Buying a business can be a good deal until you pay for blue sky potential
Many methods can be used to value an existing business.
Many people become entrepreneurs by buying an existing business. This is a good method to get into business for yourself because the business systems have been worked out, unneeded expenses have been eliminated and a customer base is in place. These are all good things for a new business owner because you will have immediate cash flow and lean operations. The only problem is that you probably paid too much for the business.
I have worked with many new entrepreneurs who have purchased an existing business and they just do not know why they are not making the money that was “promised” by the former owner. The new owner just cannot figure out why, at the end of the month, they do not have as much left over profit as was advertised. After investigation, it is clear to me and the new business owner that they simply paid too much for the existing business. They paid for “blue sky potential,” which they are unlikely to achieve. Blue sky is an additional premium paid for goodwill, or the potential to make more money by adding services or products. When buying a business you should pay for the value of the business and not for “blue sky.”
Valuing a business is part science, part art and part trust. The first thing that you must do is review the current owner's “Schedule C” that is filed with the owner’s federal tax form 1040. Obtain the last 3 years’ forms. First, chart out the PROFIT of the business for the past three years to see if the profit is trending up, trending down or if it is stable. Stable profits are a good sign. Now, average the three years’ profit, multiply it by five, and you have a starting point for a negotiation of a sale price. After all, you are purchasing an income stream, and this is what needs to be valued. Most business deals seek a five-year pay back period.
You can also review the book value of the business by reviewing a very recent balance sheet, which can be pulled at any given point in time. Business owners may claim not to have a balance sheet, but their accountant does, and you need to review the current book value of the assets. You may be better off starting a negotiation by offering the owner book value of the business; however, most businesses are worth far more than the book value would indicate.
Some unscrupulous business owners will claim that part of their business is “cash sales,” implying that some income is not reported on their Schedule C. If the owner states this, run away from the deal and find a different business to buy. If the owner is willing to lie on their federal tax filings, they are just as likely to lie to you by misrepresenting their business.
So, you will have to measure the profits of the business, review the current book value of the business, and trust that the owner is transparent in their dealings to apply a proper value to the business. After all is satisfied, you can make a purchase offer. If you would like assistance in valuing an existing business, you may reach Michigan State University Extension educator Paul J. Werner at the following phone number: 906-524-6300.