Q: Due to personal reasons, my boss is selling the small service business I work in and I’m interested in possibly buying it. How can I make sure I’m getting a fair price?
There are three common approaches to valuing a business – income-based, asset-based, and market-based. Income-based approaches primarily use earnings (such as EBIT) or cash flow calculations, asset-based approaches primarily use asset values, liabilities, and liquidation costs, and market-based approaches primarily use recent sales of similar companies.
Be sure to work with a qualified professional to apply these methods.
Once you and your qualified professional have dug through the financials, remember to think through what kind of “key person discount” makes sense for your particular situation.
First, what is a “key person?”
The IRS Valuation Training for Appeals Officers Course Book defines a key person as “an individual whose contribution to a business is so significant that there is certainty that future earning levels will be adversely affected by the loss of the individual.”
In the case of a small service business, whether it be hair styling, lawn care, or math tutoring, the founder and owner is likely to qualify as a “key person.”
Second, what is a “key person discount?”
According to the American Institute of Certified Public Accountants’ Statement on Standards for Valuation Services, a key person discount is “an amount or percentage deducted from the value of an ownership interest to reflect the reduction in value resulting from the actual or potential loss of a key person in a business enterprise.”
Third, how much of a discount is appropriate?
There is no set percentage or formula to use, so the actual discount applied will depend in the specifics of your case. Two factors to consider are:
- Is the key person responsible is for the company’s profits?
- Can the key person be adequately replaced?
For me, the person who mows my lawn can be adequately replaced while the person who cuts my hair cannot, but a man with an award-winning lawn and a crew cut may disagree with me. The opinion that matters most is probably your current and future customers. Will the current customers stay and will new customers continue to flow in?
Food for thought – If you are a business owner who may want to sell your business someday, it behooves you to build your company in such a way that this discount is minimized.
Jennie Wong, Ph.D., is a syndicated business writer, executive coach, and the author of “Ask the Mompreneur: Small Business Advice on Starting and Growing Your Own Company,” available at www.JennieWong.com. Email your entrepreneurship questions to TheJennieWong@gmail.com.