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I’m considering buying a small business and presently estimating a reasonable offer. Should the employer salary be included in the profit? It seems [that] if the very small profit is the salary, the business isn’t actually profitable as is, and I should consider that in evaluating the worth of the business. —Y.R., San Francisco
If the current owner is working in the business but not taking any compensation, come up with a reasonable compensation figure and deduct that amount from the profit the business is reporting. If the profit disappears after that adjustment, “you’re buying a job. If you’re competent and have a good résumé, you can probably find a job without paying anybody,” says Joe Knight, co-owner of the Business Literacy Institute and co-author of Financial Intelligence.
Bill Hettinger, principal at the Institute for Finance & Entrepreneurship and author of Finance Without Fear, agrees: “If the business cannot afford to pay the staff, including the owner, and produce a profit, it’s not a profitable business. Without some changes, there won’t be a return on the investment.”
It could be that the current owner is running the business as an investment and is taking no compensation because she’s not working there. In that case, determine how profit numbers will be affected if you plan to work in the company and pay yourself.
If you find that the current owner is working in the business but not taking any compensation, ask her how she makes a living, Hettinger suggests: “You might find out the owner has another job or is being supported by a spouse. You might find out the business is for sale because it is continually losing money and the owner wants to get out. Perhaps it was just a hobby business to begin with and making a profit was secondary.”
Still interested? Do a deep dive into the company’s books, going back five years if possible and using audited financials, if they are available. Pay particular attention to the profit and loss statement, comparing the company’s gross margins, operating margins, and net margins with industry benchmarks, Hettinger says. He uses industry data available through New York University’s Stern School of Business.
“Since the business is marginally profitable, chances are the margins are worse than the industry. The next step is to look at the individual line items to figure out why and make sure that correcting whatever you find is something that you are prepared to fix, and able to fix,” he says. You might want to have an accountant familiar with this type of company give you a hand evaluating the shortcomings and what it would take to overcome them, he notes.
If the numbers come out to your satisfaction, talk to the employees, find out whether the company has leased equipment or property and at what terms, do a realistic appraisal of the company’s assets, and look over the customer list, Knight advises. “The more you research the structure of the business, the customer base, the location, and the demographics, the better off you’ll be,” he says. “Make a list of everything you can think of that would affect the value of this business and try to answer every question that comes up, starting with why it is for sale.”
Small businesses are typically valued based on their Ebitda, or earnings before interest, taxes, depreciation, and amortization. “Small businesses sell for multiples of Ebitda, from three to four times Ebitda for manufacturing companies to as high as 10 for companies with exciting new technology and high growth potential. Retail would be more at the low end, particularly if there’s very limited potential for growth,” Knight says. Ask around to find out what multipliers are typically used in this industry.