What's the real value of that business you want to buy?

Any seller in his or her right mind wants to get as much as possible for their business.

This, of course, doesn't mean that the asking price is what they really expect to receive, as virtually anyone selling a business (or any item for that matter) will need to consider negotiating the price. However, the expectation of what a seller thinks their business is worth is most often higher, if not much higher, than the "actual value." Why is that?

Well, besides the ego factor, it's the numbers. Probably the most commonly used measure of value for sellers of a small business is earnings, to which a multiple is applied.

Although there are other ways for determining value that can be used in addition to, or sometimes instead of, a multiple of earnings, a discussion of those methods are beyond the scope of this article. When the multiple of earnings method is used as a measure or as the measure of value, the term "earnings" needs to be defined, e.g. are earnings based on cash flows or on the accrual method (including receivables and payables), and are the earnings before income taxes or after income taxes?

Also, is only the most current period's earnings used as the base, or is some average of current and prior years used? Once the basis for earnings has been determined, then the proper multiple should have been applied to arrive at a value. This multiple should accord an appropriate rate of return, based on a number of factors, such as what risks are associated with the particular business (discussed somewhat more fully below) and whether the earning being used are before or after deducting income taxes.

But wait! We haven't yet gotten to the main purpose of this article, which is to talk about the "add-backs" that a seller typically uses to adjust the earnings of the business being sold. Add-backs are expenses that the seller feels are not really expenses that a buyer will or should incur after he or she owns that business. So the seller starts with some earnings figure (such as cash flow or some other defined amount, as described above), and then adds back all or a portion of certain expenses, such as the expenses for autos and auto insurance, travel, meals and entertainment, telephone/cell phones and other perquisites (or what the seller has characterized as perquisites). Questions for the potential buyer to ask may include, "If these expenses are being added back, does that mean that they are not legitimate?" (The expenses may very well be appropriate as deductions for income tax purposes, and may or may not be expenses that a new owner would necessarily incur; thus the next question.) "To what extent will I, the potential buyer, need to incur these same expenses in order to generate the same level of revenue that the business is presently generating?" Actually, a new owner may need to incur more expenses than did the previous owner, at least in the beginning. This can be for such reasons as the inefficiencies associated with becoming familiar with the operations of the business, retaining customer relations and other transitional issues. Such additional expenses are, from the buyer's standpoint, an additional cost of acquiring the business.

In addition to the add-backs mentioned above, the seller who is active in the business and is drawing a salary will often add back all of that salary as if the value of that person's efforts is not something a buyer of a business needs to consider. This line of reasoning makes no sense, because either the buyer of the business is going to be active in that business and thus should receive both a fair compensation for the work performed, or will need to hire someone else to do the work. For example, assume the price being asked for a business is $250,000 based on five times annual earnings of $50,000 after adding back $40,000 of the active owner's salary. If the $40,000 is a fair salary and is what that owner could earn working for someone else or would have to pay someone else to do the work, then the return on the $250,000 investment would be only $10,000 per year. That is only a 4 percent per year return, and not the 20 percent that the seller may have been portraying. A true 20 percent return on the investment, i.e. with including the salary as a business expense (or without adding back the $40,000 salary), would be $50,000 per year, which may be an appropriate return based on the degree of risk of owning that particular business. Certainly, anything near a 4 percent annual return would almost never be appropriate. (A very low-risk business with a steady stream of income may only require a rate of return of, say, 10 percent, whereas a very high-risk business may warrant, say, a 50 percent rate of return.)

Often a buyer who intends on operating the business will be willing to accept a lower rate of return than would normally be expected under a "fair market value" standard (which is the hypothetical-willing-seller-and-hypothetical-willing-buyer-who-are-both-knowledgeable standard used by the IRS and in many buy-sell agreements, etc.). The satisfaction of owning one's business and having the job security that goes along with it is an intangible for which the buyer is willing to pay a somewhat greater price (or expect a lower rate of return). By no means, however, should a buyer pay a price for a business based on earnings that have never been adjusted for highly questionable add-backs.

In conclusion, as part of the due diligence process, which involves many components (about which a discussion is far beyond the scope of this article), ascertain as best you can that the financial figures you are presented with are credible; and however the earnings are defined and used as a determination of value, that any add-backs are appropriate under the circumstances. Also, consider start-up costs that can be expected during the transition period. Seeking the advice of a business valuator or someone having similar training should seriously be considered. Finally, I believe that, in virtually any situation where someone is about to purchase a business, having proper legal representation is vitally important before making any commitments or signing any agreements.

Richard M. Teichner is a certified public accountant accredited in business valuation, a certified valuation analyst and a certified divorce financial analyst. He is director of litigation support and business valuation services at Barnard, Vogler & Co., certified public accountants. He can be reached at (775) 786-6141 or rteichner@barnardvoglerc.com