How to value a business

Before you start a business, think about how much debt you will incur, the opportunity cost of working in a startup and the likely sale price: you may be better off buying an existing business.

Is it better to start a business from scratch, or to buy a business? Though there’s nothing wrong with starting your own business, you must first be aware of the usual pitfalls and how to avoid them.

Based on the stories I’ve heard over the years, what follows is a cautionary tale with an outcome that could have been avoided.

A young man decides to open his own café. He budgets $150,000 for start-up costs to cover the shop fit out, fixtures, stock, etc., but as it so often happens, by opening day this figure ends up being much closer to $250,000. This may sound high, but it’s actually quite conservative.

Let’s jump forward. As with many businesses, it can take some time to turn a profit, and in this case the café loses $50,000 in its first year. It has now cost the owner $300,000.

By the end of the second year, business has improved. The café has pulled its owner a wage of $50,000, bringing the amount the owner is currently in the red back down to $250,000. Or has it?

Over the course of these two years the owner had been roughing it for the sake of the business; working thirteen hours a day, seven days a week. For less than half of those hours, he could have been earning $50,000 a year working for someone else. That’s another two years of missed income.

Based on those potential earnings, the owner could now have been $350,000 better off had he never started the business.

It is at this point that the owner realises that he would need to work another three years just to break even on this loss. He decides that five years is a long time with nothing to show for, and inevitably comes to the decision to sell. He wants to place the business on the market for $250,000 expecting to at least recoup what was paid.

But businesses aren’t valued on the equipment. Businesses are valued on the profits, of which there were none. In the end the business will sell for between $50,000 and $100,000.

If that sounds depressing it’s because it is, but it happens all the time. There are two ways to avoid this very common tale. The first, is to keep in mind where the value comes from when you’re setting up your business; the profits, not the fit out. Be as conservative with spending money as possible, be wary of over-staffing and don’t over capitalise on the setup.

The second way to avoid the fate of the person in this example is to be the person who buys the business in this example. If you bought this business for $75,000 you would not only be skipping the first two years it took to break even on the running costs, but you would also be avoiding the three years it would have taken to pay off the setup cost.

Though you may have your own reasons for wanting to build your own business, just keep in mind that you could save yourself a lot of time and money by buying an already established business at a fair price.

Zoran Sarabacca is an Associate Principal at business agency xcllusive.

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