.28 times seller’s discretionary earnings (SDE). So, let’s do the math:

• SDE: $185,000

• Market multiple: 2.28

• Fair market valuation: $421,800 ($185,000 x 2.28)

That’s it! Using these two rules of thumb, you can quickly and easily make sure that you are not overpaying for a business you are looking to purchase.