Buying Decisions: Assessing a Business’ Worth

Posted by Cap-Strat on April 17, 2012

When assessing a potential acquisition, review why the current owner is selling, the history of the firm, and its internal structure.

When purchasing a company, how do you settle on a fair price? There are steps you can take to better ensure a reasonable return on your investment for the amount of business risk undertaken.

Due Diligence

First, it is important to understand why the business is on the market. Is the owner retiring, selling for personal reasons, or simply lacking the expertise needed to run the business? Is the company profitable or losing money and in need of new management?

To answer these questions, review the history of the business and how it functions. You should understand the company’s customers and how its different departments work together. Examine the financial statements, including accounts payable and outstanding debt, as well as a list of inventory and equipment.

You should also review key employees, suppliers, leases, legal issues (such as zoning, government regulations, and lawsuits), insurance and taxes, notes and mortgages payable, and any proprietary information, including patents.

Additionally, ask about the ownership structure. Is it a sole proprietorship? A limited liability company? Are there outside interests involved? Also analyze how the business fits within its industry. Is it a viable competitor? Why, or why not?

Evaluating Value

If the business appears attractive thus far, you are ready to run the numbers. To gauge a rough idea of value, you can use the multiple of earnings approach. This calculation is based on annual actual earnings before interest and taxes (EBIT). Here are some general guidelines:

  • Multiple of 8 to 10 times EBIT: A well-established and stable market leader that is likely to thrive regardless of management.
  • Multiple of 5 to 7 times EBIT: An established company with a respectable market reputation that has inconsistent earnings and will need management guidance.
  • Multiple of 2 to 4 times EBIT: An established company with significant competition and few assets that will need a strong management team.
  • Multiple of 1 times EBIT: A small personal service company where the new owner will likely have few or no employees.

Don’t Go It Alone

Obtaining independent opinions can help buyer and seller agree upon a reasonable valuation to help seal the deal. Team members usually include an accountant, a business valuation expert, and an attorney. Ask your professional team for reputable candidates to consider for financing the sale. Begin exploring avenues early in the process as it may take time to find a lender and negotiate terms. Purchasing a business is a tremendous undertaking. Conducting a thorough appraisal to ascertain value and tapping the expertise of competent advisors will hopefully result in a satisfying and rewarding endeavor.

Required Attribution

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© 2012 S&P Capital IQ Financial Communications. All rights reserved.

April 2012 — This column is provided through the Financial Planning Association, the membership organization for the financial planning community, and is brought to you by Capital Strategies, Inc., a local member of FPA.

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