Risk

For example AAA municipal bonds (muni's) might have an equivalent pretax return on investment of 7% whereas, because of the added risk, an industrial distribution business might command a 30% pretax return on investment. Thus the muni's that returned $70,000 per year would be worth $1,000,000 ($70,000/0.07), Whereas the industrial supplier would have to cash flow $300,000 per year to be worth $1,000,000 ($300,000/0.30).

The difference is in the perceived risk of the business vs. the bonds.

The ROI a buyer shoots for is made up of two parts: the risk of the business plus the base of a relatively risk-free investment (such as the muni.s cited above). So in the example above of 30% ROI, 23 %(30%-7%) of the value calculation would be attributed to the business risk.

In the transaction world, the reciprocal of the ROI percentage is sometimes used, for example, a 30% ROI is equivalent to a 3.3 (1/0.33) multiplier. 20% ROI is equivalent to a 5 (1/0.20) multiplier. So a business with a $300,000 cash flow and a 5 multiplier (20% ROI) would value at $1.5 million (5 X $300,000).

In selecting the ROI target, the buyer wants to offset the business risks, which include:

1)	Loss of liquidity (average time to sell a business is about a year).
2)	Responsibility of owning the business (hassle factor).
3)	Risk inherent in transfer of the business (the seller may be a large part of the business, key employees and customers may leave).
4)	Risks inherent in the business (markets, employees, processes, obsolescence, financing).
5)	Risks external to the business (government, natural hazards).

The risk the buyer perceives is a key factor in the value of your business.

Return to What is my business worth?