By far the biggest part of the purchase price of a small family business is goodwill. So it is vitally important to a buyer to have knowledge and understanding of just what goodwill is and how to place a value on it.

This is the third in a series of articles on valuing goodwill and discusses the factors that affect the risk level of the business.

Generally Accepted Industry Risk Levels

The risk level of a business is in the end its vulnerability to competition and market forces. Over time a generally accepted risk level has evolved for each industry that reflects the inherent, built-in risks associated with it. These depend upon:

• How cut-throat the competition is (second hand car dealers)
• How vulnerable they are to whims and changes (womens’ fashions)
• How essential are their products/services (couriers, cleaners, plumbers)
• The level of trade or professional qualifications required (builders, lawyers, architects)
• How vulnerable they are to economic downturns or market forces (resort businesses)
• How easily they can be replicated
• etc…

The best way to find the industry risk level for your chosen business is to use past sales statistics and rules of thumb. This is a two step process. First we work out what price would typically be set for your chosen business. We will use three very simple methods to do this. Don’t worry about the jargon – they really are very easy.

Method 1. The Price Revenue Multiple

There are two very valuable tools available to US readers that will take a lot of the guesswork out of assessing the risk level of your chosen business and both are revised annually. (Readers in other countries should check with your local business broker or accountant to see if something similar is available).

The first is the Small Business Valuation Formula Multiples compiled and published by BizMiner.com and for sale @ $79 (2008 edition). As it is primarily aimed at business brokers you should not have to pay for the information you want on your industry – you should be able to get it from your local broker. On the other hand it could be very useful to have if you are not sure yet which type of business to go for.

It consists of the results of actual sales of about 10,000 small businesses in around 200 industries. Nearly all sales are in the price range of up to US$1million.

The results are presented in the form of two ratios and we are going to use them both. The first one is called the “Price Revenue Multiple”. It simply says that if a business with annual sales (revenue) of (say) $1million sold for $200,000, the ratio is 0.2 – i.e. $200,000 divided by $1million.

Another way of saying this is that the selling price is 20% of the annual sales. This is a very simple example of a “Rule of Thumb”, but nevertheless is very useful information. But keep in mind that the ratios are an average within a given range

Method 2. The Price SDE Multiple

“SDE” stands for Sellers Discretionary Earnings. It is defined as “Net income before primary owner’s compensation, other discretionary, non-operating or nonrecurring income or expenses, depreciation, amortization, interest, and taxes”.

The ratio this time is the sales price divided by the SDE. So if a business sold for $216,000 and had an annual SDE of $108,000, the ratio would be 2, i.e. $216,000 divided by $108,000.

Method 3. Industry Rules of Thumb

Rules of thumb are also published annually in a very impressive and comprehensive book called The Essential Guide to Pricing a Business, published by Business Brokerage Press (bbpinc.com). The 2009 edition costs $125 and is well worth it.

It gives rules of thumb for setting prices for over 550 different types of businesses (including many popular franchises) and is packed with other useful information and statistics (including GP% figures) for many of them. If you are not sure yet which type of business to buy this book is an excellent primer.

It is also very much an in house type publication for business brokers. So once again you should not have any difficulty in getting the right formulae.

What if I Can’t Get or Don’t Trust These Figures?

In the real world it is not as straightforward as this. There will always be quite a variation between the valuation figures arrived at using these formulas.

The reasons for are there may be only a small sample of sales, there are regional differences in prices, and the same type of businesses may operate differently from state to state and certainly from country to country. For instance a Newsstand in the US is very different from a Newsagency in Australia or the UK.

So the formulae used here only apply to the US. Even though where you are may not be as well serviced with this information, you can be sure that your local business broker will know the local rules of thumb.

Even in the US I would still get a second opinion from your local business broker.

And I would also make my own assessment. In fact I would do this before doing the above calculations so I don’t have any preconceived figure in mind.

You will quickly learn how risky is the type of business you are looking at. Remember at this stage all we are looking at is an industry generalization. If there are particular risks associated with your chosen business that make it different from others in the same industry, you should make an independent assessment of the risk level.

Try them out on various businesses for sale in your area and tinker with the multiples as necessary. Compare the figures you come up with against the selling prices set by the Brokers. The more you try it out the more confident you will get.

Also remember that there is no such thing as the one and only correct valuation for a business in this size range. There are always only approximations. But from my experience you definitely should be in the ballpark, and usually on the conservative side.

And to my mind it is more important to be confident that you have uncovered all the hidden traps and know the full circumstances of a business – in other words, to take away the fear – than to vainly try to get the buying price exactly right.

Finally, to keep the whole thing in context, what we are really doing here is arriving at a value that you can use to compare with the asking price and use as a negotiating tool.

This article was written by Brian K Fitzgibbon CPA.

Brian is an experienced accountant and small business consultant. He runs his own business, lectures extensively on small business topics and has checked out and valued many hundreds of small businesses for buyers.

Brian is also the author of the highly acclaimed and invaluable
"How To Value A Business And Buy It Without Fear"
A do-it-yourself guide for first-time and experienced buyers alike.

To download a FREE Chapter from Brian's book please follow this link: "HowToValueBusiness.com"

August 23rd, 2009 | Tags: assessing risk, business valuations, buying a business, buying a job, checking out a business, components of goodwill, definition of goodwill, diy business valuations, due diligence on a small business, future expected profits, goodwill valuation, how to buy a business, how to value a business, industry risk levels, price revenue multiple, rules of thumb, sellers discretionary earnings, small business risk, tips on buying a business, valuing franchises, valuing goodwill in a small business | Category: articles | Subscribe to comments | Leave a comment | Trackback URL  |