How do you put a price on a business with no profit.

Transcript:

Hey there, it’s David Barnett again. This time I have a question from a business owner who wants to ask about selling a business and a few weeks ago I did a video about the three different ways that you could evaluate a business and if you recall, I talked about market valuation methods, I talked about income or capitalization market of evaluation methods and I talked about asset evaluation methods. So the question is, how do you put a price on a business that has no profit? Interesting question. Let’s take a look at those three methods in a little more detail. So if you recall from that earlier video, I had said that there were three different camps or methodologies for evaluating business. There are market comparison methods where we look at the subject business and compare it to other similar businesses of a similar size in the same industry. There is the capitalization method where we actually look at what rate of return are we looking for from an investment in this particular company. Then there is the asset accumulation method which are simply looking at what material things are part of this company. If we are looking at setting a price on a business that has no profit, then obviously we can’t use these methods at all (capitalization) because we have no profit for which to apply our mathematical formula, we can’t capitalize zero. Within market comparison there are two different methodologies of how we compare one company to others we’ve already sold. One method is a multiple of the cash flow or sellers discretionary earnings. The other method is what these businesses sell for as a percentage of sales. If we have a business that doesn’t earn a profit, then that also means that we can’t multiply the sellers discretionary earnings or if we can, maybe it’s a figure that’s actually below the firm market wage of what a manager would earn? So, it wouldn’t give any kind of accurate result. So this method then is off limits to us as well. What we are left with is comparing the subject company that doesn’t make any money to other companies that have sold and looking at what those other companies sold for as a percentage of sale. That’s one method we can do. We can also do the asset method. So, a business that doesn’t earn any money or has no profit. What exactly do you have to sell? Well, you got stuff, your tangibles; inventory, machinery, equipment etc. But you also do have sales. There are customers that come and they buy things from you. The problem is, either there aren’t enough of those customers or your business is not being managed in a proper fashion so that it produces a profit. That could be because of some structural problem, maybe you have twice as much space as you should have for this type of business and so you got an overly burdensome overhead for example. It could simply be that employees are stealing or there is some other problem in the way that the business is being run. When I was a business broker, putting businesses up for sale, if I had a business that didn’t have a profit, what I would do is I would use the market comparison method and use the percentage of sales, let’s say for example that give me a figure of $100,000 and then we would do an estimate of the asset accumulation; add up the value of all the things in the business, and let’s say that gives me 80,000. What I would do, is suggest a asking price that kind of averages the two. So let’s say we are going to ask 90,000. here is the other problem though. A business that has no profit can’t demonstrate to a banker that it’s going to be able to service any debt, right. So whenever I have a seller that has a business like this, I always have to give them an explanation as to what kind of offer they were going to be receiving. In all likelihood, they were going to be getting an offer that didn’t involve any institutional or bank financing. So for example this $90,000, maybe a buyer will come and say, I’ll give you $40,000 down and I will give you payment over five years adding up to another $50,000 for example. This price would certainly be negotiated downward from the asking price and the terms would always have to be flexible for the buyer because the buyers would all know that the only alternative the seller would have would be to close the business and liquidate the assets, send them to an auction for example. What I often say to many of my seller was, get any offer you can where your cash down payment from the buyer is likely going to exceed what you could hope to get in an auction scenario. If an auctioneer might get you $20,000 for the asset and you can find a buyer willing to give you $25,000 down and then you hold a note overtime for the balance; then that’s a great deal for you. The employees get to keep their job, the customers get to keep doing business with the business. It’s better for everyone all around, but it’s going to require a lot of flexibility on the part of the seller and if there are debts in the business that aren’t be serviced or can’t be serviced and the debts exceed the likely amount that we are able to get out of it, then that’s a really bad situation. Unfortunately, I have had people who have run businesses down to the point where they weren’t making any money, they weren’t able to service debt. They sold them for what they could and then they had to go to their banker and say, look, this situation is bad, I am not going to be able to pay you anyway, this is an opportunity I have to get out of this situation, and this is the kind of money I am able to bring to you. Can we work out a deal? They have been able to do something with their bankers to try to work themselves out of that debt, or in a really bad situation, they end up having to declare bankruptcy and stuff like that. Anyway I hope that answers your question, how do we put an asking price on a business that doesn’t have any profit? Basically what we look at is what is the worth of the sales and the tangible assets and we figure out how can we make it possible for someone to buy this business when in all likelihood, no bank or any other institution is going to finance a business who doesn’t have any cash flow. Thanks and don’t forget to sign up for my e-mail, newsletter that comes out every week. We’ll talk with you later. Bye. Hey, you made it to the end of the video. That’s great. Don’t forget to visit www.investlocalbook.com. Sign up for my e-mail list. It’s right down here under the welcome video. Thanks and we will see you next time. The Invest Local Book blog is all about small business, franchises, local investing, home economics, small business systems and borrowing money for your business. It’s full of great content and I look forward to seeing your feedback. Sign up for my mailing list and don’t miss a thing! [CLICK NOW]