Want to Own a Business? Learn Business Valuation

USA Today recently conducted a poll in collaboration with the Allstate Small Business Barometer that shows the best time to own a small business is now. According to this nationwide survey, 61% of the small businesses polled said they were doing well, and almost 80% said their business grew in the last 3 months compared to the same period a year ago. While hurdles still exist, the optimism of small business owners can be attributed to the ability to leverage new technology, and a looser credit environment. This optimism is confirmed by the Entrepreneurs’ Organization’s Global Entrepreneur Indicator, which surveys founders of businesses with at least $1 million in revenues and finds that 90% of the entrepreneurs in the U.S. cite willingness to start a new business in the current economic environment.

Becoming a business owner is a dream for many people. Most of the time, people associate becoming an entrepreneur with starting a business. While starting a business is one way to become an entrepreneur, it is certainly not the only way. What most people do not realize is that buying a business is another way to become an entrepreneur with much lower risks. When you start a business, you have no customers. When you buy a business, you have a proven business model, existing customer base, and cash flow from day one. That is why banks generally do not lend money to people who want to start a business, but are happy to lend money for people to buy an existing business through programs such as the SBA 7(a) Loan Program.

If you want to buy a business, learning how to value a business is an essential skill so you will know how much to pay for a business. Even if you plan to start a business, learning business valuation will help you manage your business better because you will know how your operational decisions drive company value. If you want to sell your business someday in the future, understanding the process of business valuation early will help you plan ahead by developing an exit strategy that fits into your retirement or life goals.

Business valuation may sound like a complicated field of study that only MBAs can understand. Professor Ian Giddy of New York University wrote an excellent briefing to the various business valuation methods used to value companies. While Giddy did an amazing job explaining the business valuation methods taught in business schools, most of these methods are not applicable to the average individual who is looking to buy a business. The average individual is looking to buy a small business with sale prices in the range of $1 million or less. The business valuation for small businesses is different from the business valuation for large corporations, and most of the business valuation techniques taught in business schools are designed to value large companies.

When it comes to valuing a small business, the most important set of financials to analyze is the historical performance over the most recent 12 months. Unlike the free cash flow methods of business valuation that require the business valuator to guess what the next few years of company income and expenses will be, small business buyers are more concerned with proven historical financial performance than projected future financials. Moreover, the most recent 12 months of historical financials determine the majority of the business value since the business buyers want to know that the business is profitable today, not just profitable a few years ago.

Once accurate financials for the most recent 12 months are obtained, small business buyers want to know how much money the owner makes. Ultimately, the business buyer will become the new owner, and the more money the owner makes, the more attractive the business is. Calculating the take-home pay of the owner involves taking the net ordinary income of the business and adding back the owner’s salary, non-cash expenses such as depreciation and amortization, and expenses that are unique to the seller such as interest and the seller’s discretionary expenses that have little to do with the business operations. Once the owner’s discretionary income is determined, an industry-specific multiple is applied to derive the market value of the company.

If you want to own a business, learning how small businesses are valued will help you buy a good business, run a better business, and get a higher price if you sell your business one day. Small businesses are the drivers of the U.S. economy, and the time is ripe to own your own business. Learn what it takes to value a business and improve its value, and join the fellow entrepreneurs in this country to drive our economy forward.

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