How Much Is That Business In The Window?

Let's pretend for a second, you are the owner of a dry cleaners business. Business has been good the past few years, you've managed to grow your business at about 20% per year by opening a few new locations. You've even managed to sock away about $50k per year in cash after all expenses and re-investments. You remember back only four years ago that with only a $15,000 investment, you've come a long way.

One day, a representative from a larger chain of dry cleaners, comes in and offers you $250,000 to buy you out. Do you take the money?

Knowing the value of your business is a crucial part of being a business owner. Unfortunately, the price of a business is not as clearly defined as say, the value of your house, which has comparables and mortgage value assigned to it by a bank. Unlike a single asset such as a house, anything that produces a profit takes a significant amount of financial analysis, future projections, and discounting to determine what the true value is.

In this example above, you'd be foolish to accept such a low price since a worst case scenario, valuation would still put your worth at well over $200,000. Ironically, about five years ago, insurance agents found themselves in the same scenario when a large insurance corporation came around offering independent agents a buyout price. Most of them had no idea what they were worth and were ill-prepared for the situation.

The truth of the matter is, a buyout proposition can happen at any time to any business, especially in highly fragmented industries that are cost competitive. It is the responsibility of the business owner to know what they're worth in multiple income scenarios so they can make sure the price offered is fair.

Hiring a skilled business appraiser is an investment in your business that will pay for itself many times over in the future.

I would suggest this to anyone who in the future plans to sell their business or pass it on to their children through their estate. You can do an online search for one in your area. Just make sure they have credible experience or are certified by one of the accredited valuation bureaus (IBA, ASA, NACVA, CFA Institute, or a CPA with a ABV distinction).

Having the financial transparency of a proper business appraisal will give you and anyone else the proper assurance that your business is worth the time and effort you put into it.

Benjamin Graham Was Wrong

I was doing some equities research and I ran across this from Benjamin Graham's classic 1934 edition of Security Analysis:

This was one of Ben Graham's examples of calculating the Net Current Asset value for a stock, by using a discount rate to calculate the true liquidation value of various types of assets on the balance sheet. The only thing is that Ben Graham's White Motor Company example was actually incorrect.

If you look at the liquidation value of the Total Current Assets, he only subtracts Current Liabilities to arrive at the Net Current Assets Result of $16,300 when in fact he should of subtracted Total Liabilities.

In practice, if a company goes bankrupt, all creditors go to the front of the line because the assets are collateralized by debt. That would mean that ALL creditors go to the front of the line, not just the ones who are due in one year or less. If long term creditors were left out, how would they receive their repayment if the shareholders got what's left way before the creditor's debt needed to be serviced?

The answer is it would never happen. That would be the equivalent of the owners of a house in foreclosure receiving the rest of the sale price of the house after only the first year of debt had been paid for on a 30 year mortgage. What about the other 29 years worth of money the bank forked up so the owners could buy the house? The same is true for a company. The long term creditors are due their piece of the pie and will always get theirs well before the shareholder even see the leftovers.

The funny thing is that Benjamin Graham knew this and stated on the page before this example:

"The striking fact that the cash assets alone considerably exceed this figure, after deducting all liabilities, completely clinched the argument on this score."

However, its clear in the example that he only deducted current liabilities. Perhaps this was just a flub up, but the conclusions he derives are based upon the erroneous fact of subtracting current liabilities. The funny thing is that people like Buffet, Ruane, and Graham himself based the majority of their investing decisions on this calculation when it is in fact wrong. Talk about luck!