Suppose you value a money-losing business with the valuation I most recommend for small businesses, the multiple of earnings approach. Plugging in a negative number for profits gives the business a negative value, indicating the seller should pay you to buy the business!
Seems crazy, but think about it: if the business is going to generate losses forever and you plan on running the business and funding these losses, then yes, you should be paid to take on the responsibility of buying the business.
Do buyers ever pay sellers to buy their business? It happens more than you may think. If a business has current losses and can’t be turned around, has debt or other liabilities, or the seller hopes that the current employees will keep their jobs, it is possible the owner might pay you to take over the business, or at least allow you to buy the business for less than its liquidation value.
However, that is the exception.
Even an Unprofitable Business Usually Has Some Value
If a business has been established for a few years, it almost certainly has some value. In fact, it might have a lot of value.
There are a number of different ways to value an unprofitable business, but multiple of earnings are not one of them. One approach would be multiple of sales. I previously mentioned that when I was selling my book publishing business, the standard sales multiple at that time was one times annual sales. So, if you were selling a book publisher at that time (when it was a much more viable industry than it is today), and it was slightly unprofitable or maybe just had a difficult year but was expected to return to average industry profitability, then maybe it would be worth a modest discount to the average, such as a 15 percent discount, or 0.85 times sales.
If the company had several unprofitable years and was expected to return to average industry profitability (but it was expected to take at least a couple of years and the risks were elevated), it might sell for as little as 0.50 times sales. Ideally, you would go and investigate what multiple of sales companies typically sell for in the industry you are considering.
Another way to value an unprofitable business is to look at the balance sheet; again, you might pay a discount to book value because of the lack of profitability.
You might estimate liquidation value, which includes the time, energy, and cost to liquidate, and you could value the business at that number.
If you feel you can (at least with some rough degree of comfort) estimate a range for profitable future earnings despite the current lack of profitability, you could use the discounted cash flow method that I discuss elsewhere. However, I would use an extremely deep discount in valuing projected positive future cash flows of a currently unprofitable business.
Before considering buying an unprofitable business, you really need to ask yourself what you are buying. Although it might appear to be a bargain, I urge a lot of caution.
Generally, I think it is a lot easier to make an existing profitable business larger and more profitable than it is to turn around an unprofitable business. The chances of complete failure and financial loss are much higher, too.
Why are so many businesses unprofitable?
Some businesses are unprofitable because it is taking them time to get established including building up a customer base and becoming more efficient at operating their businesses. Other businesses may be unprofitable because they are poorly run. But the most common reason that businesses are unprofitable is that they were not carefully started in the first place. Starting your business on a solid foundation and making the right decisions on the key issues is critically important to creating a successful business.
Takeaways You Can Use
- It’s not crazy for a seller to pay you to buy his or her business, but it is rare.
- Even most unprofitable businesses still have some value.
- Some unprofitable businesses can be very difficult to successfully turn around.
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