This is a common question that we get when presenting estimates of value to business owners. The answer is important to consider when developing an exit strategy and making an initial investment into a business.
Quite often, their business is heavy on invested funds and short on documented cash flow. Let’s look at a hypothetical example – let’s say we are working with the owner of a national franchise. The owner opened his business 10 years ago with an initial investment of $1,000,000. Over that time, he paid himself $150,000-$200,000 per year. The value of the business came in at $550,000. A new franchise would cost over $1,300,000 to open today. This means the cost to purchase a fully operational business with immediate cash flow and customer base had a valuation at 58% less than opening a new store with no cash flow and no established customer base. That does not seem to make sense.
The answer lies in 2 areas: actual versus projected revenue and a certain amount of optimism. A person spending $1.3M to open a new franchise is projecting and anticipating more than $175,000 in annual income. Based on their own projections they see value in the new business. When presented with empirical data a buyer will use historical evidence to set the value of the business. An existing business for better or worse has a proven track record. That track record of financial success accounts for location, competition, employee environment, acceptance of concept, etc. The buyer will see the actual results and will project a much lower amount of optimism into the valuation.
As a seller, one almost factor is the annual earnings when calculating a final return. In this case the seller made $1.5M in earnings and received a price of $550,000. The total return was a doubling of his money in 10 years.
Documented cash flow is the single most important factor in pricing and selling a small business. Having said that, as a broker our job is to work with the seller to identify real growth opportunities that will increase future cash flow. Identifying these growth areas allows us to increase the optimism in the buyer and can create an emotion that will help justify and increase the value of your business.