The IRS handles about 30 Million business tax returns every year.

The US Census Bureau lists about 28 Million business establishments

Dun & Bradstreet lists about 25 Million businesses.

About 75% of these businesses are sole proprietorships.

Many are 1-man shows with no employees (salesmen, contractors, free-lancers, etc.)

About 95% have revenues under $1 Million.

About 75% have revenues under $100,000.

About 25% have revenues under $25,000.

Less than 1% of businesses have more than 500 employees.

About 50% of businesses have less than 5 employees.

About 50% of new start-up businesses fail in the first two years.

Only about 20% of new start-up businesses survive 5 years.

Most small businesses fail due to poor management. They run out of money before becoming profitable.

Only about 10% of business failures declare bankruptcy. 90% just close the doors and disappear.

There are perhaps 1 million businesses for sale at any one time.

Several websites list over 50,000 of them at any one time.

80% of small business sales occur without the services of a Broker.

Brokers admit that they sell less than 20% of their small business listings.

In reality they sell less than 10% (1 out of 10) of their small business listings.

95% of the small businesses that are sold have revenues less than $1 Million.

99% of small business sales are asset sales.

Business Brokerage as a profession did not exist until the mid 1970’s. Prior to that time small business sales were handled by real estate agents, accountants, lawyers, or were sold by the owners themselves.

There is no special licensing required for business Brokers. In 34 States they are totally unlicensed and unregulated. In 16 States they are required to hold a real estate license. Arizona is one of the States requiring a real estate license to sell a business.

95% of Business Brokerage offices today are franchised.

There are about 4,000 business brokers in America today.

About 1,500 leave the business every year, and about 1,500 new ones begin. A few are very successful, but many make less than three sales a year.

Your chance of dealing with a neophyte who hasn’t sold a business yet is about one in three.

There is no Multiple Listing Service for small businesses like there is for real estate, and most business Brokers do not cooperate with each other. Less than 2% of business sales have 2 different brokers involved. The one who took the listing is usually the one to make the sale

There are approximately 25 prospective buyers for every small business that is for sale.

95% of these prospective buyers have never bought a business before.

95% of these prospective buyers do not know what kind of business they want.

The average prospective buyer spends about 2 years looking before giving up in frustration.

Less than 10% of people who begin looking for a business ever acquire one.

85% of prospective buyers do not have an accountant.

90% of prospective buyers do not have an attorney.

90% of small business owners work more than 40 hours a week.

50% of small business owners work between 60 and 80 hours a week.

Most small businesses keep their books on a cash basis rather than an accrual basis. Many use a hybrid method of their own. Most do not prepare a Balance Sheet. It is difficult to analyze and compare small businesses because there is no consistency in their record keeping.

The average sales price of small businesses that actually sell is about 2.2 times “Owners Benefit”

The median sales price of small businesses that actually sell is about 1.8 times “Owner’s Benefit”

WHY SUCH POOR STATISTICS

95% of buyers have never bought a business before, and are unprepared for the process.

They do not know how to evaluate and price a business for their needs.

They rely for advice and assistance on the Broker who has been hired by the business owner to sell it as quickly as possible for the highest price and best terms possible.

They will spend weeks, maybe months shopping for a used car. They will insist on driving it before making an offer. They will pay a mechanic to inspect it before buying it.

They will spend months, maybe years shopping for a home. They will have it both inspected and appraised before they can arrange a mortgage.

They will spend hours on the internet to save a few bucks when planning a vacation, an air flight or a cruise.

They will clip coupons, and buy groceries when they are on sale to save a few dollars.

But when it comes to buying a business which is often the largest purchase in their lifetime they will believe the asking price set by the seller and his Broker are reasonable. They will not spend a few dollars to have the business evaluated by an uninterested party. If they make an offer for 10% less than the asking price they will assume they have negotiated a good deal. This could be the biggest mistake they will ever make.

Many people have a problem in interpreting statistics. This short article may hopefully help rather than hopelessly confuse you.

There is no such thing as an average business. 50% of them will be above average – and 50% will be below average. And any specific business may be far above or far below average.

The term average can refer to mean, median or mode. What do these words mean?

The MEAN is the arithmetic average value of a set of numbers. To find it you add up the numbers and divide by the total of numbers there are in the set.

 The MEDIAN is the number in the middle of a set of numbers. There are an equal number of numbers above it and below it. To find the median you have to arrange the numbers in order from the lowest to the highest, then find the number exactly in the middle. If there is an even number of items in the set there will be no middle number, so we average the two middle numbers to find the median.

The MODE is the number that occurs most often in a set of numbers. A set of numbers can have more than one mode.  In some sets of numbers there is no number that occurs more than once, and there is no mode for that set. In some sets of numbers maybe two numbers will occur at an equal but greater frequency than any other number. In this case there are two modes, and the distribution is said to be bi-modal.

Example (A)       [3            5              5              6              10           12           15]

The mean is 8                    The median is 6                 The mode is 5

Example (B)        [4            5              5              5              8              12           86]

The mean is 18                  The median is 5                 The mode is 5

Example (C)                        [80          90           90           100         84           90]

The mean is 89                  The median is 90              The mode is 90

The RANGE is the difference between the highest and lowest value. In this last example the highest value is 100 and the lowest is 80, so the range is 20

The mean average can be very misleading. If I tell you the mean income of businesses in my town is  $1 Million dollars a year, you may assume that they are all successful. But maybe most of them may have very small incomes, and there is one business that makes several million a year. The average will be large because of that one very large business.

The median and mean together give a better idea of the spread of numbers. If there was just one very large business the median income would be quite low.

The mode may also help to correct false impressions if you know the mean and the median but you don’t actually have access to examine the actual data. For example:  if I tell you I am thinking of four numbers. Their mean is 50 and the median is 50. You would probably think these four numbers are close to one another. But I am actually thinking of           100         98                1              1.

The mean is 50 and the median is 50. But the mode is 1. If you know that, you will know that 1 is repeated more than once in the data, and since the mean is 50 with only 4 numbers you will conclude that the data must also include several high numbers.

Why am I writing this? Business brokers use arithmetic means of business sales figures as a “representative value” for valuation purposes. If you average the sales price of 100 businesses the arithmetic mean would be an indicator of the average sales price. But the mean is not always the best representative value to choose. It is usually better to use the median rather than the mean.

Another method used to smooth out the anomalies in the data is to just eliminate the upper and lower 10% or 25% of the data from consideration. This will get us closer to the central tendency of the data. But it won’t help in valuing a specific business that might belong in the higher or lower decile or quartile of the value range.

We believe the specific business under consideration should be analyzed and valued on its own. It should not be compared to average figures based on other businesses that may be in the same industry but otherwise are not comparable.

A major disadvantage to using rules of thumb to value a business is the number of different multiples that are used for the same type of practice. For example: Gary Trugman in his book “Understanding Business Valuation” published by the AICPA was valuing a Dental Practice, and found ten different Rules of Thumb.

In “Valuing Professional Pratices” published by CCH, James L. Horvath suggests two different methods:

(1) Fair Market Value of furniture, fixtures and equipment, plus 20 to 60 percent of annual revenues.

(2) Net asset value plus one year’s pre-tax earnings before owner’s compensation.

In the “Business Broker’s Reference Guide” published by Business Brokerage Press, Tom West  lists four different methods:

(3) 1 to 1.5 times annual adjusted earnings plus fixtures, equipment and inventory.

(4) Net assets plus 25 to 30 percent of gross annual revenues.

(5) 20 to 60 percent of annual fee revenue plus fixtures, equipment and inventory.

(6) one year’s pre-tax earnings before owner’s salary, plus fixtures, equipment and inventory.

In the “Handbook of Smalll Business Valuation Formulas” published by Valuation Press, Glenn M. Desmond suggests two more methods:

(7) 8 to 12 times monthly revenues plus net asset value.

(8) 2.5 to 5 times monthly revenues, plus net asset value.

In “Valuing Small Business and Professional Practices” published by McGraw Hill, Shannon Pratt mentions two additional methods:

(9) Equipment and fixtures plus 25  to 35 percent of revenue.

(10) Equipment and fixtures plus 50 to 100 pervent of earnings available to the owner.

These 10 methods yield values for the same dental practice ranging from $212,000 to $1.4 Million as follows:

(1)      $307,655 to $802,615

(2)      $730,489

(3)      $212,073 to $286,272

(4)      $567,935 to $629,845

(5)      $311,155 to $806,115

(6)      $535,579

(7)      $1,023,343 to $1,435,810

(8)      $516,377 to $774,168

(9)      $369,525 to $493,262

(10)      $291,270 to $532,079  

These authors are all top professionals in the valuation field. If they can’t agree, maybe we shouldn’t use Rule of Thumb to value a business.

Every child understands the time value of money. Just ask a 6 year old if they would rather have an ice cream cone now, or tomorrow. The answer is obvious. Ask them whether they would like one ice cream cone now or two ice cream cones next year. Again the answer is obvious.

Let’s assume you have just won a cash prize of $10,000 in the lottery. Would you rather have your $10,000 now, or to receive it spread over the next 5 years at an amount of $2,000 a year. Nobody that I know would choose to receive the payment spread over five years rather than receiving the same amount of money now.

Let’s do some simple arithmetic. If you receive the $10,000 today its present value is $10,000 because you can spend it all today.  You will have the option of investing it at (say 5%). This means you will have $10,500 one year from now.

But if you will not receive the $10,000 until next year its present value today will be less by the amount of interest that could be earned during the year. The present value of $10,000 to be received in one year’s time is $9,523 because that is the amount that must be invested today (at 5%) to equate to $10,000 in one year’s time.

This simple calculation demonstrates the time value of money. The value of the money you have in your hand today does not have the same value as it will have in the future.

A $100 dollar bill you have today will look the same as a $100 dollar bill you may have a year from now. It may look the same, but if you have it today you can spend it today and enjoy the benefit of whatever you may buy with it today – not next year.

Its value may be eroded by inflation. It may only have 95 cents worth of purchasing power next year. And it may never be received because either you or the person who was going to give it to you may not live long enough for the payment to be made.

Do you remember the Popeye comic strip? Wimpy would say “I’ll pay you Tuesday for a hamburger today”. He understood the time value of money. He knew it was better to defer payment until next Tuesday for something he could eat today.

The value of a business can also be affected by the time value of money. The definition of Fair Market Value assumes a business will be sold for cash or cash equivalents. If the seller holds a note or a mortgage then some arithmetic must be done to calculate the present value of the transaction because some of the money will not be received until a future date. This fact is often overlooked or misunderstood by buyers, sellers and Brokers.

Let’s consider the sale of four businesses for a price of $100,000.

One is sold for $100,000 cash at closing. One with a 5 year payout, one with a 7 year payout, and one with a 10 year payout. Discount rates of 5% and 10% would yield the following present values.

                                                 Rate 5%             Rate 10%

Business # 1                         $100,000.     $100,000.           

Business # 2                       $  78,400.        $  62,100.

Business # 3                       $  71,100.         $  51,300.

Business # 4                       $  61,390          $  38,600.

This illustrates that the cash equivalents of the sales structures of these four businesses is quite different.

DON’T BUY THE REAL ESTATE

Sometimes a small business owner also owns the real estate building from which it operates.

A big mistake is trying to sell them both together to the same buyer.

We recommend that the business and the real estate always be analyzed separately. Sometimes the real estate is not normal rental real estate but is a single use building. Real estate investors usually look for a 10% or 12% return, and buildings are often appraised by capitalizing the income.

We suggest that the owner keep the real estate. He can lease it with an option to buy at today’s price. Some portion or all of the rent payments can be applied to the eventual purchase price.

Let’s look at some figures.

Let’s say the building is worth $600,000 and the business is worth $300,000 for a total of $900,000.    The net profit of the business is $180,000 annually.

The owner wants to sell them together. He wants 25% down ($225,000) and will carry a note for the balance of $675,000 at 10% for 10 years.

Let him keep the real estate, and lease it for 10% a year ($60,000). The price of the business is now $300,000 with25% down ($75,000) and a note for $225,000 at 10% for 10 years.

We subtract the debt service from the net profit to see the cash flow.

We divide the cash flow by the down payment to see the % return in cash.

Buying the building                                                                        Leasing the building

$180,000 net income                                                                      $180,000 net income

$107,050 P&I annually                                                                    $  35,683 P&I annually

$  72,950 cash flow                                                                           $144,317 cash flow

                                                                                                                $  60,000 rent

                                                                                                                $  84,317 cash flow

72,950   = 32%                                                                                    84,317 = 112%

225,000                                                                                               75,000

Which is a better return                32% or 112%?

With the real estate we need $225,000 down.  Without it we need $75,000 down.

It’s easy to borrow $75,000 when the cash flow is $84,317

Much easier than borrowing $225,000 when the cash flow is $72,950

Why buy the real estate?  Lease it with an option to buy it later.

The selling price of a business is usually based on the replacement value of the tangible assets plus something extra for GOODWILL. There is seldom much disagreement over the value of the tangible assets such as furniture, fixtures, machinery, equipment and inventory. The disagreements occur with the arbitrary value placed on GOODWILL.

BUYERS look at a business for its ability to generate enough profits to meet expenses, to make a fair return on the capital invested, and to pay a reasonable wage to the owner for work performed.               If a business doesn’t meet these requirements then that business has no goodwill. It is not worth much more than the replacement value of its tangible assets. In fact most buyers will not want to buy the assets – even at bargain prices- if the business is not sufficiently profitable. They would rather leave their money in the bank until a more profitable business is located.

SELLERS of course see the situation differently. They have invested much blood, sweat and tears into the business. They wish to recover their entire capital investment and also want to be compensated for their time and effort spent. They desperately try to sell the POTENTIAL of the business. This is not being realistic. If their efforts had been successful the results would have been reflected in the profits of the business. A business will not sell if a buyer is expected to repay the seller for his past mistakes and all the things he didn’t do to make the business profitable.

A person will purchase an unprofitable business is because he recognizes the POTENTIAL – but it is the buyer who brings POTENTIAL to the bargaining table, not the seller. Every buyer thinks he can do much better than the previous owner. He has great hopes and expectations for the future of the business.       If he achieves his goals it will be as a result of his efforts. He may buy the business because he sees the potential – but he will not pay the seller for what he hopes to do.

He knows that if he fails to achieve his dream, and has to close it down he will only be able to salvage the liquidation value of the tangible assets. He will not be willing to pay much more than this when he takes over an unprofitable business.

Unless a business has a proven record of profitable earnings it is not worth any more than the replacement value of its tangible assets.  

There  is  no  Goodwill  in  an  unprofitable  business