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Evaluating a Small Business for Sale

Elaine Grant

Buying a business? Make sure you're striking a good deal

Determining the value of a privately held small business for sale is far trickier than figuring out the value of a new home. One reason why: Business owners have every reason to keep profits looking low at tax time and many reasons to inflate the value when it comes time to sell. Here are a few keys to valuing a small business for sale:

  1. Know the selling prices of similar businesses that have been purchased in the last year or two.
  2. Know the key value drivers for businesses in the industry you're considering. For instance, if you want to buy a bowling center, you should know that league play brings in about 60 percent of revenue for the average bowling business. If the center you've fallen in love with relies mainly on kids' birthday parties, buying it may be a dicey proposition.
  3. Many business brokers specialize in specific kinds of businesses: Some only sell restaurants, funeral homes or bowling alleys. An industry expert can be helpful.
  4. Rule-of-thumb formulas can help you value a small business for sale, such as multiples of revenue or of "EBITDA" — earnings before interest, taxes, depreciation and amortization. Be cautious about relying solely on formulas, though — every business is unique.

Do your homework

In the real estate business, "comps" are recent sales of comparable houses in the same area; they tell you a ballpark figure for the value of a house. When you're evaluating a business, consider both what similar businesses have sold for and the typical "multiple" by which companies like it are evaluated. A multiple means, for instance, "six times cash flow" or "two times revenue."
U.S. Department of Labor's SIC search page, or check the NAICS code. Once you know the industry code, search Pratt's Stats database of private company sales for comps and multiples.

Try a different formula for small businesses for sale in emerging industries

For businesses in new industries, evaluate the maturity of the business - does it have a lot of growth potential or has it had unchanging profits for the last several years?

Turn to an industry-specific business broker

A specialist can tell you the "inside scoop" on industry trends and the dramatic effects they can have on business valuation. They can also tell you how much of a deposit you'll need to come up with; money "down" varies by industry and also by whether a potential owner has industry expertise. Keep in mind, though, that the broker works for the seller.

Know your demographics, the real estate market and the business climate

If you're buying a business whose customers are mostly local, learn as much as you can about the area's demographics.

Interview the sellers

In addition to evaluating the numbers, you should evaluate the company's prospects for growth and any obstacles - including lifestyle issues - you may encounter. To do so, interview the owners extensively. Don't just ask them why they're selling; ask them how many hours they've worked weekly and how many hours a new owner would need to work to be successful. Do they know if any competitors are moving in? What are their ideas about how a new owner could grow the business?

  • Numerous factors can dramatically affect prices of small businesses for sale, including customer relationships and the owner's perception of the company's growth potential. If you're new to the industry, discuss the industry's future with neutral, expert parties.
  • Talk to employees of a small business for sale. Are they willing to stay? Would you want them to?
  • Ask the owners what it would cost for them to train you - or new managers - during the transition period.
  • Before you sign on the dotted line, ask whether the business will require any capital improvements soon.
  • Some owners will finance a portion of the sale. Don't hesitate to ask.
  • An immature business with no debt should earn a rate of return of 40 percent; look for a 26 percent rate of return on a mature business. Divide the company's net profits by 0.26 or 0.40 for its estimated value.
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Elaine Grant