Here’s How to Value a Restaurant or Bar Business

By William Bruce

How to value a restaurant or bar business.

Wondering what a restaurant or bar business is worth? Here’s how to value.

As a business broker and appraiser, I’m often asked how to value a restaurant or bar business.  The valuation of a restaurant or bar business is not an exact science but there are guidelines and rules-of-thumb that can be used for a close approximation of value.

If you have a restaurant or bar business for sale or maybe you’re considering buying one, these valuation formulas will get you in the ballpark.

Certain situations require a formal business appraisal including the larger merger-acquisition transactions, SBA loan applications, management performance tracking, estate planning, divorce — or the most dreaded of all — IRS issues.  After all, a professional, fully documented appraisal certainly takes the guesswork out of the situation.

However, what we’re talking about here is not a formal appraisal but rather the informal methods of quickly approximating the value of the restaurant or bar.  All of the guidelines we’ll quote are averages derived from hundreds of completed transactions reported to regional and national databases.

There are two methods of quickly approximating the value of a business: (1) applying a multiple to the discretionary earnings of the business and (2) applying a percentage to the annual gross revenue of the business.

The most accurate of the two methods seeks to approximate the value of a business by applying a multiple to the company’s discretionary earnings.

What are discretionary earnings? It is NOT the profit or loss that you show Uncle Sam on your tax return. To put it delicately, almost all business owners run some expenses through the business that are — a’hem – not absolutely necessary to the operation of the business.

Discretionary earnings are the total cash that the business generates in a year that is available to the owner after deductions for only the necessary operating expenses. Another way to define discretionary earnings is that it is the “total owner’s benefit” derived from owning the business, regardless of how the owner takes the money out of the business. It is the amount of cash left over after only the necessary expenses that is available for (1) owner’s remuneration, (2) return on investment and (3) debt service, if any.

Here’s an article that explains the term: What are a Business Owner’s Discretionary Earnings.   If you’re not exactly sure of how to calculate, an accountant or professional business broker can compute it for you.

Almost all restaurants and bars will appraise for somewhere between 1.5 to 3.0 times discretionary earnings.  Exactly where in this range that a specific operation will fall depends on what type of bar or restaurant, size of the operation, location, revenue trends and other factors.

The second method of estimating the value of a business is less accurate.  This method applies a percentage to the operation’s annual gross revenue to approximate value.  This method of appraisal assumes the bar or restaurant is earning the average bottom line profit for its peer group.  That’s a big assumption!

But making that assumption, we know that a full-service restaurant with a liquor license will appraise for somewhere between 30 and 35 percent of gross annual revenue.  Bars will average between 35 and 45 percent of annual revenue in appraised value.  Coffee houses will appraise for about 40 percent of revenue.

A quick check of a few popular food franchises reveals the following average appraisal guidelines expressed as a percentage of gross annual revenue: Beef O’Brady’s 22%, Chick-Fil-A 65%, Dairy Queen 45%, Domino’s Pizza 52%, Panera Bread 37% and Subway at 65%.  For a more complete list of franchise valuation formulas, including many restaurants, please see our article “What is a Franchise Really Worth.”

None of these appraisal guidelines include the value of any inventory on hand or real estate.  If the business owns real estate, the value of the realty should be added to the guideline result.  And inventory, at cost (food and liquor only), should also be added to obtain the total estimated value of the business.

However, you as the owner, seller or buyer of the business are the final arbiter of what the business is worth to you.  Remember, these guidelines are only averages. And the guidelines certainly don’t take into account any special considerations or any future plans that an owner might have for the business. What a particular business might be worth to you may be more or less than it’s worth to the next person who looks at it.

Should you need advice on restaurant or bar valuation considerations, please don’t hesitate to call or email.

Here are additional related articles that might be of interest:

What is a Franchise Really Worth (includes the valuation of most food service franchises)

How to Analyze a Business You’re Considering Buying

How to Make a Written Offer to Buy a Business

How to Handle the Due Diligence Investigation When Buying a Business

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William Bruce is an Accredited Business Intermediary (ABI) and Senior Valuation Analyst (SVA) assisting buyers and sellers of privately held businesses in the transfer of ownership.  He currently serves as president of the American Business Brokers Association.  His practice includes consulting services nationally on issues of business valuation and transfer.   He may be reached at (251) 990-5934 or by email at Will@WilliamBruce.org. 

Follow William on Twitter and LinkedIn.

Posted in Business Valuation & Appraisal, Franchises, Valuing, Buying or Selling a Business | Tagged , , , , , , , , , , , , , , , , , | 29 Comments

Looking at a Business That You Might Want to Buy? Here’s How to Analyze It.

By William Bruce

Let’s say you’re serious about buying a business and have identified an attractive business How to analyze a business to purchasethat is for sale.   You’re interested in investigating the opportunity.  What’s next?  Here’s how to analyze a business you might want to buy.

First, The Need for Confidentiality

Confidentiality is critical to the successful transfer of a business.  If word gets out that a business is for sale, several things start happening and none of them are beneficial to a prospective buyer.  First, key employees start looking for other jobs, fearing that a new owner may not retain them.  In the uncertainty, customers start looking around and begin shopping elsewhere.  Suppliers get nervous.

This is why a seller or business broker will ask you to sign a non-disclosure agreement.  It’s sometimes called a confidentiality agreement.  In this agreement, you confirm that you will not disclose the fact that the business is for sale — except to your professional advisors.  And yes, your spouse is considered a professional advisor.  After all, he/she consults with you often on a professional basis, right?  Just caution them on the need for extreme confidentiality.

If you show that you take the need for confidentiality seriously, you will be regarded as the professional that you are.

The Anonymous Customer

If you’re working with a business broker, he will probably have furnished you with a summary profile on several different businesses.  The profile will summarize all the salient points of the business including gross revenue and owner’s cash flow.  From the several profiles that your broker has given you, pick the two or three that you would like to pursue.  The first step for each business that you would like to explore is an anonymous visit posing as a customer.  We call this a reconnaissance run.

As you visit, first, note the location.  Is it appropriately located for the type of business?  As you’re driving into the parking lot, what does the business look like from the street?  What about signage and street identification?  Then as you walk to the entrance, what kind of an impression do you receive?

Once you’re inside, take a close look around.  If it’s a retail establishment, are the shelves full?  Is it clean and neat  Are there customers there?  Are the employees helpful?

What is the general feeling you received from your visit?  If you decide this is a business you want to follow up on, make a list of questions for the owner.  Make this list while your visit is fresh on your mind.  Include anything and everything you’re curious about.

It’s great if the image is good, but don’t despair if it’s not.  As one of my astute clients reminded me recently as I was lamenting the poor street image of some of my business listings, “It’s an opportunity for a new owner to make a difference.”

A word of caution:  While on this visit, don’t talk to anyone in the business about the fact that the company is for sale.  Chances are the employees don’t know it’s for sale.  And even the owner would not be free to talk about it at this point within earshot of customers and employees.  Chat pleasantly about the weather … or college football!  (‘Tis almost that time of the year, you know.)

The Meeting With the Owner

The next step in this logical sequence will be a meeting with the owner.  If you’re working with a business broker, he will set up the meeting at a time convenient with both parties.  He will go with you to the meeting and facilitate the exchange of information.

Be sure to bring your list of questions.  Ask anything you want to.  However it’s usually best, at this point, not to discuss the selling price of the business or the possibility of owner financing.  That comes later.  But ask anything else that comes to mind.  Nobody knows the business better than the owner.  If you’re meeting at the business, ask for a tour of the facility.

It’s important that this meeting remains informal and cordial.  Remember, you are both checking each other out.  If the owner is going to finance a portion of the selling price, he’s looking at you as much as you’re looking at the business.  It’s a two-way street.

At the end of the meeting, you don’t have to express any commitment.  Simply say something like:  “Well this has been very informative.  Thanks for your time.  Let me consider this new information.”  It might also be a good idea to convey to the owner that the information will be kept in the strictest of confidence.  He’ll appreciate your sensitivity to that issue.

Computing Cash Flow, Also Called Discretionary Earnings

The next step, assuming you are interested in the business, is to determine the operation’s annual cash flow.  After all is said and done, what you will be buying is the ability of the business to produce cash.

So first let’s define cash flow.  Some brokers refer to it as the owner’s discretionary earnings, which is the term I personally like.  Discretionary earnings are defined as that amount of cash left over after only the necessary operating expenses gave been paid that is available for (1) owner’s remuneration, (2) return on investment, and (3) debt service, if any.

Another way to express it is that discretionary earnings are the total owner’s benefit from owning the business regardless of how the owner takes the money out of the business.

Discretionary earnings are not the same as net profit shown on the profit and loss statement.  It’s not the same because of the bookkeeping practices of the large majority of business owners.  Simply stated, business owners do not keep books to pay income taxes.  Most business owners make strenuous efforts to reduce any taxable income.

For this reason, most business owners in an effort to reduce their taxable income run some expenses through the business that are not purely business operating expenses.  This practice reduces tax liability but it also oftentimes masks the true earnings record of a business.

As an example, take the sale of a restaurant that I recently handled.  The profit and loss statement from the business was actually showing a small loss.  However, the owner’s wife drove a Lincoln Navigator which was listed on the books of the business as a company vehicle.  The company also paid for all her gas and maintenance on the Navigator although she has no role in the operation of the restaurant.  Same for the daughter’s Honda which she drove back and forth to college.  The daughter was also on the payroll as an employee of the restaurant which furnished her with spending money at college, although she never actually worked at the restaurant.  The family ski vacation to Colorado was charged to the business because the owner attended a business meeting for a couple of hours while in Aspen.  You see where I’m heading here, don’t you?  By the time all these items plus any non-cash expenses were accounted for, the restaurant was actually producing a nice yearly cash flow for the family.

In considering a business, your challenge is to determine its true cash flow.  This process is referred to as the recasting or normalizing of income.  If you are using a business broker, he has probably already prepared a recasting worksheet on each business he presents to you.

Here another of my articles explaining more about the computation of discretionary earnings.

To Pursue or Not to Pursue

After computing the discretionary earnings of the business, the next step is to determine if the cash flow is enough for you.

To do this, you need a fairly close approximation of what your debt service will be on the amount borrowed to buy the business.  After all, it’s the amount left over after debt service that will be available for you and your family to live on.

Your broker will have amortization tables available for debt calculation.  Business loans without real estate generally run seven to 10 years.  With real estate, the term of the loan can be up to 20 years.

An increasingly popular type loan where the seller is offering financing is called the balloon loan.  It solves the problem of the seller wanting his money long before a ten or fifteen year term us up and the buyer wanting to keep his payments as low as possible.  It works this way.  After the down payment, the seller finances the sale of the business with a note from the buyer.  The payments are calculated on, say, a fifteen year amortization schedule (to keep them low) but the note calls for a payoff of the balance due (the balloon) at the end of the fifth year.  During the five years, the new owner builds up a track record and establishes a relationship with a bank.  At the end of five years, he is in a position to refinance the balloon with the bank and pay the seller.  It’s a win-win situation for both parties.

Your worksheet should show:

Annual Owner’s Discretionary Cash Flow           $____________

Less Annual Debt Service                                       $____________

Cash Left Over to for Owner’s Living Expenses $____________

It probably should be mentioned that the above calculations do not consider any increases in revenue and cash flow resulting from new ownership.  Historically, a business will experience a revenue increase of between ten and fifteen percent due solely to a change in ownership.  Nor does this calculation account for any new products and services or other changes that a new owner may plan to introduce.

Now it’s decision time.  If the business is of interest to you, and if it returns the amount of cash flow you need (or can be made to do so), and if you can envision yourself successfully running the business, then you may be ready to move on to next logical step.

If you’re ready to pursue this business, my next blog post will outline an important step: The Contingent Offer.

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William Bruce is an Accredited Business Intermediary (ABI) and Senior Valuation Analyst (SVA) assisting buyers and sellers of privately held businesses in the transfer of ownership.  He currently serves as president of the American Business Brokers Association.  His practice includes consulting services nationally on issues of business valuation and transfer.  He may be reached at (251) 990-5934 or by email at Will@WilliamBruce.org. 

Follow William on Twitter and LinkedIn.

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How to Sell a Business: First, Have a Good Reason When Selling a Business

Selling Your Business

Selling Your Business

By William Bruce

The decision to sell your business may not be easy.  In fact, it may be agonizingly difficult.  This is the first step in the “”How to Sell a Business” series.

You probably have an emotional attachment to the business.  Over the years, you have attracted a lot of customers and developed many friendships among them.  You have also hired and trained a talented group of employees who look to you for their very livelihoods.

And in America, people are identified by how they make their living. Your identity is directly tied to your business, so it’s no wonder that the decision to part with your business is difficult.

But things change.  And at some point in their life, most business owners decide, for good reasons, that the time has come to sell their business.

One of the motivations for writing this is that many business owners have told me the same thing.  They say that once they make the decision to sell, they don’t have a very clear idea of how to go about it.  They have spent their business lives managing their company – and in most cases doing a very good job of it – but they have never actually sold a business. It’s definitely a different “ballgame.”  Selling a business in today’s business environment is a major project fraught with many pitfalls. It can be compared to a narrow path winding through a field of landmines. The issues are numerous including pricing, confidentiality, offers, negotiations, financing, due diligence, taxes, and government regulations to name just a few.

Professional advice and assistance to guide you through the minefield is the best “insurance policy” you will ever buy.  But then, I’m prejudiced.  You see, I have one of the best jobs in the country.  In case you haven’t yet guessed, I’m a business broker!

In this series of articles, I’ll be discussing various issues involved in the sale of a business.  More will be posted later, but my first piece of advice to an owner considering selling his or her business is: “Have a good reason.”

Be able to give a good reason.

This may seem obvious.  However, it’s important to be able to give a good reason for selling your business. The very first question most prospective buyers ask is “Why is the business for sale.”

Buyers are naturally suspicious.  For most, buying a business will be the most important financial decision they will make in their lifetime, and because of it, they will have a heightened level of anxiety about the whole situation.

Some of the business buyers with whom I’ve worked in the past have expressed the thought that if a business is for sale, there must be something wrong with it.  This is not always the case, of course, and being able to answer this concern with a logical response will be of tremendous value in the sales process.

These are all good reasons

There are valid reasons that some very good privately held businesses are for sale.  The first reason most people would think of is retirement.  Another is the fact that the owner may be experiencing health problems that prevent him or her from managing the business as usual.

Other reasons may involve estate planning situations in which the owner would rather leave liquid assets that can be split more easily among several heirs than a business entity.

Still other legitimate reasons could involve friction among the owners.  This kind of situation can become particularly serious if the friction is among family members who jointly own the business.  I recently handled the sale of a business in which the real motivation to sell was to prevent further deterioration of the family relationships.  The differences among the partners were serious enough that they would surely have led eventually, if they stayed in business together, to an ugly family split-up.  The partners correctly decided that it was better to sell the business and preserve the family.  Each partner took their portion of the cash from the sale and went their separate ways.  And now they are still congenial when they get together at Thanksgiving and Christmas!

Perhaps the most common reason that a business is for sale is one that might not be readily apparent.  But as a business broker, I see it frequently.  And I’ll simply label it as “burn out.”  After an owner has operated the same business for a number of years, some just plain get burned out.  Some people are more prone to burn out than others.  It’s highly subjective but certainly understandable.

On a personal note, I experienced it in a previous business that I owned.  After 15 years, when it got to the point that I didn’t want to see customers come in the front door because I knew I’d have to spend time with them, I knew it was time to get out!  Burn out is real and I see a lot of it.

In summary

So in summary, be able to give a good reason for selling your business.  It’ll get you started off on the right foot.

In future articles, we will cover the additional issues involved in the successful sale of a business.

Readers of this blog can order the entire series of articles by requesting the 26-page booklet, “How to Sell Your Business While Avoiding Costly Mistakes.”  To request your copy, please email William Bruce at Will@WilliamBruce.org.

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William Bruce is an Accredited Business Intermediary (ABI) and Senior Valuation Analyst (SVA) assisting buyers and sellers of privately held businesses in the transfer of ownership.  He currently serves as president of the American Business Brokers Association.  His practice includes consulting services nationally on issues of business valuation and transfer.   He may be reached at (251) 990-5934 or by email at Will@WilliamBruce.org. 

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The Top 3 Critical Issues in Buying or Selling a Business

I’m often asked what the top critical issues are in buying or selling a business.  If the top three issues discussed below in the sale or purchase of a business are not properly addressed, then there is a good chance the transaction will fail.

So to get to the core of the question, these are in my opinion the top three issues involved in buying or selling a business:

1. Confidentiality

Confidentiality is critical to the successful transfer of a business.  If word gets out that a business is for sale, several things start happening and none of them are good for the seller or buyer of the business.  First, key employees start looking for other jobs, fearing that a new owner may not retain them.  In the uncertainty, customers may begin shopping elsewhere.  Suppliers get nervous.  Competitors can take advantage of the situation.

This is why a prospective business buyer will be asked to sign a non-disclosure confidentiality agreement early in the process of looking at a possible business acquisition. In this agreement, the potential buyer confirms that he/she will not disclose the fact that the business is for sale except to professional advisors.

If you show that you take the need for confidentiality seriously, you will be regarded as the professional that you are.

2. Valuation

Nothing causes the buyers and sellers of businesses more anxiety than the issue of valuation. The question of selling price haunts both parties. The seller doesn’t want to price his business too low and “leave money on the table.”  On the other hand, the buyer of the business is afraid he’ll pay too much and not get the best possible price.

Formal, fully documented business appraisals are now readily available.  In addition, there are rules of thumb guidelines that can be used to quickly estimate the value of a business.  As just one example, we know that a full service restaurant with a liquor license is worth about 30% of its annual gross revenue as an ongoing business.  This assumes – big assumption – that the business is earning the average bottom line profit for its peer group.

There are rules of thumb guidelines for almost all categories of business from ice cream stands to manufacturing plants.  But again, these guidelines provide only quick estimates.  And written, fully documented business appraisals are now done by several respected national firms at a cost similar to real estate appraisals.

3. Financing

Financing is always a concern, as hardly any business buyer has the financial capacity to write a check for the purchase price of a business.  If they did, they would most likely be living off of investment income rather than buying a business.

These are five possible sources for business acquisition loans:

BANKS – Although most people seeking a loan to buy a business will think first of a traditional bank loan, I can tell you from years of business brokerage experience that banks generally do not make business acquisition loans.  There are exceptions but they’re rare.

SBA – The SBA, through its approved lenders, provides business acquisition loans.  The SBA does not make direct loans, but rather guarantees a portion of the loan that is made by the approved lender.   It’s known as the SBA 7(a) program.  Wells Fargo Bank is currently the top volume SBA lender nationally.

The SBA route for a business acquisition loan is sometimes frustrating because of the time and detail that is involved.  However, keep in mind that the SBA will approve loans that others have turned down and will usually approve them with a smaller down payment.  In most cases, it’s worth the wait.

FAMILY – Many times the older generation in a family will loan the down payment or the entire amount needed to a promising member of the family’s younger generation.  If your family is willing to loan you the money, one word of advice is in order.  Have a very clear understanding as to how the debt is to be handled and put it in writing in the form of a legal note.

THE SELLER – In a significant percentage of the business transfers that I handle as a business broker, the owner of the business finances a portion of the purchase price for the buyer.  Some sellers cannot offer owner financing for a variety of reasons, but when they can, it conveniently solves the problem of financing.

The fact that the business owner is willing to finance the sale of his company provides more than a convenient finance plan.  More importantly, it provides a strong validation of the owner’s belief that the business will support the owner and earn enough cash to pay back the loan.  You can’t get any better recommendation on the business than this.

The normal down payment for owner financing ranges generally from around 30% to 50% of the purchase price of the business.  Interest rates are generally market driven but there is more flexibility here than in other forms of financing.

401(K) FUNDS AND IRA ACCOUNTS – The use of these funds to buy a business, without tax penalty, is a fairly recent development.  Several national CPA and attorney groups have developed a plan, approved by the IRS, which allows you to use your funds for business acquisition.  There are legal and accounting fees involved, but they are a small fraction of the tax penalty that would be assessed for cashing in these accounts early.

 The above ­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­five sources of financing are not exclusive to each other.  I recently handled a transaction in which three of the five sources were used to buy the business.

It’s called creativity!

If I can assist you with any considerations involved in the transfer of ownership, please don’t hesitate to email or call me.

For further reading, here are additional related articles:

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William Bruce is an Accredited Business Intermediary (ABI) and Senior Valuation Analyst (SVA) assisting buyers and sellers of privately held businesses in the transfer of ownership.  He currently serves as president of the American Business Brokers Association.  His practice includes consulting services nationally on issues of business valuation and transfer.   He may be reached at (251) 990-5934 or by email at Will@WilliamBruce.org. 

 
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8 Ways Business Owners Can Take Advantage of the Federal Stimulus Package

Thanks to Entrepreneur, this is the best list and explanation of the various financial assistance programs available to business owners during the Coronavirus pandemic.  Included are descriptions of:

  1. Stimulus Checks
  2. Economic Injury Disaster Loans (EIDL)
  3. Paycheck Protection Program (PPP)
  4. SBA Loan Forbearance
  5. Increased Access to Retirement Accounts
  6. Unemployment
  7. Paid Sick Leave
  8. Family Medical Leave (FMLA)

Read the full article by Entrepreneur here:  https://www.entrepreneur.com/article/348710.

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William Bruce is an Accredited Business Intermediary (ABI) and Senior Valuation Analyst (SVA) assisting buyers and sellers of privately held businesses in the transfer of ownership.  He currently serves as president of the American Business Brokers Association.  His practice includes consulting services nationally on issues of business valuation and transfer.   He may be reached at (251) 990-5934 or by email at Will@WilliamBruce.org. 

 

Posted in Alabama's Economy, Gulf Coast Regional & National Economy, Mobile, Fairhope & Gulf Shores, Alabama, National economy | Leave a comment

Here’s How to Value a Retail Business

By William Bruce

What is retail business worthAs a business broker and appraiser, I’m often asked about how to value a retail business.  The valuation of retail businesses is not an exact science but there are guidelines and rules-of-thumb that can be used for a close approximation of value of a retail business.

Certain situations require a formal business appraisal including the larger merger-acquisition transactions, SBA loan applications, management performance tracking, estate planning, divorce — or the most dreaded of all — IRS issues. After all, a professional, fully documented appraisal certainly takes the guesswork out of the situation.

However, what we’re talking about here is not a formal appraisal but rather the informal methods of quickly approximating the value of a retail business.   The guidelines we’ll quote are averages derived from hundreds of completed transactions reported to regional and national databases.

There are two methods of quickly approximating the value of a business: (1) applying a multiple to the discretionary earnings of the business and (2) applying a percentage to the annual gross revenue of the business.

The most accurate of the two methods seeks to approximate the value of a business by applying a multiple to the company’s discretionary earnings.

What are discretionary earnings? It is NOT the profit or loss that you show Uncle Sam on your tax return. To put it delicately, almost all business owners run some expenses through the business that are not — a’hem – absolutely necessary to the operation of the business.

Discretionary earnings are the total cash that the business generates in a year that is available to the owner after deductions for only the necessary operating expenses. Another way to define discretionary earnings is that it is the “total owner’s benefit” derived from owning the business, regardless of how the owner takes the money out of the business. It is the amount of cash left over after only the necessary expenses that is available for (1) owner’s remuneration, (2) return on investment and (3) debt service, if any.

If you’re not sure of how to calculate discretionary earnings, an accountant or professional business broker can compute it for you.

Practically all retail businesses will appraise for somewhere between 1.5 to 3 times discretionary earnings plus inventory at cost. Exactly where in this range that a specific business will fall depends on the size and type of the retail shop plus its revenue trends.

The second method of estimating the value of a business is less accurate. This method applies a percentage to the operation’s annual gross revenue to approximate value. This method of appraisal assumes the business is earning the average bottom line profit for its peer group. That’s a big assumption!

But making that assumption, we know that almost all retail businesses will appraise for somewhere between 30 and 35 percent of gross annual revenue plus inventory at cost.

As indicated above, inventory for resale should be added at cost to the formula result.  If the business owns real estate, the value of the realty should also be added to the guideline result.

However, you as the owner, seller or buyer of the business are the final arbiter of what the business is worth to you.  Remember, these guidelines are only averages. And the guidelines certainly don’t take into account any special considerations or any future plans that an owner might have for the business. What a particular business might be worth to you may be more or less than it’s worth to the next person who looks at it.

Here are additional articles that might be of interest: How to Analyze a Business You’re Considering BuyingHow to Make a Written Offer to Buy a Business and How to Handle the Due Diligence Investigation When Buying a Business.

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William Bruce is an Accredited Business Intermediary (ABI) and Senior Valuation Analyst (SVA) assisting buyers and sellers of privately held businesses in the transfer of ownership.  He currently serves as president of the American Business Brokers Association.  His practice includes consulting services nationally on issues of business valuation and transfer.   He may be reached at (251) 990-5934 or by email at Will@WilliamBruce.org

Follow William on Twitter and LinkedIn.

Posted in Business Valuation & Appraisal, Valuing, Buying or Selling a Business | Tagged , , , , | 10 Comments

What Are a Company’s Discretionary Earnings?

Cash flow and seller's discretionary earnings defined.

Cash flow and seller’s discretionary earnings defined.

By William Bruce

What are a company’s discretionary earnings, also sometimes referred to as cash flow?

It is NOT the profit or loss that you show Uncle Sam on your tax return. To put it delicately, almost all business owners run some expenses through the business that are not — a’hem – absolutely necessary to the operation of the business.

Discretionary earnings are the total cash that the business generates in a year that is available to the owner after deductions for only the necessary operating expenses.  Another way to define discretionary cash flow is that it is the “total owner’s benefit” derived from owning the business, regardless of how the owner takes the money out of the business.

More formally, it is the amount of cash left over after paying only the necessary operating  expenses that is available for (1) owner’s remuneration, including “benefits,” (2) return on investment and (3) debt service, if any.

To illustrate, let me tell you about the sale of a restaurant that I handled as a business broker several years ago.  The profit and loss statement from the business was actually showing a small loss.

However, the owner’s wife drove a Lincoln Navigator which was listed on the books of the business as a company vehicle. The company also paid for all her gas and maintenance on the Navigator although she had no role in the operation of the restaurant.  Same for the daughter’s Honda which she drove back and forth to college. The daughter was also on the payroll as an employee of the restaurant which furnished her with spending money at college, although she never actually worked at the restaurant.

The family’s ski vacation to Colorado was charged to the business because the owner attended a business meeting for a few hours while in Aspen. You see where I’m heading here, don’t you? By the time all these items plus any non-cash expenses (eg: depreciation) were accounted for, the restaurant was actually producing a nice yearly cash flow for the family.

DISCLAIMER: Hey, I’m not with the IRS and don’t render an opinion on these sort of things!

In addition to the owner perks discussed above, non cash deductions like depreciation are added back to the net profit shown Uncle Sam, as are one time expenses not likely to recur (eg: an air conditioning unit being replaced).

CPAs and business brokers often refer to the computation of discretionary cash flow as normalizing or recasting the company’s profit and loss statement.

Why is the computation of discretionary cash flow important?

It provides an accurate picture of the true cash producing ability of the business.  In effect, it uncamouflages the bookkeeping practices of most business owners.

And since many business appraisals are done based on the company’s discretionary cash flow, it’s important to be able to accurately compute the number.

If I can help with any questions or computations on this subject, don’t hesitate to contact me.

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William Bruce is an Accredited Business Intermediary (ABI) and Senior Valuation Analyst (SVA) assisting buyers and sellers of privately held businesses in the transfer of ownership.  He currently serves as president of the American Business Brokers Association.  His practice includes consulting services nationally on issues of business valuation and transfer.  He may be reached at (251) 990-5934 or by email at Will@WilliamBruce.org. 

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What Do Business Brokers Do?

By William Bruce

What are business brokers and what do they doWhat do business brokers do?  Very few people know, as the profession usually operates under the radar.

Business brokers are intermediaries who facilitate the sale of small to medium size privately held businesses by working with both buyers and sellers.  There are important differences, but in some respects business brokers operate similarly to real estate agents; however their practice is limited to business entities.

Licensing

Currently there are 17 states requiring business brokers to be licensed by their state’s real estate commission.  All states require a real estate license if the business broker is handling real estate along with the sale of the business entity.  However, the majority of small to medium size businesses are in leased locations with no real property as part of the sale.

Representation

Business brokers can represent either the buyer or seller in a sale.  Historically, the broker has traditionally represented the seller, but buyer representation is becoming more common.  The representation of one party in a transaction usually creates a fiduciary duty between the broker and the party represented.  Some states allow dual agency representation of both buyer and seller if all parties agree to the arrangement.

In some states, brokers can choose to act as transaction brokers, representing neither party as an agent but working to facilitate the transaction.  In this situation, there is no fiduciary duty created and the broker deals with both parties on the same level.

Training and Qualifications

A business background from experience and/or education is essential to a successful business brokerage practice.

Training specific to business brokerage can be obtained from several professional associations or other organizations.  The American Business Brokers Association, as one example, conducts a 2-day training seminar several times each year.  A quick Google of “business broker training” will return many options.

Credentials

Both national associations of business brokers in the U.S. offer credentials to brokers who have completed a level of education and experience in the profession.

The American Business Broker Association awards the Accredited Business Intermediary (ABI) credential.  The International Business Brokers Association offers the Certified Business Intermediary (CBI) designation.

In addition, several state associations, such as Texas and California, offer their own credentials to qualified members.

Duties

Business brokers perform many duties including:

  • Pricing the business with a professional valuation.
  • Drafting an offering summary, sometimes called a confidential business review. This piece becomes one of the most important marketing tools for the offering, and is provided to prospects only after they have signed a confidentiality agreement and been qualified by the broker.
  • Marketing the business to the widest possible audience while maintaining strict confidentiality.  This is one of the important distinguishing differences between business brokers and real estate agents.  Real estate agents put a sign in front of their properties and typically without the need for confidentiality, advertise widely the specific location.  Business brokers are trained to maintain strict confidentiality.
  • Introducing prospective buyers to the business after insuring confidentiality agreements have been executed.
  • Facilitating meetings between the seller and potential buyers.
  • Writing offers to purchase the business.
  • Handling negotiations between the parties after an offer has been made.
  • Facilitating the due diligence investigation.  Offers to purchase are almost always made contingent upon a further due diligence investigation.
  • Assisting the buyer in obtaining business acquisition financing.
  • Scheduling and facilitating the closing of the transaction.

Compensation

Business brokers have traditionally been compensated by the seller with a commission only fee arrangement which is detailed in a listing agreement and paid at closing.  However, in recent years some brokers have moved to a partial up front fee which may be credited to commission at closing.  This helps the broker defray the initial expenses involved in marketing the business, and according to some brokers, also serves to identify serious sellers as opposed to those who just want “to test the waters,” which many brokers regard as a waste of their time.

The customary commission rate ranges from 8 to 12 percent, with 10 percent being the most prevalent.  In a recent survey of the profession, 59 percent of brokers reported using a 10 percent commission rate.  Generally, the smaller the business, the higher the percentage rate of commission.

Top 3 Issues Involved in a Business Transfer

Many business brokers agree that the top three issues involved in the transfer of business ownership are:

  1. Confidentiality. Confidentiality is critical to the successful transfer of a business.  If it becomes known that a business is for sale, several things start happening and none of them are beneficial for either the seller or buyer of the business.  Business brokers are keenly aware of this and are experts at maintaining confidentiality.
  2. Valuation.  The issue of valuation is of critical concern to both buyers and sellers of businesses.  Business brokers are professionals in determining the most probable selling price of a business.
  3. Financing. Business acquisition loans were difficult to obtain in the recession of a few years ago.  Currently, however, banks and the SBA are again loaning money for business acquisitions.  Business brokers stay informed as to the type and source of loans that are available from various lenders and assist buyers in arranging financing.

Asset Sale Versus Corporate Stock Sale

Most transfers of privately held businesses handled by business brokers are asset sales rather than corporate stock sales.  The selling entity (whether sole proprietorship, partnership, corporation or LLC) sells selected assets to the acquiring entity.  The selected assets are usually all assets of the business, including trade name, with the exception of cash in the bank and the accounts receivable which are usually retained by the seller.

Number of Business Brokers

Because there is no national registration or licensing of business brokers, there is not an accurate count of the total number of brokers.  Estimates run from a low of 2,500 brokers to a high of 5,000 individuals in the U.S. in the profession.  The LinkedIn discussion group of the American Business Brokers Association, which is the largest LinkedIn Group of business brokers, has a membership of over 6,700 brokers and affiliated professionals.

Additional Information

For further reading, here are additional related websites and articles:

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William Bruce is an Accredited Business Intermediary (ABI) and Senior Valuation Analyst (SVA) assisting buyers and sellers of privately held businesses in the transfer of ownership.  He currently serves as president of the American Business Brokers Association.  His practice includes consulting services nationally on issues of business valuation and transfer.   He may be reached at (251) 990-5934 or by email at Will@WilliamBruce.org. 

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The Two Dramatically Different Definitions of “Amortization.”

The two distinctly different definitions of “amortization” explained.

The term amortization has two distinctly different meanings.  And both definitions are used in the financial world, adding to the confusion.

Most folks will think of amortization as a loan repayment table for a car or home loan, and that is the most frequent usage of the term.

If you’ve bought a car or home with an installment or mortgage loan, you’ve most likely got somewhere in your files an amortization schedule which breaks down each monthly payments between interest expense and the amount applied to the loan principal.  The amounts allocated to interest and loan principal vary each month as the principal balance due on the loan declines.

The other usage of the term amortization has no relation to the above.

Before moving into a discussion of the other meaning of the word amortization, let’s back up a moment and talk about the term depreciation.  Depreciation is the yearly write-down on financial statements of tangible business assets, usually buildings, furniture, fixtures and equipment.  This write-down of tangible assets is allowed by the IRS as an expense deduction on the profit and loss statement.

Now, let’s move back to the term amortization.  Amortization in this second meaning is a first cousin to depreciation.  It’s the write-down of intangible assets as opposed to the depreciation of tangible assets.  Intangible assets can be the value of a patent, a trademark, a copyright or business goodwill.  Intangible business assets are sometimes referred to as intellectual property.

If you see amortization listed on a profit and loss statement or tax return as an expense line item, you know that it’s this second meaning and therefore a write-down of intangible assets.  If you see a chart or table filled with columns and rows of numbers, it’s an amortization table breaking down a loan repayment schedule into the amounts allocated monthly to principal and interest.

It’s confusing to have such distinctly different meanings attributed to the same word, with both being used in the financial world.  We hope this article helps a bit to clear up the misunderstanding we frequently encounter in our mergers and acquisitions practice.

For further reading, here are additional articles that may be of interest:

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William Bruce is an Accredited Business Broker and Appraiser assisting buyers and sellers of privately held businesses in the transfer of ownership.  His practice includes consulting services nationally on issues of business valuation and transfer.  He currently serves as president of the American Business Brokers Association.  He may be reached at (251) 990-5934 or by email at Will@WilliamBruce.org.  His business brokerage website may be viewed at www.WilliamBruce.net.
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What is Intellectual Property? How Do You Value It?

Valuing intellectual propertyAs a business appraiser and intermediary in the sale, merger and acquisition of privately held companies, I’m often asked about how to value intellectual property.

Intellectual property is something originally created in the mind.  Among other things, it can be an invention, a  written manuscript, a piece of art or a company logo including words, phrases and images used in business.

Some experts in intellectual property break it down into four categories: copyrights, trademarks, patents and trade secrets.

A copyright is a person’s or company’s exclusive right to reproduce, publish, or sell his or her original work of authorship (as a literary, musical, dramatic, artistic, or architectural work).  The ownership right is protected by law.

A trademark is a distinctive design, graphics, logo, symbols, words, or any combination of these that uniquely identifies a company and gives the owner the legal rights to prevent its unauthorized use.

A patent is a right granted to an inventor by the federal government that permits the inventor to exclude others from making, selling or using the invention for a period of time.

In general, a trade secret is any confidential business information that gives a company a competitive edge.  Legal protection for owners of trade secrets is available but murkier than for the other categories.

How do you place a value on intellectual property?

It’s not easy but I’ll tell you how I do it to get fairly close.  When I’m appraising an on-going business entity, I’ll determine the total market value of the business by using industry-specific valuation formulas, sold comparables and other methods.  Then I’ll subtract from that total market value the (1) inventory at cost, (2) the furniture, fixtures and equipment at used replacement value, and (3) the value of any other tangible assets.

The remaining balance is the company’s goodwill value which may include intellectual property.  However, be aware that goodwill can include other items in addition to the intellectual property.  Such things as company reputation, trained employees and a loyal customer base are also part of the goodwill of the business.  For an article explaining goodwill in more detail, please see “What is Business Goodwill.”

For further reading, here are additional articles that may be of interest:

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William Bruce is an Accredited Business Intermediary (ABI) and Senior Valuation Analyst (SVA) assisting buyers and sellers of privately held businesses in the transfer of ownership.  He currently serves as president of the American Business Brokers Association.  His practice includes consulting services nationally on issues of business valuation and transfer.   He may be reached at (251) 990-5934 or by email at Will@WilliamBruce.org. 

Posted in Valuing, Buying or Selling a Business | Tagged , , , | 2 Comments