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Acquiring an existing business can be both exhilarating and exhausting. There are a number of ways to take over a business. However once you've identified a business to take over or to purchase, the value must be assessed.
Recommended reading: How to research a good business name.
One way to determine the value of a business is to add the total expenses of the business to the cost it would take to implement new management or annual salaries. Let me show you for example. What we would do is take the amount of the expenses that the business has had over the course of the year. So let's just say it's one hundred thousand dollars, and then the cost it would take to implement new management, say about fifty thousand dollars. We would then add these two together which would give us a hundred and fifty thousand dollars.
But what we would do with this, we would subtract this number from the amount of our total expenses. If we take the one hundred and fifty thousand dollars and we're going to subtract it from two hundred thousand dollars, which we're going to say is our annual income. You subtract the one fifty and the leaves us with fifty thousand dollars, and that's considered our free cash flow. We take then the free cash flow of the business and we're going to multiply it by a multiple of about five.
So here we have fifty thousand dollars of our free cash flow which we multiply times five, and the multiple can be anywhere from three to five, but it's good to use five. So that's going to give us two hundred and fifty thousand dollars. This then becomes the amount that we are actually going to sell the business for or what we can purchase it for.
But let's look at another example. Say that our annual income is not two hundred thousand dollars. Let's say that it's a hundred and twenty five thousand dollars, which then means we're going to have a negative cash flow position. We're actually going to be at a negative twenty five thousand dollars. This means that we shouldn't base this sale on for free cash flow, and we should look at an asset only purchase.
In most instances, an asset purchase is recommended. This avoids the purchaser assuming any unknown liabilities of the existing corporation.
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