Whether you are buying a retail store, a franchise, or a service business, your due diligence and valuation process is not much different than that employed in purchasing a multi-million-dollar business.
The three main things you want to know when you’re considering purchasing a small business are:
- What is the amount and timing of money you expect the business to generate in the future?
- When you are ready to sell the business, how much will you be able to sell it for?
- What is the risk that items 1 and 2 will not occur as expected?
As evident from these questions, the thing to focus on is the future. Although the seller will certainly focus on past performance, what happened twenty, ten, or five years ago is of little significance; you want to know what will happen in the future.
It is not uncommon for small business buyers and sellers to agree on a price based on an industry “rule of thumb” formula such as three times net income or 80% of gross revenue. Unfortunately, rules of thumb are nothing more than old wives’ tales. Every business is unique and no business should be purchased based on a formula purported to be applicable to an entire industry.
Sometimes a buyer thinks that he or she is buying a business, but they are really buying a job. On the most basic level, the value of a business is based on the amount of money you can earn above and beyond the value of the services you provide to the business. For example, if you earn $100,000 per year as an employee and you have the opportunity to purchase the business where you are employed, the purchase would make sense only if it gave you the opportunity to increase your earnings. Investing in a business is risky. If you purchased the business and continued to earn the same $100,000, you would not receive any return for taking the risk, and would be better off investing your money elsewhere.
Get professional advice before buying a small business
Professional advisors understand the issues; know the questions to ask and procedures to employ to help you understand the business you are considering and what it is worth. The earlier in the process that you get professional advice, the better off you are. Even if you just ask your CPA to look at the last few years’ tax returns of the business and offer comments and questions, you will save a lot of time and money, and get unbiased advice from an experienced professional.