Due diligence refers to the exercise of reasonable care prior to committing to the acquisition or...
Twice in the last week I have spoken with new clients who have lost hundreds of thousands of dollars as a result of not understanding the basics of how business is valued.
The mistakes in valuations revolved around very common issues.
1) The first mistake was capitalising the owners salary.
When we calculate the future maintainable earnings of the business it is after deducting a commercial salary for the owner of the business.
The calculations of future maintainable earnings are made on the basis that you can employ someone to manage and run business for you. What you are buying is the business as a passive investment without having to run the business yourself. We deduct a commercial salary because we don't want to capitalise the owners salary otherwise you are paying for a job.
In the first instance we looked at a very small business and the accountant valuing a business for their family law proceedings had multiplied the owners earnings which were less than a commercial salary by 3 to arrive at the earnings of the business. As a result they ended up with a highly inflated value to the business. The real value of the business was nil which unfortunately in the case of most small businesses.
If a business fails to generate a commercial salary to the owner of the business then it cannot have any goodwill.
2) The second mistake involved in adding back of depreciation on the basis that it was a non-cash item.
We see this quite often in many small businesses where the business brokers are attempting to show the earnings that that a potential purchaser could earn if they had this business so they add back depreciation on the basis of non-cash item. Every business will need to replace the equipment that uses in the business whether it be computers, motor vehicles or plant and equipment. The equipment will not last forever and it will need to be replaced over time.
Depreciation is really an allocation of the costs of the equipment over its useful life. By adding back depreciation you are assuming that the business will never have to replace any piece of equipment for the rest of its life.
3) The third mistake is that they accepted the vendor's word that there was cash earnings of the business.
Cash was not declared in the income tax returns. There's a couple of things about cash earnings, one is as a black money is not declared on the tax returns and is never any proof that it actually exists. The reality is that most businesses especially retail businesses that do not declare their cash earnings use those funds to pay employees or suppliers cash. This means that not only is the cash received not declared but also the cash expenses of the business are not disclosed.
If you want to find out more about business valuations in the principles involved go to our Lawyers Zone section of Dolman Bateman where we have a number of videos on the valuation of of businesses and the common mistakes people make.
