So is a business worth more to you if it has the potential to grow?
Hey everyone it’s David Barnett from InvestLocalBook.com the awesome blog site where we talk about
buying and selling businesses and local investing, personal finance issues and things like that.
First of all I want to thank everyone who attended my Business Buyer Advantage live
workshop in Moncton, New Brunswick last week.
It was an amazing day, Business Buyer Advantage goes for about nine hours it starts at 9 a.m.
and this time we finish up just before 6 p.m. around suppertime and what was so amazing
about it was the group of people that were in the room.
In fact most of the people who attended actually have already owned businesses before they
wanted to come and learn about buying businesses because they have a plan to either buy more
companies or grow their existing business through acquisition and what’s great about
these groups of course is that when people share their own stories are really enhances
the experience for everyone who are there in addition to learning the incredibly expensive
material that I go through over the course of the day.
This week though in my video series.
I have a question about potential one of my viewers wrote in and said ‘I’m looking
at buying a business and I’m meeting business sellers who tell me that their business is
worth more because of potential to grow the business’ or because there’s potentially
a new development in the area for example a convenience store, restaurant across the
street from a construction site where a huge building might be going in there maybe 5,000
new people moving into the neighborhood does this make a business worth more?
My opinion is that you don’t want to buy a business period unless there’s potential
to grow and improve the business but that doesn’t necessarily affect the price.
Let’s consider different terms that we use in the world of buying/selling businesses
so that you can see what these things mean with respect to your own deals.
Let’s say that we are talking about a small restaurant and as we know from earlier videos
that I’ve done businesses are valued based on discretionary cash flow.
So let’s say that we have a business and you do your research and you examine the business,
you do a proper normalization of the income statement and you determine that you feel
this business is worth let’s say $100,000.
So we have $100,000 is what you think is the fair market value of this business.
This is what you want to pay for the business.
So within a business we have certain tangible objects.
We’ve got maybe there is an oven and there’s tables and chairs and some cutlery maybe you
know signage outside etc., maybe there’s a POS system and when you add up the price
of all of these things let’s see you arrived at a value of $65,000.
So we have $65,000 and this is the asset value or what we call tangibles.
These are things that you can actually put your hand on, you can touch them.
So in business purchase terminology the difference between these two if the seller agreed to
sell you the business for $100,000 the difference between these two would be $35,000 and would
be the goodwill.
So what that represents to you as a buyer is the value of all those people who regularly
come to this restaurant, the people who get paid on a Friday and decide they don’t want
to cook supper for themselves at home and there is a regular habit of coming to your
restaurants, the guys who have your restaurants phone numbers stuck on their fridge so that
when they come home late on Saturday night they can call order pizza, etc. so that’s
good will and if the cash flow is there to make this business worth $100,000 then the
goodwill is certainly something real that is worth paying for you want a restaurant
with those regular customers you want to have the guy with the phone number on the fridge
because this is what drives the business is what gives the business value.
Now in this example, if the owner of the restaurant said you know what?
There’s a new building going up across the street or I have a new recipe or there’s
a new product coming out; you hear this and all sorts of different ways you’re going
to be able to do more with his business then I have had because you have a greater potential
instead of agreeing to sell it to you for $100,000, I want $120,000.
So he wants $120,000 and he says that there’s $20,000 here for the potential.
Now here’s the problem, who is going to do the work to obtain the earning that is
going to support that additional value because it’s not there today.
So what a seller is trying to do in a case like this is he’s trying to get a buyer
to pay him for work that the buyer’s going to have to do after the buyer takes over the
business and of course because the sales don’t exist today, we don’t know for certain that
these sales ever will in fact exist, the might never appear.
So a value put on potential over and above the fair value of the cash for exists today,
we call this Blue Sky.
So Blue Sky is literally paying for the promise of a clear blue day down the road.
You’re paying for the idea that the business is going to perform better over time.
Now I said earlier that to me the only reason you buy a business is because of improvements
that you are going to be able to make.
So I always tell my buyers when I’m working with them, find a business that either has
problems but is still profitable or that has issues or inefficiency is that you know how
to fix.
Because once you buy the business and you fix the problems where you improve the efficiencies
that you know how to fix the performance of the business will be improved.
This is your motivation.
This is the reason to buy the business but you shouldn’t be paying a seller for this
effort that you’re going to put in.
you should be spending the seller for what you get on closing day, which is a business
that has performed at a certain level and generated a certain cash flow.
So in this case it would be that $100,000 fair market value.
So you should pay for goodwill and good will is valuable it’s something that’s real
and it enhances the business and makes it worth owning but you shouldn’t in my opinion
paper blue sky because you’re the one who’s going to have to do the work in order to deliver
the results.
I hope that’s helpful.
We’ll see you next time.
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