Buying a business is one of the best ways to become a business owner without the risks of starting a business from scratch. If you make a good purchase, you will likely have customers coming in the door from day one. That means you have revenues and cash flow from day one to pay the bills and pay yourself, which dramatically reduces the risks of business ownership.

One of the most common questions small business buyers have is how to value a business. Business valuation can seem like a mysterious process. After all, how do you find comparable sales for businesses? The key to understanding business valuations is realizing that there are many different business valuation methods, and different business valuation methods apply in different situations.

Becoming a certified business valuation expert takes years of training and experience, and it is not the intent of this article to teach you all the different business valuation methods. However, if you are an individual looking to buy a small business, here are some simple tips to help you value the business you are looking to purchase.

First, realize that revenues usually do not mean much in determining the value of small businesses. It is wonderful if a small business has $1 million in sales annually, but it may not be worth much if the business has expenses of $1.2 million. Think about it. How much would you pay for a business that loses $200,000 a year? Most small business buyers are individuals looking to quit their jobs and become a business owners. These individuals have bills to pay and need money to live on. Therefore, the profits of the business are much more important to the valuation of small businesses than the revenues.

The next step is figuring out what “profits” mean. If the owner pays himself or herself $100,000 a year (shown under Payroll Expenses on the Profit and Loss Statement), the Net Income would be reduced by $100,000. If we simply look at the Net Income number, it may not reflect the owner’s true income. In this example, we would add the owner’s salary to the Net Income number in order to calculate the owner’s true income. There are also non-cash expenses such as depreciation and amortization that can be added back. Interest expenses can be added back if the seller is paying off all the debts of the business on closing day. If the seller runs discretionary expenses through the company (such as building a shed at his or her personal residence and putting the expense on company books), those discretionary expenses should be added back as well.

Once all the addbacks have been taken into consideration, the resulting number is called the Owner’s Discretionary Income, or ODI. As a general rule of thumb, small businesses sell based on a multiple of the ODI. The lower the ODI, the lower the multiple is. What is considered a low ODI? Think about it from the perspective of a buyer who is looking to quit his or her job, run this business, and live off the income from the business. If the ODI is $30,000 a year, it means the business buyer has $30,000 a year to live on if he or she maintains the business exactly as the seller did, and owns the business free and clear. Would you want to live on $30,000 a year? How much would you pay a business seller for the opportunity to live on $30,000 a year? In this example, a business with an ODI of $30,000 a year will probably not get a high multiple. On the other hand, let’s assume a business has an ODI of $250,000 a year. That’s an excellent income for the owner, which makes the business attractive to many more buyers. Higher ODIs will command higher multiples.

Exactly what the multiple is can depend on many factors. Is the industry growing or diminishing? Is the business owner operated or absentee owned? A business that can run without the owners having to be there all the time is more attractive to buyers, which in turn commands a higher multiple. How long has the company been in business? What is the contribution of the company’s top 5 customers to revenues? If the company derives 80% of its revenues from one customer, it becomes a riskier proposition to potential buyers. What if that customer stops doing business with the company? As you can see, a variety of factors can change the multiple that is applied to the ODI.

If you are looking to buy a business, one of the best investments you can make is to get a business valuation report on the company you are thinking about buying. Knowing how much the company is worth will ensure that you do not overpay, and give you the confidence to negotiate a purchase price with the seller.

Advantage Business Valuations provides business valuation services for small to mid-sized business owners in the United States. Founded by Aaron Muller who has valued thousands of companies as a business broker, Advantage Business Valuations helps small to mid-sized business owners determine the value of their business with ease and confidence. To discover the value of your business, visit www.AdvantageBusinessValuations.com.