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Valuations Factors Affecting a Small Business

Establishing an accurate business valuation is a difficult proposition. This is especially true when small-business operations are involved. Some of the common “rules of thumb” that are usually applied might not be appropriate when a small business is being offered for sale.

For starters, a prospective buyer often will consider an “earnings multiplier” as a short-hand method. The earnings multiplier reflects the buyer's objective for achieving a return on investment. Sales multiples can be virtually meaningless if they are not translated into earnings.

Two areas that seem to cause considerable confusion relate to the multiples for real estate and stock market earnings. Real estate is often priced at close to ten times its net operating income, while stock market prices may be even higher—say, around 20 times earnings. However, these two multipliers might not work for a typical small business. Reason: The risk of owning a small business is generally higher than the risk of owning either real estate or stock.

Furthermore, you must determine the timing involved with a multiplier. Figures based on the prior year's earnings or next year's earnings are likely to differ from an average of the past five years or next five years. This issue must be addressed at the outset.

Another concern is the calculation of “earnings” for this purpose. Does it include amounts paid to the owner in compensation or fringe benefits? What about interest expenses, depreciation and taxes? Make sure you understand the nature of the analysis.

After “earnings” are defined precisely, an appropriate multiplier is selected. This requires answers to the following questions:

*What are the risks faced by the small business? How are they measured?

*What about the values for tangible and intangible assets? Are you including real estate, equipment, vehicles and inventory?

*Has a separate value been established for a seller's agreement to provide consulting services? Does the calculation include noncompete agreements?

*What about patents, franchises and other extraordinary intangibles?

*How is “value” actually defined? Are you establishing fair-market value as opposed to a specific value for a specific circumstance?

Estimating the market value of a small business is especially difficult if there is no definitive marketplace of buyers and sellers. In some cases, there just are not that many prospective buyers in the hunt. The valuation must take this environment and other extenuating factors into account.

In summary: All too often, small businesses are sold and bought at prices that are either too high or too low. Having a comprehensive valuation conducted may avoid some financial pitfalls for entrepreneurs.

 

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