Mr PoP’s Thoughts on Small Business Valuations – Part 1

Even though Mrs. PoP and I are reasonably happy with our current jobs in sales and writing code, every now and then we like to wonder about buying a local small business. This has been going on for a while, I came close to buying two different car repair shops a few years ago, and different parts of my family have owned pieces of restaurants and resorts for decades. Buying one isn’t part of our game plan for the near term, but we’re not ruling it out as a possibility in the future.

As it turns out, buying a small business ins’t all that much more difficult than buying a house. Much like real estate agents list homes for sale on behalf of current owners, and there are business brokers who specialize in businesses with revenue under a million or two per year.  One of the brokers I peruse is this one over in Miami, but there are similar ones in any reasonably sized metro area. This is what a typical listing can look like.

BusBrokListing

In general, prices for businesses listed by these brokers range from $25K (like the bakery above) all the way up to a few million dollars. But what you’ll also notice after looking at a few of these is that the listing doesn’t give you too much information on the business. Sometimes if you know the area well, you might be able to decipher which business it is, but in general, the listings intended to be anonymous. The main items you get to see the price, and some basic financial information like gross revenue, total business assets, and “earnings”.

 

Mrs PoP’s Sidebar on The Numbers – WYSIWYG?

Take these numbers with a grain of salt. Eventually if you get serious about making an offer, you should be able to see all the financials for the business. For now, consider them more of a ballpark.

  • Gross Revenues – total money exchanged for goods or services (generally WYSIWYG)
  • Total Assets – might include inventory, real estate, fixtures, goodwill (not always WYSIWYG)
  • Earnings – some listings use the phraseology “owner benefit”; includes actual cash income to the owner, but very fudge-able (not always WYSIWYG)

 

What Makes For An Attractive Purchase?

Mrs. PoP and I aren’t fools – we want a business that has the best chance of providing an ever increasing cash flow through the years. Unfortunately, there is a ton of problems with just evaluating a business based on price, the gross revenues, and the earnings.

1.) Are you buying a business, or are you buying a job? Especially in the financiapolcalypse a few years back people would loot their savings accounts and buy a business that was little more than a single person operation with a phone number, some rented offices space, and a client list. Not for us. Listings with words like “absentee owner” are more like what we’d be looking for.

2.) How the hell do you define Earnings? The seller wants to get the best price possible, and has every reason to inflate the earnings number. This can happen a number of ways-by claiming income that is off the books, or by using creative accounting methods, or even pro-forma earnings (sometimes called EEBS – Earnings Excluding Bad Stuff). I once inquired about a car rental place with incredible “owner benefit” and found out that they had counted the depreciation of the cars as a benefit to the owner! This may be GAAP correct, but you can’t eat depreciation for dinner…

3.) Does this business have a moat? Assuming that the thing you are buying is more than just a contact sheet, and that it has a current income stream that will support the actual benefit the new owner will receive, how do you know that the business will continue to be successful in the future? Warren Buffett would say you have to find a business that is easy to understand, and has a significant moat around it so that other business can’t come in and steal your sales. Moats can come in many forms; they can be a superior brand and reputation, fantastic geographical locations, favorable governmental licensing. A little while ago I saw a jet-ski rental with great earnings and a very strong valuation; the reason was that the local government issued a very small number of licenses for those types of business.

But There Are So Many!

One last issue is that there are hundreds of possibilities for sale at one time on these sites, Mrs. PoP and I need a way to sort through the listings quickly and eliminate the ones that are duds, and leave the business that are worth further consideration. Tune in next week and we’ll show you how we’re going to give it a try…

 

Have you ever considered buying a small business? Do you peruse the local business broker listings for fun like me?

28 comments to Mr PoP’s Thoughts on Small Business Valuations – Part 1

  • Fascinating. Looking forward to part 2, I wasn’t aware that buying a small business could be so “straightforward”.
    FI Pilgrim recently posted..Get More Done: A Few Favorite Productivity MethodsMy Profile

  • We’ve considered buying a business many times. Greg has this dream that he wants to own a Jimmy John’s sandwich shop. I really want to buy a Maoz but they require that owner’s have a net worth of at least 2 million.
    Holly@ClubThrifty recently posted..For Sale By Owner Insanity: A RantMy Profile

  • Wow – great. Can’t wait for part 2 to see what you guys are getting up to…
    moneystepper.com recently posted..Airline nightmares – the worst of airlines and booking agentsMy Profile

  • Love perusing business broker websites! I do it weekly and always find it fascinating to see what sort of multiples various businesses are priced at currently. A few years from now I will get a bit more serious about that avenue as a potential passive income strategy but for now I am just looking and learning.

    My personal favorites tend to be fairly simplistic in nature, with my current “dream” being a particular ATM route near me. Contract out the repairs and management of the cash in the box to a reputable armored car service, and it is extremely passive!

    Really interested to see what you have in store for part 2!
    writing2reality recently posted..Lending Club – May 2013 UpdateMy Profile

    • I gravitate to the simple, dirty ones because nobody seems to want to do the work! Driveway paving company that is selling for 1.x owner earnings? Yes please! Septic Tank company that is selling for asset value? Sign me up!
      Mr PoP recently posted..Mr PoP’s Thoughts on Small Business Valuations – Part 1My Profile

      • Agreed! I look at it in a similar method as Buffet, but on a smaller scale. Find companies with strong operating cash flow with management in place. Buy those companies and use them to snowball into additional companies.

        Unfortunately, I’m not quite in the position to start leveraging my assets in a manner that would afford me the opportunity to pick up any of these yet. It will happen though, that I am sure of!
        writing2reality recently posted..Lending Club – May 2013 UpdateMy Profile

  • Interesting read! The job I just left was as a business valuation analyst. We never actually sold businesses or dealt with that, but we did value small and large businesses every single day.
    Michelle recently posted..What Young Adults Should KnowMy Profile

  • I’ve never really considered purchasing a small business. So if you’re purchasing a car repair shop, are you essentially giving the mechanic a way to cash out on the business he’s built but remain on as an employee? I guess that’s where you run into the problem you describe where you’re essentially buying a solo practice, which isn’t all that desirable. I guess I’d be interested to hear what you think the characteristics are for a small business who wants to sell but has real long-term room to grow.
    Matt Becker recently posted..Building a Secure Financial Base for Your FamilyMy Profile

    • It could work a number of different ways-sometimes the owner/mechanic is ready to retire, sometimes he wants to go back to just turning wrenches. It can be tough to figure out what the value is worth after the owner leaves, much less what its long term prospects are! If you are really interested in business valuation, Warren Buffett’s berkshire letters are a good primer on prices vs. value.

  • You know, we’ve considered starting a small business but not purchasing one. I suppose I’m a bit skeptical as to why a business whose numbers look good would want to sell. Do you find the businesses to be in a distressed position, needing cash?
    Done by Forty recently posted..Do It Now!My Profile

    • CincyCat

      I’ll chime in on this one. In my neck of the woods, I’ve seen a very popular business put up a “retiring, going out of business” sign. It could be that they want to move away, or they are experiencing failing health, and don’t have any “heirs-apparent” who can take over the family business. I imagine these are probably primary reasons why someone would sell out when the numbers look great.

    • Cincy is right-failing health, no heirs are possibilities. One auto shop that I looked at was where the owners were ready to retire (their kids were not interested), the other one was cheap because of a divorce. A good deal can also depend on the real estate involved…

  • I never realized you could buy a business for as low as 25k. I always figured it was something only those with mega finances could do. I might have to tuck that idea away for after I get a solid foundation on my financial house. Looking forward to part 2.
    Micro recently posted..Need Halloween costume ideas: 5 household items that can helpMy Profile

  • I think this is a great way to diversify your income stream. I would be very skeptical about believing any cash income they claim. You know some will be there but somebody who claims it for resale purposes could face potential tax fraud if they’re not claiming it on their taxes.
    ND Chic recently posted..Living on One IncomeMy Profile

  • SLCCOM

    If you are considering a franchise, spend some quality time with Entrepreneur magazine — they have fantastic information on that and on running a business.

  • I’ve always wanted to buy a business but I’m like you i should be an income stream and not a job. I deal with a lot of mom and pop stores where they bought a job. Look forward to part 2.
    Charles@Gettingarichlife recently posted..How I Become A Millionaire…In DebtMy Profile

  • Buying a business is not for the faint of heart. Money-wise, it’s not that big of a deal, but there’s a reason for that. The core of any successful business is a loyal customer base that buys profitable business.

    That involves all kinds of questions: moat, how much of the base is because of relationship with the owner vs. the employees or location, etc. If the business is owner-intensive (i.e. customers come because of the owner) don’t buy. If they come because of location, product, employees, then you can can consider it.

    Anybody can start their own business from scratch for free. But you pay when you build up a customer base: advertising, hustle, suffering losses while the revenues build, etc. So the customer base is pretty much the only thing of real value.

    When you buy (vs build) what you’re paying for is a shortcut from that long (and risky) period of building the business. And if that is nothing more than the customers like the owner, well, that walks out the door, so that’s not worth anything.
    William @ Bite the Bullet recently posted..Dividends, Part 1My Profile

  • I’ve always wanted to own a small business but one where there was plenty of quality support staff who would ensure I wouldn’t have to work all the time. I think buying an existing business would be the best way to do that. But like you say, it’s important to make sure it’s a place that won’t have crazy competition. Also, I would look for a business that owned the space if possible, but I’m sure that’s not common.
    Tara @ Streets Ahead Living recently posted..Getting up and dusting yourself offMy Profile

  • Excellent post!!

    Yeah, I once considered buying a successful B&B in a tourist town that bills itself as the Gateway to the Grand Canyon.

    Ultimately decided against it. Several reasons:

    * I didn’t (and still don’t) have experience in the hospitality industry. The owner had hired a really GREAT manager out of Northern Arizona University’s nationally respected hospitality program, but there was no guarantee the guy was going to stay there forever. If he left soon after I purchased, that could create some alarming difficulties.

    * The B&B occupied a historic Victorian house — it dated back to the late 19th century. Some expensive repairs had already been done on it. A conversation with said manager revealed that it needed more such repairs.

    * A little research into the Bed & Breakfast industry revealed a) that it’s characterized by back-breaking work and b) that it can take YEARS to sell a B&B. It’s not easy to unload one when you want to retire or decide the business is not for you.

    I think a person needs to explore any business proposition very carefully before jumping into it. Could be the grandest adventure of your life…or it could be just g*dawful. Bet there’s very little in between!
    Funny about Money recently posted..ha-HAAA! Bank Account Simpification Accomplished!My Profile