Many business buyers try to use a rule of thumb to value a business. This is a valuable tool but if you actually try to purchase a business based on it, you are sure to regret it later. Last week I received a call from an experienced restaurant manager that wanted to buy his own restaurant. He wanted me to confirm that restaurants were selling at 3 to 5 times net profit. I told him that they were not selling in that range in the current market. He insisted that he had seen comparable to prove they were. I thought this would be an interesting subject for an article.
Rules of Thumb – Business Valuation Pitfall?
When valuing a restaurant or any business by using rules of thumb you need to have an accurate profit figure. This is rarely available. There are so many definitions for net profit that there is a book used in the IBBA (International Association of Business Brokers) training class to teach calculating profit that it is actually 6 inches thick. This is not a book for CPAs but just business brokers.
Lets assume we have now come up with a profit figure that works for our purposes. The rule of thumb must clearly specify what profit figure it is based on. There are “Sellers Discretionary Earnings” EBIT (Earning before interest, and taxes but after reasonable salary for the owner) and “EBITDA” (Earnings before interest, taxes, depreciation and amortization) just to name the 3 major profit figures used by business brokers. The rule of thumb, if one exists is different for each of these three methods.
Lets assume you now have a profit figure and a rule of thumb. Lets assume the rule of thumb is 3 times net profit.
The problems with rules of thumb still would have to be addressed. Rental amount, type of restaurant or business, franchise or not, all are not addressed by a rule of thumb. Would you pay the same price for a restaurant with $2,000 rent as $10,000 rent even if they both had the same bottom line? I wouldn’t. $50,000 is a salary not a business investment.
The next big issue then comes forward: Would you pay $150,000 for a business clearing $50,000 with the owner working 60 hours a week, if there were similar businesses available for $450,000 that were making $150,000 profit, with the owner working 60 hours a week?
I hope this is of some help in navigating the river of misinformation floating around regarding how to value a business.
Creative Commons Attribution: Permission is granted to repost this article in its entirety with credit to Business Buying Services and a clickable link back to this page.
Business Valuation Pitfalls: Using Rules of Thumb to Value a Business
/in Articles/by Willard MichlinMany business buyers try to use a rule of thumb to value a business. This is a valuable tool but if you actually try to purchase a business based on it, you are sure to regret it later. Last week I received a call from an experienced restaurant manager that wanted to buy his own restaurant. He wanted me to confirm that restaurants were selling at 3 to 5 times net profit. I told him that they were not selling in that range in the current market. He insisted that he had seen comparable to prove they were. I thought this would be an interesting subject for an article.
Rules of Thumb – Business Valuation Pitfall?
When valuing a restaurant or any business by using rules of thumb you need to have an accurate profit figure. This is rarely available. There are so many definitions for net profit that there is a book used in the IBBA (International Association of Business Brokers) training class to teach calculating profit that it is actually 6 inches thick. This is not a book for CPAs but just business brokers.
Lets assume we have now come up with a profit figure that works for our purposes. The rule of thumb must clearly specify what profit figure it is based on. There are “Sellers Discretionary Earnings” EBIT (Earning before interest, and taxes but after reasonable salary for the owner) and “EBITDA” (Earnings before interest, taxes, depreciation and amortization) just to name the 3 major profit figures used by business brokers. The rule of thumb, if one exists is different for each of these three methods.
Lets assume you now have a profit figure and a rule of thumb. Lets assume the rule of thumb is 3 times net profit.
The problems with rules of thumb still would have to be addressed. Rental amount, type of restaurant or business, franchise or not, all are not addressed by a rule of thumb. Would you pay the same price for a restaurant with $2,000 rent as $10,000 rent even if they both had the same bottom line? I wouldn’t. $50,000 is a salary not a business investment.
The next big issue then comes forward: Would you pay $150,000 for a business clearing $50,000 with the owner working 60 hours a week, if there were similar businesses available for $450,000 that were making $150,000 profit, with the owner working 60 hours a week?
I hope this is of some help in navigating the river of misinformation floating around regarding how to value a business.
Creative Commons Attribution: Permission is granted to repost this article in its entirety with credit to Business Buying Services and a clickable link back to this page.
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Buying the First Business: I had never negotiated to purchase a small business before…
/in Client Comments/by Willard Michlin“I had a long background as a corporate manager before deciding to purchase my first business. I knew how to value a company and how to negotiate in many settings, but I had never negotiated to purchase a small business before. So, I knew what I wanted to achieve, and figured I had what it took – but I had no idea how to ‘get there’.
“From the initial offer through the beginning of escrow, Willard advised me every step of the way. He coached me in detail about each interaction with the seller and each key tactical choices. As a result, I got where I wanted to get and actually exceeded my objectives. Without WIllard’s help, it is very possible I would have overspent by an amount several dozen times his fee.”
—Pat C, Northern California
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Business Buying Process Consultation: Your company is doing a lot to educate people…
/in Client Comments/by Willard Michlin“I would tell people to see Willard first. Your company is doing a lot to educate people to help themselves while buying a business.”
Creative Commons Attribution: Permission is granted to repost this article in its entirety with credit to Business Buying Services and a clickable link back to this page.
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Business Evaluation Consulting: I developed a better understanding of how to evaluate leases and business financials.
/in Client Comments/by Willard Michlin“I developed a better understanding of how to evaluate leases and business financials.”
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Business Due Diligence Services: …did a thorough job.
/in Client Comments/by Willard Michlin“Willard took care of all my demands. He got all the right papers and did a thorough job on the due diligence. I was totally satisfied!”
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Experienced Consultant: As opposed to other brokers who straight out lie and don’t even try to get you the financials…
/in Client Comments/by Willard Michlin“Willard is VERY experienced and very honest! You know that if you are buying a business from him that his listing prices are in-line and you know you are getting a good deal. As opposed to other brokers who straight out lie and don’t even try to get you the financials-never mind their accuracy.”
—Kathleen Hambley
Independent Broker Analysis: … I could trust and rely on him…
/in Client Comments/by Willard Michlin“Basically, Willard gave me help acting as an independent broker. He was on MY side and so I knew I could trust and rely on him. The listing broker wasn’t on my side at all and actually wouldn’t help me at all! This service is very valuable as buyers need all the help they can get and you can rest easy knowing Willard is on your side.
“Willard with his experience gave me other points of view—which I never thought of—to help me evaluate the business I was looking at buying. He looked over the financials and told me things that my CPA never would have caught or recognized.”
—Ron Dennis
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Neutral Third Party Business Evaluation: Independent verification of seller’s representations, at an affordable price
/in Client Comments/by Willard Michlin“I really like your Due Diligence service. I believe it fills a need for people who are looking for an independent verification of seller’s representations, at an affordable price. I will definitely recommend you to my future business acquisition clients as a practical alternative to hiring an attorney.”
Business Buying Horror Story: Pizza Parlor – He Did Not Do Any Due Diligence On Any Level
/in Business Due Diligence Horror Stories/by Willard MichlinPizza Parlor in San Fernando Valley, California: This is an interesting deal. “Joe” the recent purchaser had been in this business before, some years back. He also saw our Due Diligence 101 article on one of the Business for Sale websites. When asked why he did not hire us to do even a quick preliminary review of the purchase, he responded, “I really should have. I was stupid.” He realized that he really got taken to the cleaners.
When I asked again, “Why he didn’t contact us he explained “I figured the fee might be a lot of money and did not want to spend any more then I had to.” When I asked how much he thought it would cost he said, “I figured a few thousand dollars, but I didn’t even ask.” That falls under the old saying “An ounce of prevention is worth a pound of cure.” A better one might be Read more
Business Due Diligence: My husband and I were fighting over whether to buy the business…
/in Client Comments/by Willard Michlin“I would definitely use Willard again. He gave us excellent service. Without Willard’s services we would have bought the business. He put my mind at ease. Thank god I can sleep at night. “Willard saved my marriage as my husband and I were fighting over whether to buy the business. I wanted to buy it and my husband not. I found Willard so I could get a professional opinion; we were in escrow just about to close and I got Willard’s advice just in time! It saved us and showed us we were paying way too much for the business. We of course backed out of the deal. “Because of Willard, when I drive by the business and see it I don’t feel any loss—what if’s— as I know I did the right thing. And god knows if we had bought it and been under further financial pressure our marriage might have been at stake.”