Buying a Business mentor Tom West responds to the following question from an inc.com user:
My partner and I are looking to buy a small computer services company. The owner's asking price is equal to the profit he made last year. Is that reasonable? I figured we'd be looking at average profit ? over, say, three to five years ? to smoothen the peaks and valleys. What do you say?
Tom West responds:
Keep in mind that formulas are still only ballpark estimates. Many service businesses sell for much more than one times the owner's net profit.
The real question here is what is net profit? Is it earnings before owner's salary? Owner's cash flow including add-backs such as interest, depreciation, and the like? Are we talking about pretax or after-tax profits? Or, as I suspect, are we talking about some mix of all these possibilities?
Here's an exercise that will lead us to a benchmark: Let's take the actual pretax profit of the business, then add to that the owner's salary, depreciation, interest, and the value of any other owner "perks." For this exercise, we'll assume the owner is working full-time in the business. OK, do the math. What did you come up with?
In my experience, most typical small businesses sell for between 1.5 and 2.5 times that number you just crunched, which is actually the total cash flow of the business.
I should also tell you that, in my experience, many service businesses sell for close to 100% of gross sales or revenues. If the revenues (and profits) of the business varied considerably over the past few years, or revenues have increased dramatically, then it may be correct to take the past few years into account. But let's face it: the business should probably be priced on last year's performance. Check out the deal thoroughly, and good luck!
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