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What do you buy when you buy a business?
Business value? Can't see the forest for the trees?
Buying a Business vs Buying the Equipment a Business Owns
Buying a business can be tricky business. I'll try to explain the core concepts in this post.
Sometimes it's easier to think about the whole and move down to the parts.
Let's use an example that is based on an actual business sale. Mary owned a business that made signs. Mary's customers were consumers who needed some signs for various events (garage sales, boats for sale, party directions, etc.) and she also had commercial account customers that were regular customers. These commercial accounts were real estate companies, auction houses, advertising agencies, real estate agents and promotional products companies.
Unfortunately, Mary had developed some health problems and felt that selling her business was her best course of action so she could devote her time and energy to resolving her health issues. Mary hired a business broker to find a buyer and sell the business. Mary's business was profitable, it paid her a salary, paid for her vehicle expenses and still had some profit left over to grow the business.
Mary really had no idea what her business was worth or even if there were any people who wanted to buy a sign business like hers.
The business broker found a number of potential buyers but the one with the best background was in advertising who felt good about Mary's business and decided to make an effort to buy the business. Mary's business had a few sign machines, computers, miscellaneous inventory and 1 vehicle. The current value of those used items (assets) was about $40,000. Mary's business was netting to Mary before tax over $90,000 per year with top line sales of $500,000.
Mary has 5 employees. Mary and the business broker decided to ask $270,000 for the business. The income of $90,000 is based on Seller's Discretionary Earnings (or Seller's Discretionary Cash Flow) which is a common industry earnings measure. Always make sure that you conduct your due diligence to be certain that any earnings the business owner or business broker claims can be backed up with logical and verifiable accounting records. Due diligence on a small business can be tedious but you can often uncover a hidden gem among the businesses available to buy.
Assets- Tangible? Intangible? What is Goodwill?
Some people are surprised when they look at businesses to find out that good businesses sell for more than the value of their tangible assets (equipment, vehicles, etc). Why is that? It's no coincidence that good businesses have a lot of valuable goodwill in the business. Goodwill is the amount of value in a business over and above the tangible assets value. Just think about brands who's names are hugely valuable...Nike, Apple, Microsoft, Coke. All of those names are worth a small fortune but the value is derived from the goodwill in the name itself.
The reason is that the Mary's business' value is higher than the value of the individual assets is that the business has the ability to deliver $500,000 in top line revenue at a profit to Mary of $90,000. The equipment can't do that alone. The business buyer could have gone on EBay or other equipment auction sites and bought the exact same equipment for $40,000. If the buyer did that he would have $40,000 worth of equipment but here's what he wouldn't have:
- A customer base, built up over many years, that knows to call the sign shop when it needs signs because it has a history of high quality and excellent service
- Trained employees who knows requirements for signs, knows the customers and the permits required
- A location that is known to be a sign company. People just show up to order signs because of their history with the business
- Vendors who know the sign business has been buying sign products for years and it must be a good business because they always pay their bills.
- A lease with a landlord who knows it's a good business because the business pays it's rent every month like clock work.
- A telephone number that customers have in their speed dial
- A website with a history and a good position on the web for sign keywords.
- A database of customers with all kinds of important information. .
Just think about how much time, effort and money it would take a buyer to recreate the above 5 intangible assets above. If the buyer, instead on buying Mary's business, had decided to buy the $40,000 worth of equipment and start from scratch he likely would lose money for years..trying to establish the 5 items above. These items are called intangible assets. Intangible assets are called intangible because, well, they aren't tangible...but they sure are valuable. For instance, the brand name Nike is an intangible asset and it is worth a not so small fortune.
Could the buyer have built the business to where Mary has it for less than $270,000? Maybe, maybe not. But now he owns the business and the business is paying that $270,000 off.
It's been reported that the average start-up business takes more than 3 years to reach break-even. If you buy the right existing business and run it properly, it can be immediately profitable.
The buyer decided to buy Mary's business and the business was profitable from the first day he owned it. It was profitable because he bought the business, not just the equipment to try to build a business.
If you need a new bicycle do you plan to go on EBay and buy a bunch of parts and try to put them together so that they work correctly? Or are you going to buy a bicycle all ready assembled and working so you can ride immediately?
Intangible assets can be best described in celebrity "branding". Take for instance Lady Gaga. I might not like her (or even have any real clue who she is) but there can be no doubt Lady Gaga is a marketing machine. Adding her name to anything can rocket sales overnight. That's what an intangible asset is, it's something of value that you can't manufacture out of raw materials. Which would you rather have today, a 5 pound sack of flour (a tangible asset) or the name Lady Gaga? Or Nike? Or Tiger Woods? You get the idea.
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This article is provided for thought and discussion only and is not legal, accounting or tax advice. Seek appropriate council from licensed professionals before taking any action. This content is copyright protected and can not be reproduced without the written consent of Sunbelt Business Brokers Houston Texas or Dan Elliott.