Let me
teach you about Blue Sky.
Hi there,
it’s David once again from www.InvestLocalBook.com
where I answer questions relating to local investing, buying and selling
businesses and personal finance and home economics.
This week I’ve
got a question from a viewer who asks, ‘What about business sellers who say
that their business is worth more because of the great potential it offers?’ Watch my answer in this video: https://youtu.be/INMiJJbXrZw
This is a great
question.
First, let
me state that any business you buy should offer the potential for improvement
or growth. This, in my opinion, is why
you would buy a business. You want to be
able to bring your own skills to the table and make improvements. Since we know
from earlier videos that businesses are valued at a multiple of earnings, if
you can improve the workings of a business by $1, you increase the value of
your asset by several dollars. The exact
amount depends on your industry and the size of the business.
But does
this potential mean that you should pay the seller more than what is fair given
the cash flow that exists at the time of purchase? In my opinion: no.
Let’s cover
some terminology so that we can be clear about what we’re talking about. Let’s say you decide that, based on the cash
flow, a given business is worth $100,000. If you add up the value of the
physical goods in the business such as tables, chairs, machinery and inventory,
you might get a value of $65,000 for this example. This is the tangible asset value or
replacement value of the business.
Given the
fact that there are loyal customers and a profit though, you’re willing to pay
more than this asset value. The
difference between the two, in this case $35,000 is called goodwill.
Goodwill is
amazing. Of course, you want to buy a
business which has goodwill; it means that it is profitable. Now, what if the seller says something like
this, ‘My business is worth another $20,000 because of the new housing
development being built across the street.
The potential is there to earn more money.’
An asking
price beyond what the cash flow will support is called Blue Sky. It’s literally a
payment for the promise of a brighter tomorrow.
The problem is, who is going to guarantee that the necessary sales and
profits will appear to justify this additional asking price.
Furthermore,
who is going to do the work to get those sales and transform them into
increased net-profits? It’s you. Now why would you pay someone for work that
you were going to do?
When you
buy a business, you should only pay for what you get today. That is the cash flow that exists
currently. If the seller was so
confident that profits were about to increase, why doesn’t he keep the
business, experience the new profits and then sell the business at its new
higher value?
If you want
to learn the ins and outs of buying a business and avoid costly mistakes, you
should take my business buying course, it’s at www.BusinessBuyerAdvantage.com
or at least read my new special report, ’21 Stupid Things People do when Trying
to Buy a Business’ It’s available as a .pdf and from Amazon.
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