There are many ways to determine the value of a business that will help you make a variety of decisions including, should you buy the business; how much money you can borrow from a bank; whether you will need to seek investor financing; and whether you need an estate plan. Jeff Jones, a business counsellor with The Service Corps of Retired Executives (SCORE), has been appraising businesses for over 30 years. According to SCORE's website and Jones' article "How to Value Your Business," the value of a business will depend upon a lot of factors, such as the number of years in business, number of employees, the amount and condition of the equipment, facilities, supplies and inventory, the type of customers, and the stability of earnings.
- Skill level:
Determine the owner's salary plus net operating income (NOI) for the last three years. NOI measures a company's profitability and includes earnings after deducting the company's operating expenses but before deducting interest and income taxes. An accountant, or a good set of financial books, should be able to provide you with three years of solid financials.
Review the value of a company's assets -- for example, inventory and equipment. You'd have to buy all the same start-up materials if you were starting the business from scratch, so the business is worth at least the replacement cost of its assets. The balance sheet can give you a good indication of the value of the company's assets.
Multiply 2.5 times net earnings to get a rough idea of a company's value. The company's net earnings are gross revenues from the sale of products and services minus depreciation of company's assets, taxes, interest, and other expenses.
Tips and warnings
- "A company's value should never be based solely on revenue numbers. The value should be based on industry standard multiple numbers of 3 or 4 times net earnings," according to Elayne P. McClaine, owner of ESME Market Specialists LLC and a business consultant with the Rutgers University Small Business Development Center.
- Think twice about buying a business if the company's financial books are not in order. You need to know whether or not the business is profitable. If the current owner does not know this, you will not be able to determine the value of the business.
- Consider working with a business broker who can help you reduce risks. Most brokers are hired by the seller of the business however, for a first-time business buyer, it may be worth paying a commission -- normally a percentage of the business purchase price. Or, consider hiring a broker only to conduct specific tasks -- for example, pre-screening businesses for you.
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