There
are many reasons to want to know the value of your business, not
the least of which, of course, is to sell it.
But it's nice to know the value so you can assess if all your
hard work is paying off. Is this the time to sell, or should you
plug away for another year or two to build income and profit before
finding a buyer?
And if you have a partner, it is good to establish the formula
by which you will arrive at the value when it is time for one
partner to buy out the other.
You can just about be sure that a seller will overvalue the business,
accounting for memories, undeveloped potential, outdated inventory
and sweat. Such inflated values do neither the seller nor the
potential buyer any good. That's the compelling reason for selecting
a proven formula instead of just picking a figure out of the air.
Here is one formula that I've used several times and each time
the final figure has been a reasonable asking price and in line
with the results of applying other formulas to the process.
This is an excellent time of year to do this exercise since you
should have your 1999 figures compiled. While you may initially
find this approach confusing, it is simple, especially when you
have your current financial information available. And the whole
process can be done in a half hour.
Start by getting your year-end income statement (or profit and
loss statement) and your year-end balance sheet close at hand.
Gather a piece of paper, a pencil and an adding machine and you're
ready to go.
REAL EARNINGS
First, you want to find the real earnings of the business. Do
this by starting with the gross sales for 1999. Subtract the following:
cost of goods, operating labor, owner's salary, administrative
expenses and the replacement fund (that replaces the book depreciation
expenses so funds will be available to replace assets as they
wear out.) Do not include interest expense, depreciation or those
one-time expenses (such as flood damage clean-up) that are not
part of the regular operation. The final figure will be the real
earnings of the business. Hang on to this number.
ASSETS
Now place a value on land, buildings, inventory, equipment, furnishings
and fixtures and other tangible assets. Get a total figure for
tangible assets.
WORKING CAPITAL
Look at your balance sheet. If the assets are greater than the
liabilities, there is no need for additional working capital.
If, however, the liabilities are greater than the assets, the
difference in these two amounts is the working capital needed.
Add together the figures you arrived at for total tangible assets
and working capital needed.
CURRENT INTEREST RATE
Use the figure the bank would charge you for borrowing money.
COST OF MONEY
Multiply the total of working capital and tangible assets by the
interest rate.
EXCESS EARNINGS
Use the real earnings figure and subtract from it the cost-of-money
figure.
OTHER FACTORS
Using a zero to six rating scale, zero representing the worst
situation and six the strongest situation, rate your business
in the following areas:
Risk of income-always at risk to growing income assured.
Competition-unstable market to little or no competition.
Industry-declining industry to dynamic, rapid-growth industry.
Company-recent start-up to solid, sound reputation.
Growth-decline to history of significant growth.
Desirability-no status and dirty work to challenges in attractive
environment.
You should have a total somewhere between zero and 36. Divide
your total by six for an average.
EXCESS EARNINGS VALUE
Use the average number (somewhere between zero and six) arrived
at in the "other factors" exercise above and multiply
it by the excess earnings figure arrived at in the "excess
earnings" exercise.
BUSINESS VALUE
Finally, you are ready to find out the value of your business,
that is, what a buyer might reasonably be expected to pay.
Start with the real earnings figure, the first exercise you did.
Add the excess earnings value. The total represents the value
of your business.
Variations on this formula appear from time to time in business-related
publications, often with different terms and sometimes with the
exercises arranged in a different order, but the results are always
the same.
Does this mean you have arrived at the price for your business?
Perhaps. But there are other considerations such as the size of
the down payment, the interest rate, your income needs and your
accurate appraisal of those "other factors" categories.
In addition, the business climate and economic and population
growth rates of your community can be factors.
Generally, however, the figure will be pretty close to what a
sophisticated buyer will want to pay. Even if selling isn't on
your mind, conducting this exercise every six months or annually
will help you understand whether your business is growing, staying
the same or losing ground.
Remember, business success is less about gross sales than it is
about what is left over for the owner.
EXAMPLE
Gross sales $100,000
Cost of goods 58,000
Labor (incl. taxes, etc.) 9,100
Owner's draw 12,000
Expenses 17,500
Real Earnings 3,400
Assets
Land 0
Building 0
Inventory 6,000
Equipment 500
Furnishings 500
Fixtures 0
Total Assets 7,000
Working Capital Needed 0
Current Interest Rate 9.5%
Cost of Money (7,000 x 9.5%) 665
Excess Earnings (3,400 - 665) 2,735
Other Factors
Income 3
Competition 1
Industry 4
Company 3
Growth 3
Desirability 5
19 divided by 6 3.16
Excess Earnings Value (2,735 x 3.16) 8,643
Business Value (3,400 + 8,643) $12,043
Only $12,000? But gross sales are $100,000, isn't my business
worth at least that much? After all, I've worked hard and there
is so much potential. Unfortunately, the answer is "no."
Look again. There is only $3,400 left over at the end of the year.
You've only taken $12,000 in owner's draws, hardly a living wage,
and you have few tangible assets. Unfortunately, there is not
a lot for a new owner to buy. If you were able to lower your cost
of goods from $58,000 to $48,000 and your expenses from $17,500
to $15,000, then your real earnings becomes $15,900.
Following the same formula, your business value would become $64,000.
Why? Because you are running a much tighter operation with a considerably
better profit, thus greatly increasing the value of your business.
n
____________________________________________________________________________
Marcia Pry is a business consultant. She can be reached at Business
Advocates, 503/227-3866, or marciap@teleport.com.
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