What Should I Pay for a Small Business?

My name's Robert Bonavito, New Jersey forensic accountant. This video is part of a series of videos where I discuss forensic accounting topics for educational purposes only.

At some point in every body's life, they want to buy a small business. And the way they buy the business is they look at what businesses are selling for and they make an offer. But that's not how you should do it. You should actually try to calculate how much you want to buy the business for. That's what we do a lot of, that's why we're here, and all the time we're going in and doing valuations for people who are potentially looking to buy a business. But I'm going to discuss three simple methodologies that you can use to value a business or at least get information together on it, and it's the asset, ratio and income.

The asset, let's use the example of a laundromat. A lot of people, for some reason, like to buy laundromats, maybe because it's a cash business. But if you're going to buy a laundromat, you would look at the assets, which would be the dryers and the washing machines, and you'd figure out how many dryers they had and what the cost or value of those was. And once you figured that out, you would know what the business is worth as an asset. You'd basically make a list of everything they had and estimate the value, and that's how much you'd buy the business for.

Or you could do a ratio. This is what we do. We have proprietary information databases we go to to figure out what laundromats are selling for. For example, if sales are a $100,000, maybe they sell for three times sales. Well, $100,000, it would sell for $300,000. This method is used on Wall Street, so it is a legitimate method if you can get good ratios. It gives you, at least, some kind of guideline if you're paying too much or too little. I encourage you to do some research in the industry to find out what is a ratio. The income, this is how most businesses are valued. And when I say income, it's usually net cash flow after all the expenses. And what you do is you project your income, estimate all your expenses, and whatever is left over after taxes is your net cash flow. And then what you do is take, like, five years and discount it back at a discount rate.

These three methodologies are used on Wall Street. Of course, it's much more detailed and sophisticated, and it takes a tremendous amount of time. But anyone who's looking to buy a business should sit down and think about these methods, see if they can get any kind of information on the business, just to get an idea. Maybe they want $300,000 for a business, but when you look at these methodologies, you're saying, "Well, it's only worth $200,000." I see it often, where businesses are way overpriced or underpriced because no one has done this work here, and actually figure out what these type of businesses are selling for. If any questions on this video, please feel free to call me.