Q. 4 years a friend and I started a media business and have steadily grown the business into what it is today.  It is a strong business with steady returns but my wife and I are ready to leave the business and return home for the kids to attend High School.  Given that I started the business with my longtime friend and business partner, I’d like to sell my stake to him.  How do we do that fairly so both of us leave the table happy?

A.  Firstly congratulations on building the business.  Secondly, have you spoken to your business partner?  Perhaps he might be interested to sell to a third party, although it’s hard to say without knowing the sub-industry you are in.  Keep in mind that may include some kind or “work-out” agreement such as staying in the business for two years to ensure a stable transition.

Moving on to valuation.  There are a lot different ways to value a business usually only a few are applicable to a small business.  You can use a straight asset valuation, use sales of comparable business or use an earnings multiple to determine value.

An asset valuation involves calculating the present value of all tangible assets which can include land, property, prepaid leases, furniture, equipment and décor.  This bases the business value on how much it would cost to replace your physical assets at current cost.

Using the Earnings Multiple method is a common way that small businesses are valued.  It is an easy method to determine a business’s listing price and is quite insightful.  Essentially, the concept is to determine a business’s ‘discretionary earnings’ that it delivers to the owner and then applying it to a multiple to determine the value of the business.  For example – if the discretionary earnings of a business is $200,000 and it is determined that the earnings multiple is 3x then a valuation of approximately $600,000 would be suitable for that particular business.  Multiples can vary depending on the industry, profitability and growth potential.

Which is why looking at sales of comparable businesses can give you a good idea on where to go with your business.  If there are no recent sales, and few if any are reported publically here in Shanghai, then you may need to talk to a few lawyers or business consultants to see if someone knows of a sale.  In every industry, there often networks of gossip such as suppliers who talk to everyone, and might be able to point you to someone who knows the details.  We’ve met wine distributors who can tell you every opening, closure or sale in the restaurant game.  What’s the equivalent in your industry?

Even, then we recommend using a qualified accountant/appraiser to assist you with any calculations.

For a list of possible valuation methods depending on the size of your business see http://www.schultzpartners.com/valuations.htm.

Is the Owner a key part of the business?

If the business cannot operate without the owner being there than the business might be worth no more than the physical assets.   Also ask yourself are customers/clients are loyal to the business or the owner.  A consistent brand has value.  Blue frog is a good example in Shanghai: people really don’t care about who owns it, they just appreciate the quality brand so that keeps them coming.  Sometimes business can follow an owner out the door – witness the rapt attention some restaurateurs demand in Shanghai.  Once they leave, often so do their loyal patrons.

Consider the cost of regular updates

Some restaurants and bars need to continually refresh their looks and appearance, some at least every two years or so.  It might seem like an accounting trick to use amortisation (i.e. slowly reduce the value of the assets based on their life) to reduce tax, but actually it’s a good discipline you should employ to understand the profitability of your business better.

Let’s give a tangible example.  If you need to spend $100,000 updating the furniture and fit-out every two years, then this should average each month across the two years.  Once you include the monthly update costs of $4,160 (or 25,000 RMB), how profitable is your venue truly?  I suspect that some sports bars and wood paneled bars that have their wear as a part of their charm, suddenly look a much better investment than the glossy bars with a pricy fit-out that seem to have a 12 month shelf-life at most.

Remove Emotion:

Business owners commonly think of their businesses as “their baby.”  They have worked hard at growing their business and they surely want to avoid getting anything less than full value.  We’ve seen business owners try to calculate the business value as the sum of the amount (time and money) they have invested over the years.  Sadly it doesn’t usually work like that, unless it is the first week or two of the businesses’ life before the fit-out/equipment has had a chance to degrade.

Ultimately it’s either based on the assets within the business or how much cash flow it can generate (or a combination).  If however you have been feeding your business a few things “just to upgrade” or as “a once off” and not making it stand by itself and produce a profit, its value could be simply nothing more than the physical furniture and equipment (the replacement value).  That might seem wrong in your gut, after all the sweat and tears, but life is like that sometimes.  We have seen business owners knock back an offer of say 1 million RMB only to desperately accept 500,000 RMB barely six months later.

Using Appraisers:

Business appraisers can be a valuable resource when it comes to a small business valuation.

An advantage of using an appraiser versus doing it on your own is that often gives you the true value of the business. This is because the seller will have to much emotion in the decision and either discount it too heavily or put the price tag way too high.  Furthermore, potential investors will give a professional valuation more credit than one created by the owner.

Your business partner is a lucky guy that you want to do the right thing by him.  If you can find one, let us help direct you in the right direction.