In the world of small business, the sale of a business is dependent on two critical elements. They are DISCRETIONARY INCOME and the BUSINESS RISK MULTIPLIER. These two elements are multiplied to create the overall value of the business operation. In general, no small business operation is worth more than three times the discretionary income. As an example; suppose the operation earns $92,000 of discretionary income and has a multiplier of 2.3. Then the value of this business would equal $211,600. This would be the maximum price a willing buyer would pay for that business operation. This includes the associated physical assets to generate this income. If a buyer pays more than three times the income for an operation, he commits to a long term payback in effect making him a slave to the seller (lender). Furthermore, no banking institution is going to lend more than 80% of the value of the underlying assets to finance this arrangement; so most sellers end up financing their own sale.
Notice the buyer will most likely earn around $92,000 per year of extra income to pay for the operation he has bought. It will then take him 2.3 years to pay for this operation. The buyer looks for ways to increase the value immediately in order to pay off the debt in the least amount of time. For the seller, he is trying to maximize the value of the operation by having the largest profits possible and having the highest Business Risk Multiplier.
What is Discretionary Income? What is the Business Risk Multiplier?
There are textbook answers and there are realistic approaches to determining what this amount would be. The straight forward answer is the net income of the business under normal operating circumstances. It is best to use the underlying elements of the business operation to determine this amount. In most situations, the business is owned by one or two individuals, most often family members. These owners take higher than normal salaries and benefits. These benefits include transportation (a company paid vehicle), communications (a nicer cellphone), excess rent (they own the building and pay higher rent to themselves) and personal benefits (health, life, disability insurance). For the seller, it is important to add back these costs and then deduct the normal costs associated with these items. Thus, if the current owner receives a $70,000 a year salary plus benefits, the seller would add all these costs to the actual net profit and then using the substitution principle, deduct what would reasonably be paid to some manager/key individual to provide the same set of skill sets.
In addition, the seller would add back some onetime expenses such as legal fees for lawsuits or write-offs of unusual bad debts. Other items include the following:
- Excess rents paid over normal rents that would be charged;
- Benefits that are not normal in the industry including deluxe insurance packages, high end retirement plans, travel that is not customary given the nature of the business;
- Excess depreciation – often the business uses IRS accelerated depreciation and not some form of units or straight line depreciation. The seller should add back the depreciation and then subtract normal depreciation given the nature of the business operation;
- Unusual transactions from the sale of a division or an asset to losses from accidents or non- covered incidents (job performance discrepancies).
The goal is to generate the final net income from normal operations for a three year look back. Sum the three years and divide by three to get the average. You may give more weight to current or recent year over the period three years ago, but this is often addressed in the Business Risk Multiplier.
Business Risk Multiplier
This multiplier takes into consideration all of the normal operation factors affecting the ability of the business to maximize the net income from operations. Factors such as the quality of the staff and location of the business are evaluated and weighted to derive the final combined multiplier. The final multiplier is a number between zero and three. There are 10 underlying risks that make the business operation what it is. They are in the following weighted order:
- Stability of Historical Earnings – weight of 10
- Business and Industry Growth – weight of 9
- Type of Business – weight of 8
- Location and Facilities – weight of 7
- Stability and Skill Sets of Employees – weight of 6
- Competition – weight of 5
- Diversification of Products/Services – weight of 4
- Desirability and Marketability – weight of 3
- Depth of Management – weight of 2
- Availability of Capital/Terms of Sale – weight of 1
The above illustrates that the most important risk factor is earnings, otherwise known as net income.
Each of the risks is graded from .1 to as high as 3.0. From .1 to 1.0, the element in question is performing well below industry standards or has poor characteristics. From 1.1 to 2.0 indicates normalcy in that area. From 2.1 to 3.0 highlights exceptional ability over other similar businesses. Below demonstrates how to grade one of the risk characteristics in question:
Evaluating element number 4 for Location and Facilities, take into consideration the following:
- To grade this element less than 1.1, the buyer should take into consideration the proper location for the respective business operation, including retail, office, medical, or a business park. If the operation is a service based operation, then any location in a retail environment is inappropriate. What is the condition of the facilities? If in an older building without modern utilities such as bathroom and wiring, then grade this element less than 1.1.
- Mid-range grade is given between 1.0 and 2.1 if the location is appropriate and the facilities are within modern building codes, etc. How well is the exterior maintained? Does the association or landlord maintain the grounds, etc.? Consider all of these characteristics when evaluating the operation.
To grade this element higher than a 2.0, the location not only has to be appropriate but in an ideal environment. To clarify, if your market is young customers than a location near a college campus is better than one near a retirement facility. The customers in the zip code of the location should reflect the type of customer this business markets to for dollars. To evaluate the facilities, is it up to code, relatively new in construction, renovated, or extremely well maintained. Are the bathrooms or heating/AC systems new? Is the wiring for communications up to speed?
All of the above determine the correct number to assign to this element.
Each Risk Category is evaluated similar to the method illustrated above. Then, based on the weighted value of that characteristic, you determine the weighted sum by multiplying the score by the weight. If you score the category of Location and Facilities with a 2.4 and it is weighted a 7, then the final weighted value is 16.8. Each of the Risks is determined in the same way. All 10 weighted numbers are summed and the final number is divided by 10.
Summary – Discretionary Income Multiplier Formula
The final number should be between .1 and 3.0. It is extremely unlikely that any business operation is a perfect 3 or a zero. If a perfect 3.0, then the buyer should ask why the seller is stepping away from this perfect operation. If the multiplier is at the other end of the spectrum, then it would be easier and less expensive for the buyer to start his own business in the same industry. You are in effect only buying a name. And often this is not good news.
There are a lot other factors involved in this formula as well as a lot of subjective analysis to determine the real value of a business. As a seller, you should be looking at how to improve the risk characteristics identified above and increase the net income. This is called generating Marginal Value, and future articles will be dedicated to illustrating how to do this. As a buyer, you would look at how you can increase the value of the business by changing the score of the risk characteristics and the net income.
The key is the multiplier formula of net income times the risk multiplier. An increase in either one causes a significant increase in the overall value. If your income increases from $92,000 to $97,000 per year and the risk multiplier increases from 2.3 to 2.6, then the business goes from $211,600 in value to $252,200 in value. A whopping $40,600 increase in value is generated by making a few minor changes in how the business operates. This is referred to as generating Marginal Value. Act on Knowledge.
Do you want to learn how to get returns like this?
Then learn about Value Investing. Value investing in the simplest of terms means to buy low and sell high. Value investing is defined as a systematic process of buying high quality stock at an undervalued market price quantified by intrinsic value and justified via financial analysis; then selling the stock in a timely manner upon market price recovery.
There are four key principles used with value investing. Each is required. They are:
- Risk Reduction – Buy only high quality stocks;
- Intrinsic Value – The underlying assets and operations are of good quality and performance;
- Financial Analysis – Use core financial information, business ratios and key performance indicators to create a high level of confidence that recovery is just a matter of time;
- Patience – Allow time to work for the investor.
If you are interested in learning more, go to the Membership Program page under Value Investing section in the header above.
Join the value investing club and learn about value investing and how you can easily acquire similar results with your investment fund. Upon joining, you’ll receive the book Value Investing with Business Ratios, a reference guide used with all the decision models you build. Each member goes through three distinct phases:
- Education – Introduction to value investing along with terminology used are explained. Key principles of value investing are covered via a series of lessons and tutorials.
- Development – Members are taught how pools of investments are developed by first learning about financial metrics and how to read financial statements. The member then uses existing models to grasp the core understanding of developing buy/sell triggers for high quality stocks.
- Sophistication – Most members reach this phase of understanding after about six months. Many members create their own pools of investments and share with others their knowledge. Members are introduced to more sophisticated types of investments and how to use them to reduce risk and improve, via leverage, overall returns for their value investment pools.
Each week, you receive an e-mail with a full update on the pools. Follow along as the Investment Fund grows. Start investing with confidence from what you learn. Create your own fund and over time, accumulate wealth. Joining entitles you to the following:
- Lessons about value investing and the principles involved;
- Free webinars from the author following up the lessons;
- Charts, graphs, tutorials, templates and resources to use when you create your own pool;
- Access to existing pools and their respective data models along with buy/sell triggers;
- Follow along with the investment fund and its weekly updates;
- White papers addressing financial principles and proper interpretation methods; AND
- Some simple good advice.