Valuation of a Business
A business is worth only whatever someone is willing to pay for it at a particular point in time.
Buyers and sellers are natural adversaries; the sellers want as much as they can get and the buyer wants to pay as little as possible. The broker is intensely interested too, because the commission amount is usually based on a percentage of the total selling price. However, both buyers and sellers should be aware that sometimes the broker’s strongest objective may be to just close the deal at any price.
A business value, and therefore its selling price, only makes sense when it’s based on the earnings stream, also known as the excess earnings or net profit. Both of these terms, the earnings stream and excess earnings can be thought of simply as the available cash flow.
Capitalization is a complex word with a relatively straightforward meaning: the process used to determine today’s value of a stream of future earnings.The valuing of a business, of today’s value is the value of the business, and the “stream of future earnings” is the expected available cash flow of the business based on current profits. The valuation concept can thus be described as the Capitalization of Available Cash Flow. What this concept really means is that a business is an investment which is only as good as the money it provides for its owner.
Ways Of Purchasing A Business
There are some other important points that you need to understand. There are basically two ways to purchase an operating business for sale:
1. Purchase its assets (even if it’s an incorporated business)
2. Purchase its corporate stock (only if it’s an incorporated business)
We generally recommend against a buyer purchasing the corporate stock if a business is incorporated, except in the much more sophisticated situations involving many shareholders, subsidiary operations, complicated ownership of assets involving extensive liens and notes, etc. For the vast majority of operating business transactions, even if the business is currently operating as a legal corporation, conducting an asset purchase and sale is usually the best course of action. The business assets in this case are purchased from the corporation rather than from the unincorporated owner. Yes, you can still purchase a trade name, customer lists, employee contracts, copyrights, etc., that are not always thought of as assets that are easily transferred.
The main reason though, that you don’t want to purchase corporate stock is because of the potential unknown contingent liability that goes with it. A hidden creditor could suddenly arise, a past disgruntled employee with discrimination claims or compensation issues, an injured customer from several years ago that’s late in bringing a claim against the company, unpaid state or federal income taxes,etc. It’s true that you may be able to get the corporate seller to give you a “hold harmless” agreement that pertains to any hidden liabilities that originated during the seller’s ownership, but the corporation you purchased may still be liable and you may still have to spend significant amounts of time and money on legal fees to protect yourself, even if you didn’t own the corporation at the time.
Ultimately though, the structure of the purchase and sale of a business is usually predominantly a legal and tax consequence issue. We strongly recommend that you receive good advice in these areas from your respective legal counsels and accountants. For most small to medium size business sales to an unrelated person, the asset-based sale is the best route, but corporate stock sales are done every day too, with little harm to the buyers if the transaction is structured properly.
Tangible And Intangible Assets
In an asset sale, you buy (or sell) only the assets of the business (with or without liens), and the corporation is left to the seller to legally dissolve or use in some other way unrelated to the business being sold. Either way, corporate stock or asset sale, you still need to identify the assets themselves to determine what makes up the business. There are basically two types of assets and some of the typical assets that you’ll purchase include:
– Real Estate
– Accounts Receivable
– Seller contracts
– Employee & Customer Contracts
– Open Orders
– Trademark name, logo
– Licenses, Franchise
– Customer Lists
– Proprietary Information
Tangible assets are generally things that you can see, touch, feel, count, or measure, and for which you are generally able to provide an accepted fair market value. Such things as listed in the previous table include inventory, equipment, contracts, etc. Intangible assets are generally things that exist more in perception than in physical substance and have a specified life to them, and consequently are much more difficult to value.