When it comes to buying a business, size does matter. Most lifestyle or micro businesses have under 1 million in annual sales. When it comes to lifestyle and micro businesses, the owner is also the top manager. For valuation purposes, a good rule of thumb for a marketable lifestyle or micro business is that the owner should generally earn about 10 to 20% of the gross sales. Therefore, a lifestyle or micro business that does $400k in revenue should have an owner that earns between $40k to $80k per year from owning and working in the business.
…owner should generally earn about 10 to 20% of the gross sales
Often when the million dollar gross sales per year threshold is eclipsed, the owner’s income drops to 10% or less. This drop is mostly due to the need to increase management, which leads to thinner margins, and higher inventory or carrying costs. In summary, the important issue for you as a buyer is how much can I expect to earn? When it comes to lifestyle and micro businesses where the owner is responsible for managing employees, taking care of customers, and other day-to-day activities, the owner likely views bookkeeping as a low priority. If anything, he relies on compiled financial reports and is far less inclined to use these reports to run their business. Therefore any financial records provided by the seller may be less accurate and require more due diligence on the part of the buyer.
From the perspective of an accountant or a banker, the value of a business is purely based on historical financial statements, which can be an incomplete view of a company’s real value. Other factors that drive the value of a business is its location, equipment, inventory, employees, patents, existing customer base, industry, vendor supplier relations, completion, and what you plan to do with the business after a sale. Therefore, you cannot rely on your accountant or banker to define a quantitative value of a business you are looking to buy.
Other value drivers aside, another rule of thumb is that businesses often sell for a little more than two times discretionary earnings. To understand discretionary earnings, you must first understand that a small business is an economic entity that provides a product or service that customers buy in sufficient quantities to allow the owner to pay all costs and operating expenses, including the owner’s salary. Let’s say that water represents revenue and a bucket represents the volume of all non-discretionary costs and operating expenses such as rent, employ salary (including a fair wage for the owner), marketing, insurance utilities, etc. The lip of the bucket represents the breaking even point of discretionary income. The water or revenue that overflows the bucket is considered discretionary income.
…businesses often sell for a little more than two times discretionary earnings
Let me be clear– discretionary income is not yet profit since the surplus revenue can be used in a variety of ways. The owner can use the surplus to buy more inventory, increase his promotional expenses, pay off debt, or pay himself more money. It is the discretionary income that is most often used to value a business. According to a business broker’s friend, with over 15-years experience selling businesses, the average selling price for lifestyle and micro business was 2.3 times the business’s discretionary earnings.
Do you know how to value a lifestyle or micro business?
