Business #11 came to us in a roundabout way. We were advertising for drafting employees to meet the needs of our cell tower engineering customers. A young lady came in to apply for the position. We asked her why she was leaving her existing job and she said her employer was retiring. We took that information and called the owner to find out about his business. Sure enough, he was selling his business. He was old, tired and ready to move on.
I contacted the business broker and we started in on the negotiations. The first thing I received was a copy of the appraisal, which the owner paid a lot of money for. Historic income statements showed declining sales: 2001, $1,119,655; 2002, $716,131; 2003, $439,599.
The appraiser then developed a risk factor model:
Build-Up Model, Risk Factors:
Risk-Free Rate 3.97%
Market Equity Risk Premium 6.92%
Small Business Risk Premium 20.00%
Total Discount Rate 30.89%
The appraiser then capitalized the earnings with a weighted average:
Capitalization of Earnings Normalized Weighting Weighted
Earnings Factor Earnings
Fiscal 2001 401,135 1.0 401,135
Fiscal 2002 239,774 2.0 479,548
Fiscal 2003 80,132 3.0 240,396
Sum of Weighted Earnings 1,121,079
Divide this by Sum of Weighting Factors 6.0
Weighted Average Earnings 186,847
Divided by Historic Capitalization Rate 30.89%
Total Equity Value 604,877
It is important to note that business appraisals are part art and part science. There are a lot of assumptions to be made and the combination of those assumptions can change the value wildly. In this case, the appraiser weighted the last 3 years of earnings, giving more recent years a higher weight. This is a common method, but past performance does not predict the future. If you follow the trend line, the sales will hit zero in a matter of a couple years. Stating that the company will generate free cash flow of $186,847 in perpetuity is wishful thinking at best. The new owner needs to pull the business out of a nose dive, which could cost even more capital. For this reason, its important to appraise a business in at least a few different ways to get a good idea of what’s at stake. We plan to cover some of these ways in future articles.
With an appraisal in hand, the owner opened negotiations with a sales price of $600,000. We told the broker we were not interested at all at that price. His expensive appraisal was only looking at past results and did not forecast the most likely scenario going forward, which was a continuation of 2003 results. We just stayed in touch while the broker tried to find other buyers. The seller and broker came to the realization if they wanted to sell his business he needed to lower the price to a reasonable number. We entered serious negotiations and the business sold for 25% of the appraised value. I negotiated my usual 50% down, 50% financed over 5 years.
We were able to stream-line the operation and this became a very profitable branch office, even at historically low volumes.
Keys To Success
- Business appraisals are just assumptions, if yours are different, don’t buy
- Do not be put off by the initial asking price
- Be observant and look for opportunities everywhere