This follows up on my March 23 post about valuing businesses in hard times. A broker who attended called me today and pointed out something that I should have made much clearer.
His question was: how do you value a business that generates a fair salary to the owner manager and enough cash to pay off the acquisition debt in a reasonable period of time, but provides no additional return on investment?
My answer was based on the good old justification of purchase test. You first project the performance of the business (on a reasonable basis, no unjustified growth, etc.) with a fair market salary to the owner/manager, assuming no debt at all, and calculate the cash flow to equity.
Then, guess what the purchase price should be, and assume that it is financed with (say) 50% buyer cash at closing and 50% in a seller note. Assume the seller note bears interest at 8 to 10% (current rates for such financing, but you can play with this) and that the seller has to be repaid in full in 5 to 10 years, a pretty normal range. Redo your cash flow to equity calculation net of the (after tax) interest expense and principal repayments. If the business still generates cash flow to equity, raise the purchase price. When cash flow to equity goes negative, your price is too high. By doing these iterations (a spreadsheet model is easy to build), you can come up with a reasonable selling price.