Buying a business without a clear understanding of its value can lead to costly mistakes.
A business valuation and a thorough assessment of financial information help you make informed decisions and protect your investment.
You have likely heard the term “let the buyer beware.” If buyers do not thoroughly evaluate a product before making a purchase, they risk overpaying and regretting the decision later. This assessment should be done by the buyer or by a professional representing the buyer, not the seller or someone acting on their behalf. If you are preparing to purchase a business, a detailed assessment of the product is critical, and this includes obtaining a business valuation and requesting financial information to determine future cash flows.
Why A Business Valuation Matters to a Buyer
Simply put, a business valuation helps protect your interests as a buyer.
The Importance of an Independent Business Valuation
The first component of pre-purchase assessment is understanding the value of the business through a professional business valuation conducted by an independent third party. The seller may have hired a business broker who will provide them with a business valuation as part of their service, but this will not serve you, because brokers work on a commission basis, earning a percentage of the sales price. As a result, both the seller and the broker are financially motivated to achieve the highest price possible. They do not represent your interests. Therefore, the seller’s broker is not an independent third party in the transaction.
When you seek financing for a business acquisition, the bank’s standard procedure can unexpectedly lead you to overpay. While real estate financing requires an appraisal, assuming the same is true for a business purchase can lead to costly mistakes. Financing for a business purchase is often based on the buyer’s personal assets rather than on the actual value of the business, so there is no appraisal. As a result, if a buyer has sufficient assets to reduce the bank’s risk, they may be approved for a larger loan and ultimately pay more than what the business is worth.
A business valuation can be performed by a wide range of certified professionals. These certifications require experience, coursework, an exam, and a case study. A certified professional can provide a buyer with an independent assessment of the value of their business. The following list gives you a few options:
- American Society of Appraisers (ASA): Accredited Senior Appraiser (ASA)
- CFA Institute (CFAI): Chartered Financial Analyst (CFA)
- Institute of Business Appraisers (IBA): Certified Business Appraiser (CBA)
- American Institute of Certified Public Accountants (AICPA): Accredited In Business Valuation (ABV)
- National Association of Certified Valuation Analysts (NACVA): Certified Valuation Analyst (CVA)
You can also ask your trusted advisor (lawyer, CPA, banker, other) for a referral to someone who can provide support for you.
How to Assess Future Cash Flow
The next essential component of a thorough pre-purchase assessment involves gathering information from the buyer to determine the business’s expected cash flows. This requires requesting at least five years of financial data, including profit and loss statements and balance sheets. With this information, you can build your own projection of future cash flow to gain an understanding of the ability of the business to generate cash. Can you earn a return on your investment? Can you pay off any debt associated with the purchase? It is not just the purchase price of the business that matters, but the terms of the transaction as well.
Why Due Diligence Matters
Before purchasing a business, be proactive in your assessment so you don’t become another business owner who learns too late that they paid too much for their business. As an owner, integrating into a new business has its challenges such as being accepted by customers, employees, and suppliers. Don’t compound these challenges by overpaying for the business by failing to assess its cash flow.