Calculations involved with buying a business
How to calculate the value of a going concern
When buying an existing business you will need to negotiate with the owner but it is always easiest to agree on a formula.
Standard Bank’s advice on determining the value of a business includes the following formula:
- Net worth of the business – liquidation value of the assets minus the liabilities
- Your present earning power – annual earnings with an equal amount of net worth (say 15%)
- Add a reasonable annual salary for owner or manager
- Average earnings required (item 2 plus item 3)
- Determine the average annual net earnings of the business (net profit before owner’s salary) over the last few years
- Extra earning power (item 5 minus item 4)
- Ask yourself over how many years you are prepared to sacrifice the extra earning power of the business to pay for the goodwill (item 6 multiplied by item 3)
- Final price (item 1 plus item 7)
Get a professional valuation
It is well worth the time and expense to get a professional business valuation. An accountant or lawyer can help locate the right professional. Inexperienced sellers have a tendency to set a price before they have established the value in the real world. Valuation is based on quantifiable criteria, not the owner’s personal estimation. To avoid this mistake, get an objective third-party valuation.
There are different approaches to valuing a small business. These include assets-based, income-based and market-based valuations.
This is the simplest way to value a business. Examples of tangible assets include accounts receivable, furniture and fixtures, equipment, inventory, customer contracts, vehicles, leasehold improvements, prepaid expenses (paid insurance premiums for example), franchise agreements.
If you own the real estate that your business occupies you may be better off selling it separately from the business, which means it won’t be part of this valuation. However, if the business is dependent on the current location, then add the value of the real estate in this step.
The income-based approach determines the value of a business based on its ability to generate desired economic benefit for the owners. The key objective of the income-based method is to determine the business value based on income statements. Some valuators prefer to use the company’s income before depreciation, interest and tax while others do not. Much depends on the type of business that is for sale.
The market approach based valuation method is based primarily on the market price for similar businesses at a given point in time.
Preparation for sale
First impressions make a big difference. Before buyers come to see the business make sure the offices are neat and clean. Remove any unnecessary clutter. Shred old documents. Replace worn out and broken furniture. Update signage.
Confidentiality is important
If the word gets out that your business is on the market, it could adversely affect sales and your relationship with your staff. A good broker will know how to simultaneously market your business and maintain strict confidentiality. Consider your employees. Decide how and when you will communicate the sale with your employees.
- Update your company’s financial statements
- Buyers will typically require 2 to 3 years of financial statements (profit-and-loss statements, balance sheets and/or tax returns) for their evaluation.
- Make sure you have supporting documentation for nonoperational expenses (fringe benefits such as your personal health insurance).
- Prepare a simple list of the business’s important furniture, fixtures and equipment.
- Document your inventory.
- Clean-up your accounts payable and any pending legal, employee or environmental issues.
- Organise your legal paperwork such as operating licenses, property leases, customer agreements and insurance documents.
How to calculate the goodwill equation
The intangible known as ‘goodwill’ is a key consideration in a business’s value. Goodwill may range from a long-established distribution network to a sterling market reputation. And sometimes a buyer will pay top dollar to obtain a business with great goodwill. While there is much talk of goodwill when businesses exchange ownership, but the concept can be vague in some people’s minds so it’s something you need to discuss.
Generally speaking, goodwill can be calculated by working out the difference between the book value of the assets (equipment and stock) and the selling price of the business. Make sure you check the stock and all the assets and don’t take on anything that is damaged. You will need to do a stock take again on the day you take over the business to determine whether there is any discrepancy between the amount of stock agreed upon when the purchasing price was decided and what you are actually getting.
How do you value a business owning only ‘Intellectual Property’?
The approach to valuing intellectual property depends on the specific circumstances and type of intellectual property to be valued.
We value a business on the same basis that we value any other asset such as a building or a machine, and we would look at four approaches, market price, historical cost, replacement cost and income stream,” explains Faan Wolvaardt Trademark Manager at Bowman Gilfillan.
“In terms of market price, it would be difficult to attach a value as there probably isn’t enough comparable information. Historical cost would also be problematic especially if it’s a trademark. When trying to determine value measured against replacement costs this method would also be difficult as the cost and the value are not the same,” Wolvaardt says.
The income stream valuation is the preferred method if we are dealing with trademarks. This value would be based on the future economic benefits produced by the intellectual property. “We can accept that the value of the trademark equates to the amount that the trademark proprietor would have paid in royalties if the proprietor didn’t own the trademark. The calculation revolves around turnover, royalty rate and the expected life of the brand and that gives the future income stream”, explains Wolvaardt.
Current and future money
The future income can be converted into current money by means of a standard net present value (NPV) calculation. In finance, the net present value (NPV) or net present worth (NPW) is a standard method for using the time value of money to appraise long-term projects. Valuation is not a science, but an external judgment.
Because of the increasing importance of intellectual property in a company’s valuation, turning ideas and innovation into profit is, and will continue to be, one of the biggest challenges facing business.
What is meant by the term ‘acquisition’?
There’s only one real way to achieve massive growth literally overnight, and that’s by buying somebody else’s company. Acquisition has become one of the most popular ways to grow today. Since 1990, the annual number of mergers and acquisitions has doubled, meaning that this is the most popular era ever for growth by acquisition.
Why do businesses acquire other businesses?
Companies choose to grow by acquiring others to increase market share, to gain access to promising new technologies, to achieve synergies in their operations, to tap well-developed distribution channels, to obtain control of undervalued assets, and a myriad other reasons.
But acquisition can be risky because many things can go wrong with even a well-laid plan to grow by acquiring: cultures may clash, key employees may leave, synergies may fail to emerge, assets may be less valuable than perceived, and costs may skyrocket rather than fall. Still, perhaps because of the appeal of instant growth, acquisition is an increasingly common way to expand.
What is the next step after agreeing to a purchase price?
Once you have agreed on a purchasing price, draft a letter of intent. It’s also a good idea to consult with various professionals at this point. Attorneys, tax experts and accountants will all be able to offer expert advice and raise any red flags. Finally, work out the payment terms and bear in mind that paying everything upfront leaves you little room for comeback if problems arise, as well as negatively affecting your cash flow.