Ask an Expert
Cost of a Business
Expert: Lorne Siebert
Dan Walters asked:
What is a company worth. One of the suppliers for the company I work for has approached me to become a partner. It is a sole proprietorship and has been earning $70,000 per year for the last 3 years with the proprietor holding a full time position elsewhere. The rough plan is to set up a corporation with me as the business manager. Profits will be split based on shares and my share will grow as the company grows. What should my buy in be? Or who should I turn to for help on evaluating this opportunity.
Lorne Siebert answered:
There are a few issues that you need to consider. Of course, the first one is how much you are going to pay for your interest in this company.
The typical equation for evaluating a business would be annual earnings multiplied by an earnings multiple. So if a company earns $1 a share and the company's shares are now trading at $20 on the stock exchange. The price earnings multiple would be 20.
A public company can easily be 20 but private companies are no where near that, generally speaking. In after tax earnings they could three to eight times a multiple. So if the multiple was three that would equal $210,000 as a total value.
Now having said that that is a very simple formula, which may be, total worthless in arriving at the real price. The big question is what are the risks that are inherent in achieving the $70,000. Here are some questions that need to be asked: If the $70,000 in earnings is dependent on the skills of a particular individual, and if that individual is no longer in the business, will it fail? Does one customer or account make up 50 per cent of the business? If you lose this customer your profits are also lost. I wouldn't be paying a lot of that kind of business.
Another factor is whether or not the company has something that is uniquely it's own that no one else has, such as a certain technology. If you buy the business you gain access to that product. That can make the company worth more. What is this company's unique advantage?
Ultimately though, if this company makes $70,000 and has no hard assets like equipment or property it's going be worth a lot less than a company with a lot of hard assets. So your downside risk, is that if the company doesn't work out you've got these assets you can sell to recoup some of your investment. The more hard assets there are the higher the price.
The amount of assets over and above the hard assets is called goodwill value. The more unique properties the business has, and to the extent that business can be transferred over to another owner and still continue to make a profit, the more it's worth.
I suggest that there are a couple more issues that you need to consider. The first is what are you really getting into? I wouldn't underestimate the relationship you have with the other owner. You want a written shareholders agreement as to how you're going to split the profits, how much you're each going to put into the company, what's your exit strategy if you want to leave.
Do your homework
The next issue is how do you know what you're doing is right? For example, this person who owns the company today says it's been earning $70,000 per year for the last three years. That's a good start for information on which to base a decision. But how do you know that information is right, or that it's not distorted? It could be an average of $70,000 over the three years meaning in one year it made nothing and the next $140,000.
You have to some basis on which you believe the information you are being presented with. A major element of due diligence when you purchase a business involves asking what you're getting into, what the business does, how much it really makes, how did the earnings arise, that is from what products or services. You've got to do some homework on the businesses you're getting into.
From your question it sounds like you are not part of this business today. It's one thing to get involved with something you're familiar with and it's another thing to get into a different kind of business where your knowledge factor is a lot lower. It's pretty typical for a manager or employee to end up buying an interest in the company. There's a comfort level because you know the person you're working for. Presumably, you would also know how the company works and have some concept of its ability to continue to earn $70,000 a year.
Why does the owner want to sell?
You also need to ask why this person is wants to give up a company that is making $70,000 per year while they hold another full-time job. Is something happening in this business, such as a major change, so that it's not certain that you're going to earn $70,000 next year. What is going on in the business and the industry in which it functions? That's critical to know.
For example, if you have a particular product that you sell and all of a sudden a competitor comes into the market with a brand new product which is much better and takes your market away. Or the product could be just as good as yours but priced lower. Now your gross profit margin has eroded and you don't make anything any more because of the competition.
Where to find help
As far as seeking help, certainly business valuators assist in this area all of the time. What you don't need though, is a business valuation report. You only need to do that if the report is for a third party. Such as being in litigation and you want to convince a judge what the value of the company is.
You need verbal advice. That's usually obtained by the hour. There are probably two areas you can find this help. Either a Chartered Business Valuator who is familiar with how businesses are bought and sold or secondly, it's pretty typical that small business accountants have a fair amount of knowledge in this area. So maybe your local Chartered Accountant who has worked with small businesses. They're going to see this issue all the time.
It's not a cheap service, it's high level advice. But if you're going to get involved with something like this where you're writing the cheque out of your own bank account, it's going to be a big cheque. Good advice is important and doesn't have to cost a lot, compared to the money you're going to spend on this business.
About the author
Lorne Siebert is a senior business valuator with Clark Valuation Services Ltd. He is also sits on the Board of Directors for The Canadian Institute of Chartered Business Valuators (CICBV).