Many questions accompany the sale of a business, but few are as important as a question of determining a value for the business.
The buyer and seller share much the same problem as each asks: How can the value of the business be determined? What are the methods for evaluating the business and how do they differ? When should each method be used? Is the business being sold or acquired at too high or low a price? How do you negotiate the best price?
Admittedly, small business valuations can be difficult. And it is far from a precise science, as no one equation can deal with all the factors that must be considered. In simple terms, valuation is a blend of many subjective and objective considerations reduced to a perceived value which must be closely shared between buyer and seller if a sale is to result.
Special Problems in Small Business Valuations
Unlike a large company whose value can be determined by the trading value of its stock, the small business can be difficult to value for several reasons.
1). Lack of Accurate Records: Many small businesses suffer from lack of records that accurately portray the true performance of the enterprise. The seller is perhaps the only person who really knows the value of the business as in income producer and will value the business on the earnings (including many hidden benefits) he realizes from the business. Unable to prove the profit history to the buyer, the buyer will normally assume a far lower valuation.
2). The Human Element: Small businesses are oftentimes only an extension of the seller. The seller has developed an emotional relationship, as well as a financial relationship with his own business. This is particularly true when the seller owned the business for a number of years as his primary livelihood. The seller may have started the business and nurtured it to maturity, and is typically difficult for him or her to use objective standards in measuring the true value of the business in economic or market terms. This explains why so many small businesses are overpriced and remain unsold. The subjectivity of the human factor does not, of course, change the actual value of the business, but to the extent the seller refuses to sell at a reasonable price it does present an obstacle.
3). Future Changes: While the value of the businesses to the buyer is the projection of how much the business can earn under his or her management, forecasting becomes difficult. Small businesses as income producers are exceptionally volatile. In many cases the business is built around one or two owners and the success of the business is nothing more than the mirror image contribution of these owners. This same successful pattern of operation may or may not be duplicated by the buyer. Small business transactions are replete with examples of businesses that quickly doubled or tripled its sales and earnings under new management. Others have seen the business shrink. To the extent the buyer is really buying an economic future, the financial forecast must translate into an accurate present value.