Business Valuation – Why the Asking Price of a Business Can Differ From the Actual Purchase Price

The other day I came across a social media site and noticed an old post. Someone was asking a question about how to value a business. Ten people were good enough to answer. I was not surprised when all 10 replied with completely different methods on how to value a business. You have to assume that people taking the time to answer the question were reasonably confident that they knew the correct answer. It made me wonder where they actually got the information from and how much confusion this subject creates with almost everyone including accountants and business brokers. I can hear you asking how to go about establishing the asking price of a business.

This is the method a Business Broker will use to determine the asking price of a business.

The method below is used by business brokers to determine an asking price for a small business; it is based on the adjusted net profit using the most recent profit and loss statements. The business broker will look at all the business expenses to see what they can add back to profit. This is referred to as add backs or recasting. The adjustment is made by adding back to the net profit all the non essential or discretionary expenses not necessary to run the business to show a more accurate net cash flow for the owner.

The business may also have unaccountable business expenses. A good example may be the rental expenses, if the business owner also owns the freehold and is only selling the leasehold you would need to ensure that the rental expenses are correct and adjust the profit if necessary, in this case it would be adjusted down.

Once this number is determined, the next step a business broker will take is to multiply the adjusted net profit, usually by 2.5 times, and they have an answer.

Let me give you an example of business broker method.

Business A; Established 12 years, trades 9-5 Mon-Fri with consistent sales, strong industry growth, selection of quality suppliers, and abundant customers etc.

Business B; Established 2 years, operates 7 days a week, sales are inconsistent, cut throat industry with aggressive competition, and it only has one customer.

Both businesses A and B show $100,000 adjusted profit after the owner operator wage is taken out. The business broker will then use the same multiple on both businesses i.e. 2.5 x $100,000 = $250,000. This will include stock, the written down value of the plant and equipment and the goodwill.

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