By Jay Fenello
While homes were one of the first classes of property to enter deflation, Small Businesses and Commercial Real Estate are now deflating as well. And for many of the same reasons: people’s expectations of future value have gone down, there’s a lack of financing available, the declining net worth of buyers, rising unemployment, etc.
But there is also one major difference: small business and commercial real estate prices are directly related to the profits that they are expected to generate. If a small business is expected to earn $100,000 a year for its owner, its value is drastically different than the same business if it is only earning $50,000 a year. If a commercial strip center is expected to generate $100,000 a year in profits from lease income, its value is drastically different than the same property if is only generating $50,000 a year in profits.
For a concrete example, two years ago it was common for someone wishing to “buy a job” that generated $100,000 per year in profits to offer $250,000 for the business, paying $50,000 down in cash, and financing $200,000 with an SBA loan. (Note that this value is based on a multiple of 2.5 times cash flow.)
Then the Great Recession began, and small businesses started to suffer. It’s been very common to see gross incomes decline by 20% or more across the board. Because of the high level of fixed costs in a small business (things like rent and utilities), a 20% decline in sales could translate into an 80% decline in profits. The result is that this same business is now only generating $20,000 per year in profits, and would only be worth $50,000 using the same multiple.
But that’s not the worst part. Two years ago, businesses and commercial real estate were selling for premiums. Money was easy, and people were using pro-forma estimates of future earnings to justify higher prices. This was easy to do, because most business were showing a three year trend of improving results. So a buyer looking to buy a business that was reporting $60,000 in profits in 2005, $80,000 in 2006, and $100,000 in 2007, was happy to pay a high multiple on 2007 numbers, because they expected profits in 2008 to be $120,000 !!!
Today, the situation is reversed. Buyers are looking at sales trends that are going down, and they are expecting the down trend to continue again next year. Consequently, they are offering lower multiples, on these lower cash flow estimates.
Going back to our example, instead of offering $5o,000 for the business, today’s buyer may only offer $30,000 instead. Here’s a summary of how this has played out, using our sample company:
Small Business Valuations in the Great Recession