The basic concept of business value is that the future benefits (returns) of owning a company must be adjusted (discounted) for the risks associated with owning the company. The sales or earnings of a company are typically used to represent the benefits (returns). Multiples and rates are used to represent the risks. The basic formula of business value is - Value = Returns/Risks. This article will address how to quantify the returns of a business.

Earning Capacity
There are many benefits to owning a business (financial and non-financial). Non-financial benefits like: being your own boss, controlling your own destiny, prestige, etc. are impossible to quantify, so valuation focuses on the financial rewards. The returns from a company are generally measured by its ability to generate earnings (earning capacity). The value of a company that does not have earning capacity comes primarily from its tangible assets.

Earning capacity is not just the net profits from financial statements and tax returns. Net profits must be adjusted to compensate for accounting principles, tax regulations, and related party dealings that do not accurately portray what really happened. Cash flow is considered a purer form of earnings because it is not affected by accounting principles and tax regulations. For these reasons cash flow is the preferred measure of earning capacity for valuation purposes.

The earnings of a small, owner-operated company must do two things. First it must provide adequate compensation to the owner for the services he or she renders to the company. Any remaining cash flow or earnings represent the earning capacity of the company.

Many small businesses don’t earn enough to provide the owner with adequate compensation. Some of these companies have existed for decades, have established customer bases, and have excellent reputations.

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A valuation is based on a hypothetical sale of the company, so two critical issues need to be well defined from the beginning – 1) exactly what is being sold (valued), and 2) who is the most likely buyer.

What is Being Valued?
Businesses are generally sold in two types of transactions – asset or stock sales. A stock sale involves selling the shares of the stock of a company that operates as a corporation. Most buyers are not interested in a stock sale because it involves acquiring liabilities – existing, contingent and potential. An asset sale gives the buyer a clean start. Therefore, stock sales of small businesses are not common. Many valuation methods produce results based on stock sales, so the results must be adjusted accordingly.

Asset sales involve selling the main operating assets of the company. That typically includes inventory; furniture, fixture and equipment (FF&E); leasehold improvements: and all intangible assets, commonly referred to as goodwill. The intangible assets include items like: customer list, trade name, telephone numbers, assembled workforce, etc. These assets are typically sold free and clear of all liabilities. Cash, trade receivables and payables, and miscellaneous assets or liabilities are commonly excluded from the sale. If the owner also owns the company real estate, it may or may not be included in the sale. The sale will also include the assignment of existing leases or contracts, or will be contingent on the buyer obtaining new ones. If the company operates under a franchise agreement or needs a specific type of permit or license like a liquor license, the sale will include the transfer of these items.

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As a business owner, you know more about your business than any one, but there is one thing you are not too sure about - how much it is worth. This is the first in a series of articles designed to help you learn about business valuation and, if you choose, do your own business valuation.

Defining Value
Before we begin discussing business valuation it is important to define what value is. When asked, most people will struggle to define it then end up using an example like a one dollar bill is worth more than a quarter. Value is difficult to define without comparing at least two items. The comparisons must be well defined to have any meaning. For example a rare quarter may be worth more than a common dollar bill. The first step in any valuation is to accurately and completely define the property that is being valued.

Value is also subjective.  Someone who needs a quarter to plug a parking meter in order to avoid a parking ticket would gladly pay a dollar or more for a quarter. Similarly, one business may have a number of values. A strategic buyer that can plug the customers of the business into its existing system may perceive more value than a person who is going to run the business day-to-day. The second step in valuation is defining for whom the property is being valued.

What is a Business Valuation?
A business valuation is simply an estimate of what a business is worth based its hypothetical sale. It may also be called a business appraisal and has some similarities with real estate appraisals.  A big difference is that much of business value is in the form of intangible assets, or goodwill. Valuing intangible assets involves a process of using various accepted valuation approaches and methods. The goal is to determine a value that can be explained and justified to others.

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Let the Buyer (ALWAYS) Beware
As a proper thinking entrepreneur, you have decided that the pizza place that’s been on the corner of your street for 15 years - and is now for sale by its original owner - would be the perfect business to buy.  You have some cash on hand, you know that the owner is willing to provide a loan for the balance (at a below market rate), and you have worked your way up through the fast food jungle from counterperson to assistant manager. All the stars appear to be properly aligned, so what could possibly go wrong?  Well, let’s think about the asking price for a minute.  Pay too much and you may find that it will take a lot longer to reach profitability.  Pay too little and…well, that almost never happens, does it?  How do you value an existing business for sale?

How to Value a Business For Sale
Any existing business has some intrinsic value, even if it’s on its last legs.  Maybe the equipment can be pawned or resold, or perhaps the brand name still pulls in a few customers.  There are many ways to calculate the fair value of an existing business - successful or otherwise - but it rarely makes sense to take the owner’s word for it.  At the very least you will want to apply your own metrics to the process.  It usually makes good fiscal sense to get a business valuation done by a professional or, at the very least, by a trusted yet disinterested third party.  Sad to say, there are literally dozens of methods that people use to determine the value of existing businesses for sale.  Not all of them will apply to the company your eye is on, but there are some basic rules worth following.

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When the full content of the deal in its entirety is fully explored and strongly considered … price, financing terms and conditions, taxes, debts, real estate, sellers goals, and the qualifications / resumes of all parties involved are all factors that should be fully considered in a well thought out deal.

“If I could get $X for my business I would sell it today.”
“I need to get $X to sell my business.”
“I know my business is worth $X.”

The above are comment statement s and feelings business owners share in the consideration of the sale of their business.  But no business operates within a vacuum and many factors affect the business outside of the business including the rest of the industry, and local, regional and worldwide business climates.   What sort of a return should one get on a business purchase is somewhat relative to what one can achieve in other investments.  If one can expect a double digit return on a conservative investment, this may drive up what one may expect from a riskier investment in a business.  But as investment returns on fairly conservative investments go down, interest in business acquisition may go up, and expected / projected returns reduced.  The price of your business is not determined in a vacuum as well.  The terms of the sale, the other party or parties involved with the sale, financing and terms, and the timing of the sale are a few of the important factors (outside of price) that can greatly affect the success of a sale.

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Start a Franchise Business
Many small-business owners reach a point where their company’s success makes them think of expansion.  One possible way to enjoy additional income involves opening a second location, and then adding more as time and cash allows.  But an increasingly popular method involves franchising your business.  The franchising process will allow you to earn significantly more in both fees and royalties than you could ever hope to make by running multiple locations on your own.

The Process of Franchising
Franchising opportunities are available no matter what kind of business you run - whether it involves retail or wholesale locations, a mobile operation, or even a work from home situation.  The question of how to start a franchise rests upon several basic elements, all of which must be present in order to be successful.

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Over the years, I’ve heard a million horror stories from business owners about their experiences with some of the “fly by night” business brokers out there.  It’s always the same names and it always makes me wonder, “How did you get hooked up with these people?  Why did you hire them?”  I mean, I’ve seen some of their work and it’s TERRIBLE!

So, of course I feel bad for the business owner and I begin to question my ability to market my business brokerage services.  If only I had been there first.  If only these folks knew to call me or one of the other good credible brokers out there rather than the yahoo they ended up using.  Yes, you heard me right; there are a lot of good credible business brokers out there.  The problem is, there are a lot of bad, unqualified brokers out there as well.  I’m in the business so it’s easy for me to tell the difference.  But how can you, as the business owner, tell the difference?

Well, that’s a tough question to answer but I’ve been giving it some from thought and I’ve decided that the most important factors that separate the good business brokers from the bad are:

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The Basic Business For Sale Agreement
Whether you are buying a business or selling one, a certain number of legal papers are a necessary part of that transaction.  One of the most important is the Business For Sale contract.  While the exact form of this document may vary from state to state (or from country to country) depending upon various laws that govern the sale of a business, every Business For Sale agreement will have common provisions regardless of the jurisdiction in which it is filed.  Much of the language may be considered “boilerplate,” which is a block of text that can be reused from one contract to the next.  The purpose of a Business For Sale contract is to explain, in great detail, exactly what is being sold to the buyer, at what price, and under what terms.

Standard Contract Provisions
The Business For Sale agreement will begin with something called “recitals,” which include the names of the two parties involved in the transaction and explain the purpose of the document.  It will go on to list a definition of terms, so that there is no misunderstanding by either side as to the meaning of such words as “stock,” “transfer date,” “warranties,” and so on.  There may also be sections that address the following elements:

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