There are two broad ways of going into business for oneself. You could either start from scratch or purchase an existing business. Starting from scratch has the advantage of allowing you to shape the business exactly as you want it. Purchasing an existing business also has advantages, such as an existing location that is often hard to find, and ideally, a track record of proven performance.
Business Owners who start from scratch have to do many months of preparations to ensure that the business idea can indeed turn a profit. However, those who purchase an existing business should apply the same level of diligence to ensure that a fair price is paid and that no nasty surprises are hiding around the corner. Always a good idea to do a proper financial analysis by a professional consultant.
Calculating the value of a business is a tricky exercise because there are so many variables that should be taken into account. The help of a professional is recommended. However, there are a few basic principles that prospective business owners can keep in mind to get the negotiations ball rolling.
Most people enter into business for themselves to fulfill a particular passion or to be their own boss, but although these are the main driving factors, everyone does so with the expectation that the business will pay them to do so. The easiest way to find out whether the business can afford its new owner is to look at its cash flow or do a proper financial analysis. This figure also makes a big contribution to the price the seller is going to ask.
Although businesses can generate cash flows from investments or by extending credit, the cash flow most pertinent to the health of the business is the operating cash flow. Operating Cash Flow is simply the money paid to the company by customers (its revenue or turnover) minus the money paid to suppliers. This is the money generated by the company’s core operations.
A company’s cash flow statement is different from the income statement and balance sheet because it does not factor in cash that will be coming into or leaving the business in the future. While the balance sheet and income statement calculate the company’s net earnings, it is the revenue recorded on the cash flow statement that is all-important in determining the health of a business. A company might show huge net earnings without being able to pay its bills. If a company records high earnings growth but little growth in cash flow, it is usually because it has sold the product or service on credit, in other words, there are many people owing the company money. While debtors are good for business, they can be bad for cash flow. If these debts turn bad, the company could be in serious trouble.
The cash flow statement gives a good indication of future revenue through its recording of past performance. Therefore, if a person is looking to buy a business and renovate it, the ash flow statement gives a good indication if there will be enough money available to pay for any plans that the new owner may have.
FREE CASH FLOW
One of the disadvantages of only looking at cash flow to determine the sales price of a business is that it does not include capital outlay for fixed assets. Capital outlay is any expenditure on assets that is paid off over a term longer than a tax year. Capital outlays can vary dramatically from industry to industry. Compare, for instance, the heavy machinery that has to be purchased by manufacturing companies, with the rent of an office and an IT infrastructure for some service industry companies. The cash flow that is available after provision has been made for capital outlays is called free cash flow.
Increasingly, free cash flow is being factored in to determine the asking price of a business. Some companies that report massive cash flows have little free cash flow because of the expensive equipment used in manufacturing the product. When a company reports its earnings on its income statement, it is possible to prop up the final figure through clever accounting. This is much harder to do with free cash flow, which is why it is an effective tool to determine how much the company generates for its stakeholders.
Another calculation often used to determine the business price is earnings before income and taxes – (EBIT). This figure is the operating revenue plus the non-operating revenue, minus operating expenses. This calculation allows the owner to know how much money can be taken from the business as a personal salary. After the money that the owner wishes to take out of the business is subtracted from the EBIT, the money that is left should be around 25% of the asking price of the business. For instance, if the business generates R1 million a year and you or the manager requires a salary of R400 000 for the year, what is left of the earnings before interest and taxes for the company comes to R600 000. A good price for the business would therefore be R2,4 million, because R600 000 is 25% of this total.
The EBIT of a business is a broad tool and differs considerably in practice. In general, the higher the price of the business, the higher the percentage of EBIT left after subtracting the owner’s salary would be. The age of the business would also determine the EBIT, with more established businesses able to command a higher percentage. Businesses that operate in a riskier space should charge a lower percentage.
EBITDA is another ratio that is often used to valuate companies. It is the earnings before income and taxes, with depreciation and amortization added back to the figure. The figure shows the profitability of the company, regardless of the way its operations are financed, through credit or cash, for instance. This figure shows whether a company is able to service debt in the long run, and is therefore an especially popular valuation tool for companies that own expensive equipment that must be paid off over a long period. EBITDA is therefore a good indicator of the company’s profitability, but not its cash flow.
The value of the assets owned by a business plays a major role in determining the sale price of the business. Many business owners do not wish to part with every asset in the business when they move on. It is therefore important to receive a list of every item that forms part of the transaction and not to simply assume that all business assets are included in the price and will automatically be transferred to the new owner.
The aforementioned ratios are some of the ones used most often to arrive at a good selling price. There are many more than these available, and volumes have been written on how to determine business value, with intricate and confusing formulas being used by people with master’s degrees in economics. While these calculations can go a long way to provide a clear cut value, the human element should not be disregarded. A prospective business owner who is serious about making a success of the business about to be purchased should not be afraid to break a sweat when analyzing the value of the business. This means not only perusing the financial statements of the business, but to actually be familiar with every inch of the physical premises and the employees that will still be there when the owner departs.By visiting a company, one can get a feeling for the strengths and weaknesses of the business that may not be apparent from the financial statements alone. One gets to see the managers in action, as well as being able to gauge the demographic composition of the average clients.
PREPARING YOUR BUSINESS FOR SALE
“Rick Grantham” of Quickberry gives the following guidelines for the sales process:-
Phase 1 – Preparing for sale:
This is after you have made the decision to sell and before you actually take the business to the market. It involves documentation, business plans and researching potential acquirers to approach.
Phase 2 – Initial discussions with interested parties:
Run through what to say and what not to say, and develop tactics for each prospect. For example, how do you answer a question like: “How much do you want for your business?”. The response can potentially cost you millions!
Phase 3 – Selecting the acquirer:
You may not want to go for the acquirer who offers the most money. There are a number of issues relating to structure and credibility that need to be taken into account.
Phase 4 – Closing:
This is so critical, and it is amazing how many deals fall apart at this late stage. The simple rule is: the longer it takes to close (i.e. the money changing hands), the more likely the deal is to fail.
8 KEY TIPS TO GETTING THE BEST PRICE FOR A BUSINESS:
Actively look for buyers.
Never have only one potential buyer.
Look for strategic buyers.
Look internationally as well as locally.
The value of your business can only be assessed by a buyer.
Be well prepared.
Choice is critical.
Sell the future, not the past.