There are many ways to value a small service business without real estate. Here is the one we used when we sold our cleaning/restoration business. Let me stress to NOT put any business up for sale without competent tax and legal advice. (This information has been excerpted from my "Cleaning Up: Building Financial Wealth in the Cleaning Industry" Report. If you want the entire 70 pages e-mailed to you just drop me a line at
stoburen@homefrontsuccess.com- no charge- just please read it.)
The Initial Business Valuation System consists of four parts:
1. Owner’s adjusted cash flow divided by
2. Desired return on investment plus
3. The fair market value of your business assets plus
4. The wholesale cost of your inventory equals
YOUR BUSINESS VALUE
Owners Adjusted Cash Flow- So just what does a prospective business buyer want to purchase from you? In the final analysis, from a valuation standpoint, a buyer wants to purchase the future income stream of your company. Most buyers, at least initially, will view buying your company just as a “means to an end.” Your company is just looked upon as a “cash machine”.
After all, that’s the same way you viewed your company when you started out, a “means to an end.” But while twenty years ago you just wanted to pay the rent, your prospective buyer now wants three things:
1. To make the greatest possible return on his investment.
2. To encounter the least amount of business hassles and problems.
3. To have a reasonable certainty that his new investment will not only give him this financial return year in and year out. In addition, he will expect that this “cash cow” will not only continue but even increase it’s output.
4. Finally, the prospective owner will want to eventually do what you’re doing- sell out for a nice profit. After all, you can’t blame him, it’s the American way!
The IBV will help you determine the true profits right now of your business. Why not just use the figure at the bottom of your Income Statement, the “net profit” you show at the end of the year? Because small service business owners traditionally run their companies to show as little net profit as possible. Be honest with me. Aren’t there many, many expenditures in your business that give you a better lifestyle ... tax-free? Even better, most of these “loopholes” are at least arguably legal!
All these tax free perks are wonderful, they’re a great reason to own a small business, and chances are the new owner of your business also will shelter a lot of his income from the IRS. However, most of the value of your business will be based on it’s profits, so you now want to make the profit amount as large as you honestly can. Your priorities have changed with the IBV- tax free perks have no place in the valuing of your business. That why you need to “adjust” your Cash Flow.
First, write down your year end net profit- before taxes, interest and depreciation. Why? Because tax strategies differ for each owner and running a business for tax avoidance is completely different from running it for a profit. The interest charges you are currently paying will likely be paid off during the business transfer, so they will not affect a new owner. And accounting depreciation usually has nothing to do with the true value of your assets.
Now go over your detailed trial balance for the last full year, the report that shows each and every check you wrote, or just go back through your check stubs. List out every expenditure you made that wasn’t absolutely necessary for the ongoing health of your business. We’ll call it your Extra Profits List. In other words, we’re going to recast your earnings as if there was no IRS. (Isn’t that a wonderful thought?)
For example, your country club dues that the business has been paying for years? Will your business suffer if you stop showing up there? If not, add it to your Extra Profits List. Was it absolutely necessary for your wife to accompany you to that cleaning industry trade show last year? Yes, I know she’s shown as the treasurer of your corporation, but would last year’s net profits have plunged if she hadn’t gone? If not, add all of her travel and convention expenses to your extra profits list. In other words, add all of your tax-deductible expenses that benefited you, but not your business, to your Extra Profits List.
Now how do we figure Owner’s Adjusted Cash Flow for a valid expense that can be justified, just not on such a grand scale? For example, obviously your business needs a “company car.” But a Mercedes 560SL? I think not. The only reason for that Mercedes is because you wanted it. And that’s fine, but if you don’t adjust this expense you will suffer on the selling price of your business. So add the 900.00 Mercedes lease payment times 12 months to your extra profits list, but then deduct 250.00 per month times 12 to lease a practical and sensible business vehicle. (How boring!)
You get the idea, our first step in determining Owner’s Adjusted Cash Flow is to determine the total pool of money your business would have available … if you weren’t funding your tax-free perks. In other words, the profit your business would generate if there were no Internal Revenue Service. (Isn’t that a wonderful thought!) Also add in any charitable contributions you made through the business. Charity is a wonderful thing- but it doesn’t belong in the IBV.
Finally, add to your Extra Profits List all the money you took out of your business last year. Whatever you called it, salary, draw, dividends... if it went into your pocket add it in. Your Owner’s Adjusted Cash Flow is starting to look impressive, isn’t it?
But before you get too excited about this huge sum of money, now you must subtract what it would cost to hire someone to do your day to day work in the business. Are you the General Manager? What is the going rate for a quality manager in your area, including fringe benefits? Put it into your worksheet and subtract it from your total. Why? Because remember we’re doing this exercise to determine the Owner’s Adjusted Cash Flow, the amount of business profits a buyer is willing to purchase the rights to.
After all, no prospective purchaser of your business wants to “buy a job”- he can find a job on his own, without paying you a dime! Your buyer wants to buy the money that is available to him without working, as if he would have no future daily role in your business. Now it’s true, in most small service businesses the buyer probably will function as the manager, at least at first. But he deserves to be paid a manager’s salary for fulfilling the job. He shouldn’t have to pay you for the privilege of a job in his new business.
So your Owner’s Adjusted Cash Flow is the total of your book net profits plus your owner’s perks plus all the cash you took out of the business less the amount it would cost you to hire someone to do your day to day work.
Desired Return On Investment- Remember that your business is competing with 1,000's of other investment opportunities. The yardstick by which your buyer will judge all these different places for him to invest his money is called “Return On Investment.”(ROI) This is the percentage of money he can expect to earn for leaving his cash in this investment, your business, for a given period of time.
For example, a money market fund or savings account will yield a ROI of between 2 and 8 percent, depending on where interest rates are. That doesn’t sound like much, but look at it from an investor’s viewpoint. Any risk? Almost none. Any owner involvement required? None whatsoever! Liquidity? Can’t beat it! Just write a check. What’s this mean to you? Your projected return on investment must be better, a whole lot better than the return on a money market fund to entice a buyer to invest in your company.
In fact, few things in are perceived by a potential investor as riskier than purchasing a small service business. When many stock market mutual funds can consistently average a 10% or 11% rate of return over a ten year period, with no ownership involvement, good liquidity and a fairly low risk ratio.... and with the possibility for substantial capital gains, it’s obvious you need to offer a better rate of return to the buyer of your small business.
What’s normal? Your business appraiser will give you a much more accurate and specific picture, but most small service businesses are priced to give a ROI, or a capitalization rate, of between 20% and 50%. Much lower than that and other (safer) investments are too attractive too pass up. Much higher and there isn’t any money left for the new owner. Obviously the higher the ROI percentage the lower the selling price will be for your business. In other words, if your adjusted owner’s cash flow is 50,000 and you divide by a ROI of 25%, the amount your buyer will pay for this income stream is 200,000.00. If we change the desired ROI to 50% your buyer will only pay 100,000.00 for the same income stream your cleaning operation produces. So obviously the rate the percentage your business is capitalized at will have a huge effect on it’s final selling price.
What determines whether the high end or the low end of the ROI scale is chosen? It all comes back to the perceived risk of your business in the buyer’s mind and the amount of owner involvement they think will be required, along with your company’s potential for growth. All the more reason to follow the next two steps in our Business Sale Preparation Process, Dressing It Up and Making Your Business a Turn-key Operation. (More about these in future chapters.) These two steps not only will make your business sell faster, but the buyer will be content with a lower ROI. The result? A higher sales price for you!
If you have a successful, well organized cleaning business, with a long track record of increasing profits, a 33% capitalization rate is a good place to start your IBV. So now you have your owner’s adjusted cash flow, along with a starting ROI. This gives us the amount of money a buyer will pay for your future income stream.
Fair Market Value (FMV) of your business assets- FMV is not what you paid for your business assets. FMV is the amount you would receive in an orderly, planned liquidation. Not a fire sale where you’re taking 5 cents on the dollar, but also not a price dependent on you finding some “sucker.” In other words, Fair Market Value is what your buyer would receive for your assets if he bought your company today and then tomorrow decided to liquidate. (Yes, I know that would be crazy.)
How do you find this Fair Market Value? Don’t depend on your balance sheet. The depreciation schedules you’re using are artificial book values created by the IRS. Much of the time depreciated values have little basis in reality. After all, many business assets of value aren’t even on your balance sheet anymore! It’s time to get your hands dirty.
This weekend (when none of your employees are around) grab a tape recorder, start on one end of your operation and start talking. Set up categories, such as vehicles, office furniture, tools, cleaning equipment, etc. Then list what the item is, approximately when you purchased it, what you paid for it new, and how much you reasonably would be willing to pay for it now, in it’s current condition, if you were to add to your business. (Be honest here!) That is the very best way to determine Fair Market Value- what you would pay for it if you needed it in your operation.
Don’t skimp on determining Fair Market Value. Chances are you have a lot more assets than you realize. After all, you’ve built them up fairly painlessly over time. The temptation is to say, “Oh, I figure everything is worth $50,000.00, more or less." It’s the “more or less” that will kill you here. Your Initial Business Valuation will include 100% of the actual FMV of your assets. So if you miss something that would sell tomorrow for 100.00, you’ve just walked away from a 100.00 bill. You’re going to have to itemize everything sooner or later, so why not do it now and receive a more accurate idea of the value of your business?
Since no one knows your business better than you, you’re probably elected to spend a weekend afternoon developing your Business Asset List. Actually, it’s kind of fun, nostalgic, a real walk down memory lane. If you find something that hasn’t been used for years, or even worse, you don’t even know what it is, mark it for sale now or throw it away.
Your office staff can produce the Business Asset List, but remember it’s important, especially at this stage, to maintain confidentiality about your selling plans for the future. Both employees and customers tend to bail out when they hear your business is for sale. When I had my secretary type my Business Asset List I explained it was for my insurance agent, and yes, he received a copy.
Wholesale value of your inventory- I realize this fluctuates. Right now you want an average to plug into your IBV formula. Your business appraiser will want you to be much more specific.
Now your business valuation model is complete. Your projected sale amount consists of the Fair Market Value of your assets and the wholesale cost of your inventory, along with the capitalized amount your buyer is willing to pay for your future owner’s adjusted cash flow. Now maybe you’re thinking, what about all my customer goodwill, my superb reputation I’ve spent twenty years building? And where is the “blue sky” I’m always hearing about? That’s the beauty of this type of formula. All these “intangible” things contribute to form your owner’s adjusted cash flow, so we really are including them in the IBV when we capitalize your income flow.
This particular Initial Business Base Valuation formula is conservative. Likely a formal business appraisal will show a higher sale amount. (For example, your valuation expert will probably factor in the value of projected future earnings.) But right now in your Business Sale Preparation Process I’d rather you estimate the value of your business on the low side. Far too many small business owners err way too much on the high side and lead themselves down the “primrose path of rosy deception.”
Let me stress again, as the car commercials are always saying, DO NOT try this at home. This particular Initial Business Valuation formula is only designed to give you a starting point, something to help you know where you are and to finish your Goal Setting Phase of the Business Sale Preparation Process. As you proceed you MUST engage the services of a Business Appraiser who is accredited for Business Valuation and preferably experienced in the real world of small service business transfers.
So now you have an initial number, a base-line value for your business to set goals from. Run the IBV on your business every quarter and you’ll see where you’re heading. More importantly, you’ll be well on your way to creating a “constantly appreciating asset”, a janitorial service, carpet cleaning business or a restoration operation with real value.
Respectfully submitted,
Steve Toburen
Director of Training
Jon-Don's
Strategies for Success
PS Yes, I know the above post is long and the "Cleaning Up" Report runs 70 boring pages. But how long have you spent building the business that you are prepared to slap a casual price on and walk away? I marvel at how and why people refuse to invest any energy in the pricing and marketing of a profitable small service business that they have spent half a lifetime building! But whatever floats your boat ... I gotta go run my mother-in-law to the emergency room with an eye infection. This stuff always happens on a sunday!
