Is a Business Really Worth the Price?

There are three tests to determine if the price of a business provides reasonable value to its owner:

1. Salary: The business generates sufficient cash flow to pay at least fair market value compensation to the owner

(for his or her services as manager of the business)

.

2. Profitability: The business generates positive cash flow after debt interest and principal, taxes and capital requirements.

3. Return on investment: The business's cash flow relative to the amount invested is sufficient to meet the hypothetical buyer's return of his/her investment and meets the overall required rate of return.

The problem is, not all of these tests necessarily apply to any given business!

For hobby businesses, none of these tests are relevant. The owner does not care whether he or she earns a reasonable salary, is willing (within reasonable limits) to accept losses, and is unconcerned about return on investment. All a hobby business owner cares about is the non-economic benefits of ownership. Such businesses are usually liquidated when the owner loses interest in them. These businesses usually have no economic value to others.

Some small business owners care only about “buying a job”; that is, personal income security. Many single-location retail establishments and professional practices fall into this category. It is very difficult to sell such businesses (let alone for a desirable price), as they are usually highly dependent upon their owners' skills and relationships.

These businesses are managed only to earn secure incomes for their owners. They are not managed for profit; in fact, taxes create a huge disincentive, since dividends are taxed twice (for “C” corporations). As a result, such businesses often have below-average financial track records. For all of these reasons, it is difficult to recover one's capital investment from a sale of a business like this. Many of these businesses are sold to similar owners at a price equal to the liquidation of assets. When debt (to banks and/or prior owners) is assumed as part of the purchase, the second test becomes relevant. As debt is repaid, business owners build equity, just as homeowners do as they pay down their mortgages. These businesses offer their owners reasonable prospects of recovering their capital, and possibly capital gains.

The return on investment test applies to businesses where there are equity owners who expect to get their money back and make a return (profit) on their investment. These businesses (if successful) are the ones that generate capital gains when they are sold. The value to these prospective owners is based primarily on their personal "required return on investment."  This return on investment threashold is determined by the relationship of alternative investments and their relative degree of risk.

Business buyers need to be clear and realistic about their financial objectives and whether a desired business can meet them. A small business can provide its owner with a very nice current income during his or her working life, but it may not provide a pot of gold at the end of the rainbow when the owner wishes to retire. Caveat emptor! True business investments are made at prices which permit a return of capital and a return on the capital invested.