I received a
question from one of my viewers in South Carolina. Ben has an opportunity to buy part of a
business and wants to know what he needs to do to figure out what it’s worth.
Splitting up
businesses is a funny thing. Usually
businesses want to combine to realize synergies.
Think of two companies merging
and eliminating some of the administrative staff. The result of the merger should be lower
overheads as a percentage of sales.
So if you
buy part of a business and this leads to dis-synergies how do you figure out
what a part of the business is worth?
Well, all you can rely on is the sales figure.
Start by
taking the sales of the existing company for the department or product lines
that you’re going to be acquiring, then build yourself a new income statement.
Be prepared
for a tough negotiation though, the parts may often be worth less than the whole
and the sellers expectations may be very different from yours.
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If you would
like to hear from me weekly before anyone else, you can sign yourself up at www.DavidCBarnett.com If you need my help with your
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Do you live
in the Maritimes? I’ve got workshops
coming up on buying and selling businesses in the fall. Book now http://davidbarnett.eventbrite.ca
Good day, it’s Dave Barnett from InvestLocalBook.com. I’ve got another
question today about buying a business. This question is from Bob.
Really the question is about evaluating businesses and Bob wants to know
when he looks at a business, how many years of results should he average out
when deciding what kind of numbers to use. So if sales, you know change every
year, do we average out, for example, three years of sales or five years of sales,
what averaging do we do to the numbers? and then the truth of the matter is,
it’s maybe frustrating answer for you Bob, but it depends. and this is what it
depends on it depends on the trend. Let’s take a look at the white board.
Aright Bob, so what I’ve done here is it created an example company and
we’re going to call this one the Growing Company. Now each one of these columns
represents a year and so we have six years of data here, and then the dotted
line is our forecast year, so it’s our best guess as to how the upcoming year
is going to shape up. Now normally you’re evaluating businesses based on
financial statements which means that if the financial statement for this last
year is in your hands, it means you’re already into that forecast year. So you
may be able to look at least a few months of results for the upcoming year and
see if it looks like it’s going to be performing as well as prior years now, in
this case what people sometimes want to is say looks let’s just average
together a bunch of years but in realty that’s not the best way to look at a company.
The most recent year of performance is the best indicator of the
performance of the company and if I’m evaluating a business that has sales that
were continuously growing year after year. And profits that were lined up just
as nicely growing year after year that would I would actually do as I would
probably do it weighted average and I would probably put fifty percent of the
weight on the most recent financial statement. I might put ten percent of the
weight on the forecasted year. If we’re reasonably certain that it was going to
perform as we expected. And then I might put some waiting on these past years
but I wouldn’t make it an even weighting. I might put 20% on the year before
this gives me 70 and then I might put 15%. And then this gives me 60, 80, 95
and then I might put 5% there. So I would use a weighted average with the
majority of my weighting being on the most recent year. So this is an example
of a growing company.
Let’s take a look at some other example. Here we’ve got the opposite
situation. We have a declining company. We have sales that are going down every
year and we’re projecting another small decrease in sales and we got profits
that are going down every year as well. This is a completely different
situation if you we’re trying to sell a company like this. You would probably want
to make some sort of argument to use even average of several years of results
if you were buying the company though, the very first thing you’d have to
isolate is why are the sales declining. Is there a reason why this industry is
falling out of favor? I mean are you buying a video store in the modern age of
online streaming movies for example. Is it just the industry is dying off or
are there problems with the way the company is managed and run that maybe you
could fix. You never pay for something that could be as I mentioned in many of
my other videos, you always pay for what
you get.
So in this case if I was doing an evaluation from bob’s point of view as
a buyer. I would actually want to have all of my weighting on the most recent
years and in fact you know I would probably do something like 85 and 15 so if I
was projecting even more decline in the last year I want to have some weight on
that. So that we drag down the overall fact of the different year’s
performance. This company in the future year has very little in common with
this company back here. This company was bigger, had more sales, probably more
customers, maybe more employees, or profits, etc. then this company over here
there is a material difference between how these companies operate.
Let’s take a look at 2 more examples. Here’s another example and I’m going
to call this one Uncertain Trend. And what we see here is a bunch of moves up
and down up and down. There is no real consistency to the performance one year
after another. We can clearly see that there’s an increase or a decrease in
what’s going on in this business. Now if we can identify why? so for example a
ski resort maybe has its revenues and profits directly tied to the amount of
snowfall every year that can give us an indication as to why the performance
jumps all over the place but from the point of view of a buyer who wants to buy
the business, your concern is how do I average these numbers together? Again in
all of the different situations I’ve looked at. The last full year performance
is still your best indicator of what you know What the business is worth how
the performance is. So in a case like this, I would actually want to put a
little more weight than the first example, so I might put 60% weighting on this
year and then maybe 15 and 10 so this would give me 75-85 and maybe five here
and 10 over here. So were still using an average in this case we’re getting
more of a sampling of other year’s performance but we’re still primarily look
at the last full year results. Given that the most recent performance is in
most likelihood the most relevant performance to how the company is going to
perform. What you’re probably noticing is that in none of these cases have I simply
taken four or five years of results and just average them because, quite
frankly, a company five years ago is very different from the way that the
company operates behaves the market condition of a company today and so as we
get further into history the results increasing become less relevant.
I always love it when people say ‘’Hey it’s a great company, has been around
for eighty years. Well you know a lot of steel mills have been around for eighty
years and a lot of other big industries that don’t have such a great
performance track record in today’s day and age. the fact of the matter is the
longevity of a company may be good for its’ story, its marketing, its number of
customers, the people who’ve heard about it but what we’re really concerned
about is how this company operating? How does it perform today and what is the
likely outcome of the company going to be in initial time period when we take
it over as buyers.
Let’s take a look at another example that’s a little bit different. Alright
in this last example I’m going to call this one Rapid Growth Example because I’ve
had a few cases recently that I’ve worked on where this has been the scenario. You’ve
got companies that because of really unique intellectual property have been
able to create products. Where they’re the only player and they create
significant value for their customers such that everyone in a given industry
wants to switch over to their products. So there is growing demand from all
over the world for these products. People want to sign on to be customers and
every year the company is logging incredible growth like 30%, and 50% and 70%
and a hundred percent and 150% growth. Year after year now that kind of growth
creates certain challenges obviously as far as cash flow and receivables and
things. But in some industries are able to demand deposits up front and things
like that. You can actually work with that kind of growth.
Now in a situation like this, This company in the final year literally
has nothing in common with the company of a few years ago. And in this case
what I was suggesting to the person who wanted to have the business evaluated,
what is that from the sellers point of view he’s going to want to drum up the
fact that the future is so bright and that this thing is going to carry only
probable we’re like crazy in the future the buyer obviously wants to get as a
good a deal as you can as this thing grows and grows and grows, clearly the
business has more and more and more value in a case like this, would actually
ended up happening was I put eighty percent of the valuation on the final year
and 20% on the future forecasted year. With the idea being that this valuation
would have to be updated its a deal didn’t happen within a few months there’s going
to have to be updated again because the company keeps changing in a material
way as we move forward into the future and not only is this kind of growth and
give you sort going to base of your evaluation on the biggest sales and profits
numbers but the sellers also going to come and top-ranked multiple given the
fact that the company to such a shinning jewel that a lot of people obviously
in a way to get their hands on.
So Bob I hope this helps your question do we
averaged the last three years? No I’ve never used sort of an average of any
number of year, it’s always got to be a weighted average you’re always going to
want to put a maximum sort of weight on the most recent history and if things
are going down in a big way or up in a big way than your want to consider maybe
even forecast year as the company changes in a material fashion. anyway I hope
this was helpful and if you have any other questions about how do you buy or
sell small business come to my blog site in InvestLocalBook.com check over my
business buyer course or BusinessBuyerAdvantage.com and soon I’m going to have
my exit planning course which will be online come to my blog site and get yourself
up for that one as well. Have a great day
Hey you made it to the end of this video. That’s great! Don’t forget,
visit InvestLocalBook.com, sign up for my email list, it’s right down here
under the welcome video. Thanks and we’ll see you next time.
Phil asks, ‘Can we trust the valuation that a
business broker puts on a business?’
When I was a business broker, people would come to
me with their businesses and I would evaluate them. I would do what was called a Most Probable Selling Price evaluation. I'm pretty good at it and I still do them
today for people who want to have a value put on a business. Generally
my MPSP prices would come out within five or 10% of what the actual end result
selling price would be, so they were pretty accurate.
Back to Phil’s question; If the business broker is
qualified and competent, knows what he is doing, has experienced proper
training and you hire the broker to evaluate a business, then probably you're
going to get a pretty good accurate idea of what the business is worth.
If you go to a business broker and say, ‘Show me
businesses for sale and what are the asking prices?’ That’s not the same question at all.
In my own experience, I would do an MPSP and then
the seller would set their own asking price.
Now if I told someone that their business was worth
$220,000 and they said they wanted to ask $500,000, I wouldn't take them on as
a client. I would tell them to try
somebody else because if it's just so far out of whack to what is reasonable,
it is just going to be a waste of the broker’s time.
Nobody is going to seriously consider that business
because it is priced so far outside the realm of reason, but if I said ‘the
business is worth $220,000’ and the sellers said ‘let’s asked $249,000’ and
I’ll have room to negotiate, then that
was perfectly reasonable.
You have to know that when you're looking at
businesses that priced for sale with a broker, those are asking prices, they are not the result of some kind of
business valuation.
Beware though, there are people out there that call
themselves business brokers who will basically take any listing that is offered
to them at whatever price the seller wants to ask for.
They’ll put it out there in the world and hope to
sell it. What’s unfortunate is that
people end up wasting a lot of time with
these types of people because ultimately an overpriced business can’t create a
positive cash flow and nobody would be able to buy it.
If
you’re going to buy a business or you’re going to sell a business and you want
to find an experienced, qualified business broker who has proper training and
who uses proper methodologies, one of the things to look for is membership in
the IBBA (International Business Broker Association) or one of the larger business brokerage
franchise names.
They have
their own training programs internally that are also very good. You want to
look for someone who's a part of those organizations, who has had access to
training and you want to talk with them a little bit about how they do the
evaluation. You want to hear that they
compare businesses by industry and size to other similar businesses that have
already been sold.
This is called
the direct market data method.
Don’t try to
hire a business broker to do an evaluation on a business he has for sale, it
creates a conflict and he’ll probably just ask you to make your best offer and
work things out in a negotiation.
In this video I discuss the difference in mindset between entrepreneurs and investors. These two mentalities often clashed during my business brokerage career.
I talk about the differences between a business owner working towards a dream and a potential business buyer who wants to analyze this business and determine its worth based on cash flow.
