I just received this inquiry from a friend. Following is my response.
My son has a business in xxx. REAL estate management. been in business about 3 years.
An investor he has met, for whom he manages several properties, is offering to buy in as a 50% partner in his business.
He told (my son) he’d offer him about 2.5x the annual income of the business for this share. It sounds low to me, and I’m wondering is there a formula that most investors use to calculate what a business is worth to buy or sell?
Perhaps it’s not so simple, but i’d love to get your reaction.
It is most important to have agreed to definition of terms. So, for this simple explanation, here is the lexicon:
Revenue – cash brought in
Expenses – cash sent out
Income – net of revenue and expense
Cash Flow to Owner – the term under which we will define what the owner makes. It includes, usually with small businesses, bottom line of business plus non cash items, plus owner salary, plus interest, plus personal items not used in business (owner health insurance, personal car, etc.)
It is rare that a small business, under, lets say, $300,000 in cash flow to owner will sell for more than 3 times cash flow. When they do it is because they are larger, have growing revenue and cash flow to owner, are in sound industry, have longevity in the market place, are well managed, etc, likely have significant hard assets.
There are no rules of thumb or industry standards so much as there are unique evaluations for each circumstance.
So, lets assume that the ‘I buy 1/2 for 2 1/2 x annual income’ means 2 1/2 times cash flow to owner for the entirety of the business. This could be a very good offer. If it is 2 1/2 x (total)cash flow to owner for just 1/2 it sounds exceptional. Now, a caveat to this entire discussion is – where is real estate industry in this neck of the woods? If it is lagging, the offer looks even better. It may mean the buyer is perhaps paying for his expectation of the future, rather than the norm (paying for the past performance.)
Make sense? Confuse you more? I would be happy to have a chat with someone if it would help.
If they need an independent valuation – I do that as a profession. Happy to help.
Cautions: Partnerships are hard. What would be buyer’s motive to perhaps pay so much for a rather new company? Is he paying cash? What will be the partnership agreement? The contents of the latter is critical. One of the wise attorney folks I have consulted before said ‘before you get in, know how you are going to get out.’
NOTE: It is really important to understand what the true value of a business is, what the buyer wants, what the ongoing operating agreements are to be, and do I really think I can manage with this person as my partner, by whatever the terms are.