If you plan to acquire a small business, a central question is what the business is worth. Business valuation is the key step to determine your offer price and terms.
Business value: what happens after you buy?
In addition, understanding the target business economic value is essential to address some strategic questions after the purchase:
- Which business value drivers are important?
- What can you do to continue increasing business value?
Knowing what creates business value helps you focus your precious resources on things that matter most to your business worth. Smart allocation of resources is what sets apart successful business acquisitions from failures.
Approaches and methods to valuing a business for sale
Regardless of your acquisition target, you have 3 ways to determine the value of a business:
- Market approach.
- Asset approach.
- Income approach.
To get a reliable, accurate appraisal of business value you should use several methods under each of these key valuation approaches. This strategy is adopted in all professionally prepared business appraisals. The reason is that no one business valuation method is better then the others. Each approach lets you see the business against the background of important economic considerations.
Market based business valuation methods let you compare the target business against similar businesses that sold recently. Needless to say, this is a very compelling way to estimate your offer price!
Asset-based business appraisal methods, such as Capitalized Excess Earnings, help you determine whether the costs of buying the business are consistent with its true economic value. Should you pay the business seller’s price or build a similar business – and save?
Finally, the income-based business valuation methods, such as Multiple of Discretionary Earnings, let you look at the core of business value – its earning capacity and risk. The power of income based business valuation is that you can determine what the business is worth based on your specific business ownership objectives.
Structuring a business acquisition deal – cash is king!
Determining the business value is one important step toward a successful business acquisition. To ensure that your business purchase works you need to structure the terms of your offer. The important questions your offer terms must address are:
- Does the business throw off sufficient cash flow to cover all my financial needs?
- Can the business service debt without difficulty?
- Is there enough cash to fund important capital expenses going forward?
- When do you get your down payment money back?
Debt service – margin of safety
The focus in your deal structuring analysis is on the business available cash flow. If you plan to fund the business acquisition with debt, whether from a lender or using seller financing, adequate debt service coverage is critical to your success. A key funding criterion by commercial lenders is debt service coverage ratio of at least 1.25.
Project costs – more than the business purchase price
Most small business acquisitions are so-called asset purchases. This means that you must account not just for the purchase price but provide for adequate working capital as well. You total outlay will also include the transaction costs of buying the business. The sum total of these three elements is your business acquisition project cost – which may exceed the contract purchase price by a hefty amount!
Can the busines pay the working owners?
Make sure that the business acquisition gives you a living wage. If a bank loan is involved in deal financing, your banker will certainly check if the business cash flow supports adequate salary for all new business owners.
Cash flow drain: deferred maintenance and equipment replacement
One key mistake to avoid is failing to allocate enough funds for new equipment purchases and other capital investments. You need to check the condition of business equipment and other hard assets and determine if they need to be replaced or upgraded in the near future. Unexpected capital expenditures can wreak havoc with your business finances!
Return of your investment
Smart business buyers and investors always want to see a return of their down payment. Make sure that business cash flow allows you to recover your investment within as short a period as possible.
As with successful business ownership, in business acquisition the golden rule is: cash is king!