A friend of mine has recently started a business that is doing well. It’s about two years old and my instinct tells me it’s about to explode. If I wanted to buy a piece of it, how would I go about coming up with a fair price? I figure, in general, I should find out how much revenue they expect to do in a year, multiply that by the percentage of the business I want to buy, then multiply that by some subjective value that represents growth (the multiple, right?). So how would I go about getting hard numbers for that formula? What else do I have to consider?
What kind of deal are you talking about?
You need to know how the business will be organized…corporation, partnership, LLC, that kind of thing. Whatever form the business takes, there will be various legal issues to consider, so you’ll want to discuss it with your own attorney, and possibly also with a tax professional as well.
What is your role to be? You going to work in the business, or just invest?
Going solely by Dragon’s Den, the investors there never valued a company based upon future earnings. If you’ve done $10,000 in business and see your company earning $50,000, $250,000 and $1,000,000 over the next three years, great. But your business isn’t worth $1.3 million. It’s worth $10,000.
Oakminster has a great point. Are we to assume it is a corporation or LLC where you can join without putting your own personal assets on the line if the business eventually fails? If not, I’d stop right there, because you need some kind of downside protection. Even if it’s not a high risk business that sells guns, parachutes, or something else that might open you up to obvious potential liability, you can’t predict the future. He could take out a massive loan for expansion and then blow all the money and be insolvent, or he might buy inventory, not pay for insurance, and have it all get stolen. I should also mention the obvious, which is that it’s a bad idea to go into business with friends or family in general. All that said, are you asking how you should evaluate percentage of ownership versus amount invested? I assume it’s a very small business so projections for growth are difficult at best. You could try to evaluate how other businesses doing the same thing are doing. If they are small businesses in the same line of work, they might even talk to you about it frankly if they don’t see you as a direct competitor. If they do, talk to someone farther away doing that same type of business since I assume it probably serves a local population. If it’s a specialized industry, I’d look up details about it online and ask your local librarian where you can find information about that industry. Hell, I’d flat out tell them you are thinking about investing in a business that does X and ask them what resources they have that might help you evaluate whether its a good decision. You’d be surprised what they might point you to.
I’m not aware of Dragon’s Den, but in your example, the business is worth significantly more than $10,000 (assuming the $10,000 represents 1-year profit after taxes and interest on debt).
But if you’re selling the business, I’ll be happy to take it off your hands for $10,000. 
I had heard somewhere, dont remember where that rule of thumb was a business is worth about 1 year of its net receipts (gross - cost of goods). That would make a small retail store that does 1 mil a year with 70% COGS should be worth about $300K + something for inventory on hand. Sounds pretty reasonable to me. By that guideline my biz would be worth around $100K and if someone offered me that I would probably take it for the chance to start fresh with more cash and the chance not to make some of the mistakes I made over the years.
I’m pretty sure it’s an LLC.
My role would just be as an investor. I might get a contract there at some point in the future, but I’d rather just give them some money and keep my current position.
This particular person is less of a friend and more of a business associate. We hang out sometimes and keep in touch, but we really just talk about business, although we don’t have any direct linkage to each other’s pockets. So he’s more of an “industry associate” friend than a “can you babysit for me” friend. So I’m not really afraid to throw money into the ring with this guy.
As for competition, it’s a huge market. There are a bunch of small companies and a few mega-MNCs but it’d be hard to get ahold of their information. They’re pretty secretive about that. And no, our services are not local. It’s a global thing.
I have been the lead on a team where we acquired a few multi-million dollar businesses over a period of a few years.
Yes, your basic formula is correct - for larger businesses executing multi-million dollar acquisitions. You scrub the numbers to arrive at EBITDA - Earnings before Income Tax, Appreciation and Amortization (i.e., the real money the business is throwing off) then multiply that by the % you are looking to acquire and multiply THAT by a “multiple.” What multiple? That is typically based by scanning the marketplace for “comps” - deals involving like companies to see what kind of multiple they got. Can be hard to find comps, although some “known” ones make it clear that you have to find the RIGHT comps. E.g., in healthcare, a professional / management services company might have a comp of 6EBITDA; whereas the right biotech may be as high as 20EBITDA.
Unproven companies that have not yet started to earn a profit are valued COMPLETELY differently and should be approached in a very different manner, i.e., dot-coms.
So - yeah; ground your basic thinking in that basic M&A equation, sure. But this is you and your friend’s business. Within that context I recommend laying out the basic equation but then having a conversation with your friend about it. This is more about you two coming to terms that it is about comps - we don’t know what sector the business is in, and it doesn’t sound big enough such that the standard equation should be adhered to aggressively. Does your friend want you on board and need the money from your investment? What can you make work that “smells right” within the context of the standard M&A equation?
Hope this helps.
What kind of contract? Would it be subject to any regulations (government, internal, professional ethics, etc.) regarding conflict of interest? If you want to work with this company in the future, you may be closing that door by investing in it now (or maybe not, but it’s definitely something to consider).
Damn. You’re right. I didn’t think of that. I have to sign a C.o.I. statement every time I pick up new work. I don’t think it’ll be a problem, but it could. The contract would be between the company and the government. I’d just be a contractor. I’m pretty sure owners can be contractors, too. I’ll add that to the list of things to look into. Thanks.
I was right, btw. It’s an LLC in Delaware.
That’s not really correct. Even if your company only does $10,000 in business for the next 5 years, it’s worth more than $10,000.
There are a number of valuation techniques, one of the most common being the Discounted Cash Flow model. Basically you are valuing the company based on the total expected cash flows over time, taking into account debt, discounting over time and so on.
I’m sure I was overly simplistic with my evaluation method, but the overall point remains. Yes, a business that’s made $10,000 in profit is worth more than $10K. But it’s not worth what the company will be worth in three years. It’s worth what it’s worth now. If your projections are to make 1 million dollars after 3 years, one of three things is happening
- your projections are wildly off base
- You plan on doing that without my investment
- you plan on doing that because of my investment
If it’s #1, there’s a fundemental problem with your analysis. If it’s #2, you really don’t need an investor in the first place. If it’s #3, then I, as the investor, shouldn’t get dinged in the negotiations based upon what I’ll be contributing. That seems backwards.
If you are approaching him unsolicited you may have to be willing to pay a premium. The main question for him is why would giving you a piece of the action make more sense than going to a bank or other financing source?
There are a lot of financial and accounting terms being thrown about carelessly here. The business is currently “worth” it’s current equity (assets minus liabilities) plus the total cash flows over time (discounted to present value) using those assets and debt structure. It’s highly unlikly that the company will grow a thousand-fold without a corresponding increase in assets and costs.
It’s worth what someone else is willing to pay for it.
What stops management from rewarding themselves in the form of salaries they may have forgone thus far? Larger and larger portions of the profits may go to this as the business moves from scratch to semi-mature.
You won’t have control of it and the normal control placed on large business isn’t there. Common with small business investing, so you have to make sure it’s addressed.