In order to know what a business is worth, one must understand what is being sold, and how the buyer evaluates how much he will pay for it. The price paid for a business is based on a thorough and unemotional analysis, one that evaluates the subject company and compares its potential risks and rewards to other potential investments. What does this mean in plain language? No one cares about the sacrifices you made in starting the business, or how much money you made last year or last week. The buyer is interested in projected future cash flow (reward) and the chance that the cash flow will not be achieved (risk). The bottom line is this: if I buy this business, how much money will I make? If the business is a risky one, there is a greater chance that the projected cash flows will not be achieved, so he will probably require a higher return to compensate me for taking the risk, and pay less for the business. If there is little risk associated with the business, he is probably willing to pay a higher price. But if the business does not have positive cash flow, it probably isn't worth much more than the value of its net assets.
There are two types of risk; those that can be controlled and those that cannot. Examples of risks that cannot be controlled are the economy, unemployment, tax law, and other government policy. Risks that often can be controlled are diversification risk (customer, product, supplier), technology, competition, and management depth. For example, when the economy is in recession, almost all business is affected, and little can be done about it. But a business that lacks diversification can take steps to diversify. For example, if the continued success of your business is based on one product, customer, or supplier, you should take steps to diversify; the loss of the one customer or supplier upon which your business depends would be viewed as a great risk by any potential buyer. Management depth is a risk that is often overlooked. I know so many business owners that are so proud of the fact that they know everything about their business and no one else knows anything. Guess what? This is very bad. If something happens to that person, the business is not worth much.
Another way to decrease the perceived risk, and increase the price of your business, is to maintain excellent accounting records, records that tell the story of your business without explanation. Time and time again, I see businesses sold where the seller left dollars on the table because the accounting records did not tell the complete story. Every business owner thinks they can explain away the problems, but each explanation adds to the buyer's perception of risk, until there are so many explanations that the buyer just walks away. There are many excellent accounting software packages available, and there is no reason why every business does not have computerized accounting records, that tell the financial story of your business.
When should you start getting ready to sell your business? Right now is the perfect time. Even though you think you are not a seller, you never know when the time will come, and when it does you have to be ready. What can you do right now to improve cash flow? A few ideas are reducing payroll, managing inventory, and dropping unprofitable products or customers. What about risk? When was the last time your looked for new customers? Can you identify other sources for your products? What are you doing to be better than the competition? You should be thinking about these things every day! What about your accounting records? Do you have accurate accrual basis financial statements within two weeks after the end of every month? If not, something is wrong. Go to Staples and buy QuickBooks. You will be glad you did.
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