Tuesday, October 30, 2007

Why The Value of Your Business Isn't Based on your Efforts

Many small business people believe that their business an unrealistically high price. Here is one of the arguments that I have heard to justify excessive valuations and the problems with that argument.

A very emotional reason is that the business owner has put his heart and soul into the business. When I asked one owner why he thought his business was worth $1,000,0000 he answered “I’ve put 19 years of my life into this business. That’s the minimum that 19 years of sweat is worth.”

As delicately as I could, I pointed out that a buyer is going to look at the business as an investment. The buyer wants a reasonable return on his investment, regardless of how much effort has been put into the business,

Imagine yourself in a buyer’s shoes for a moment. You are considering buying two businesses. Business A has a dedicated owner who works dawn to dusk. Over the last five years it has been running at break even. Business B has an owner that works 5 hours/day, and throws off $100,000 in profits every month. Which business is worth more to you?

Since buyers are interested in profits, as an owner charge your clients enough to make a fair return for your time today. Don’t count on a future buyer to make up for your lack of profits today when you sell your company. If anything, taking unprofitable clients to increase your volume of business today will decrease the price of your business when you sell it, because of the decreased margins.

There are a few exceptions that prove the rule. In certain industries, such as payroll or web hosting, the cost structure of the acquired business generally goes away almost completely post acquisition. When a large payroll company acquires a small processor they value based primarily on the gross revenues, because the largest costs, such as software, marketing, and labor, are not relevant. If a small payroll service spends 25% of revenue on software it doesn’t mean that the acquirer will incur a 25% cost for payroll software.

Another exception is in the rare instance where a company has put a lot of money into R&D that is not yet producing revenue. For example, if you own a software company that is about to release a completely new line of software, you can make an adjustment. If, however, your company produces Sudoku Software, the fact that you have a new version of Sudoku software in the works would probably not make a difference in the valuation, because a buyer will view the cost of producing a new version as part of the cost of doing business. However, if you have a new vertical market application for finance companies in which you’ve invested a substantial sum of money, that may merit an adjustment. R&D that produces intellectual property that is defensible (patents, for example) may produce larger adjustments.

2 comments:

Mel Eldridge said...

Interesting post. I want to run a business soon, so I'll keep this post in mind. Becoming, what I hope, an entrepreneur is somewhat new to me, so I can use all the help and advice I can get! I know it'll be tough. Lately I've been thinking about the idea of buying a business instead of starting from scratch. I'm not sure what I should go for. Franchise? Home-based? I don't know. Do you have any suggestions or advice? Thanks!

Victoria Cullen said...

@Mel -- You're right. It will be tough running your own business, but if you stick through it, it can be extremely rewarding. If you really do want to be an entrepreneur and buy a business, then I suggest searching the Internet to what is available in your area. There are sites, like BizTrader.com, which are online global marketplaces where you can buy and sell businesses. They can also provide you with additional resources like finding a lender, broker, etc.
I also suggest checking out current books and magazines for help and advice. Local small business groups can also be very helpful, and it doesn't hurt to network.
Good luck!