How Do I Calculate What a Business is Really Worth

or more importantly, how do I make sure I don't pay too much?

by William Bruce, Sunbelt Business Brokers

Nothing causes the buyers and sellers of privately held businesses more anxiety than the problem of valuation.  The question of price haunts both the seller and buyer.  The seller doesn't want to price his business too cheap and "leave money on the table."  On the other hand, the buyer of the business is afraid he'll pay too much and not get the best deal.

The appraisal of privately held businesses is not an exact science but there are guidelines that can be used for a quick approximation. 

As opposed to formal valuations with fully documented conclusions, there are two types of rules-of-thumb for quick approximations of value.  The first -- and the easiest to use -- says that a business should sell for a certain percentage of annual revenue.  The other formula works off of the discretionary cash flow of the business.  These formulas include all the furniture, fixtures and equipment of business.  The formulas do not include the value of the inventory, accounts receivable and any real estate.  These values should be added to the result of the guideline formulas.

Value as a Percentage of Annual Revenue

First, almost all privately held businesses with annual revenue under $5 million will sell for somewhere in the range of 20% to 80% of annual revenue.  In one large database, the average price was 44% of revenue.

Exactly where in this range of revenue the value of a specific business falls depends on the kind of business.  Convenience stores, for example, are at the low end of the range.  Dry cleaners are at the high end.

A good business broker can give you industry specific guidelines.  (Hey, you don't mind an occasional commercial, do you?  You may have guessed that I'm a business broker!  You can visit my eBay store at http://stores.ebay.com/Sunbelt-Business-Brokers.)

Value as a Multiple of Cash Flow

The other set of guidelines seeks to approximate the value of a business by applying a multiple to the discretionary cash flow (DCF) that the business generates. 

Discretionary cash flow is the amount of cash left over after paying the necessary -- and only the necessary -- operating expenses of the business.

From the database of closed transactions, we know, for example, that an air conditioning/heating contractor would sell for somewhere around 1.5 times DCF.  A hardware store is worth around 1.2 times DCF.  Wholesale distributors in general can be bought for 1.5 to 2 times DCF.  These values, as pointed out above, are plus inventory, accounts receivable and any real estate involved in the transaction.  Contact a business broker for other industry specific guidelines.

One interesting observation:  There is little geographic deviation in the value of businesses.  A gift shop in Georgia is worth about the same as a similar one in California.  And remember, these rules-of-thumbs are only averages.

And a word of advice might be in order here.  In buying a business, don't loose a company you really want by trying to squeeze the very last dollar out of the transaction.  You are the final judge as to what the company is worth to you.  Look at the big picture.  Don't be penny wise and pound foolish.

William Bruce is a Senior Valuation Analyst and Accredited Business Intermediary with Sunbelt Business Brokers.