Would you buy a house, sight unseen, for the seller’s asking price? Of course not. You’d first want to compare prices with comparable sales in the neighborhood, thoroughly inspect the condition of the property, and find out as much as you could about the house’s history and future.
The same goes for purchasing an existing small business. You risk losing money whether you pay too much for an overvalued business, or too little for a weak operation that may require a substantial investment to revive. To assess the true value of a business, you need to look at its tangible assets, accounts receivable, sales and balance sheets. Intangibles such as goodwill and reputation, while important, are only marginally important to a business’s cash value.
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There are two basic methods of evaluating a business: the appraised value of the assets at the time of negotiation and future expectations of profits and return on investment. Both the buyer and seller should agree on the valuation method; otherwise, further negotiations are pointless.
Appraisal of assets is the more common method of setting the value of a business, probably because the present value of the business is based solely on the value of its current assets. As an asset the value of inventory carried on the books for merchandise is the price paid rather than the current value. This can lead to assets being dangerously overvalued. Base inventory valuation on current value, not purchase price. If the inventory is loaded with items no longer in demand or items whose price has dropped, the total inventory value could be grossly overstated. Establish the actual business inventory and its current real value, not original purchase price.
Another key area is accounts receivable. Examine these accounts carefully to make sure that there a minimum of them that are overdue. Ask for a report showing the age of receivables; e.g., accounts that are not due yet; due now at 30 days; and overdue by 30, 45, 60, 90 and 120 days. The older the accounts receivable, the less likely the money will ever be collected. If the business has a large number of accounts at 45 days or 60 days, check the payment history of the clients in question. Do those clients routinely pay slowly? This is crucial information; money you can’t collect offers no value to the business.
Santa Barbara SCORE meets every Wednesday, from 8:30-11:30 a.m., at 402 E. Gutierrez St., Santa Barbara. No appointment is necessary. For more information, call 805.563.0084, visit www.santabarbarascore.org or register for counseling online at www.edmisscore.org/0166. In addition, the Santa Barbara SCORE Chapter publishes a great tool for aspiring entrepreneurs, How to Start a Business in Santa Barbara County.
The second valuation method, future expectations, is riskier. This method establishes a value for the business based upon the future expectations of its profits and return on investment. The buyer looking at the business history and projections for the future may opt for obtaining financial statements, business trends and forecasting of the business’s future based upon its past performance. Both the potential buyer and the seller need to consider factors such as trends in sales and profits, the capitalized value of the business and the expected return on inventory. Such projections are not easy, but can begin with the preparation of projected profit and loss statements.
The buyer should always remember that the seller’s own statements are likely to be overly optimistic and even overstated. The buyer must be wary of the business that looks too good to be true. For how long should these statements be projected? One year? Three? The best way to decide is in terms of the expected return on investment. If it’s estimated that the business should return 20 percent on the investment, then the investment capital should be returned in five years. On this basis, the projected statements should cover five years.
You can plug into a wealth of business know-how by contacting your Santa Barbara chapter of SCORE “Counselors to America’s Small Business.” SCORE counselors offer free, confidential advice about every aspect of starting, running and growing a successful business, even mentoring.