Hello,

The owner of ballet school where I teach is offering me to purchase the school/business. How to put the price on a business? I heard two options:
1. the price would be based on 2years of net income that the seller had
2. or, the average of past 5 years of net income

Which one of the them is fair?

Thank you,

Oleg Gorboulev

Depends, is the business gaining or losing money now compared to 5 years ago.

Are they going to open another school ?

What is an estimated loss of students when they leave.

Oleg, as Fr Chuck so aptly points out, there are a number of case-specific variables which determine (or at least suggest) an appropriate price tag--or reasonable price range--for any business. I wish I could tell you that there's a simple formula, but the range of variables is so vast that anyone who tries to sell you on a simple "rule of thumb" is doing you a disservice.

Fundamentally, a biz's value is a function of its expected future cash flows. Sounds easy, but as soon as you put pencil to paper you immediately realize that forecasting the cash flows depends in turn on a huge number of variables---locations, quality of personnel, current and expected competition, client attrition (those last two as pointed out by Fr Chuck), the area's demographics and growth projections, sales and marketing plans, favorable or unfavorable contractual commitments, the assets' tax bases... and that's barely the iceberg's tip.

History--as culled from tax returns, financial statements, and other reports--will provide valuable clues in your forecasting exercise, but it's really in the projections where the biz's value is revealed.

That said, though, there exists a wide spectrum of biz-pricing expertise you can rent. There are some consultants who can use some pretty fancy (and expensive) methodologies in helping you to read the tea leaves, but in most cases involving the purchase of smaller businesses, the cost-benefit ratio of such expertise is poor.

Instead, consider dropping a little coin, just enough to rent an accountant (or similar professional) who's had experience in small-biz purchase deals. Look for small, local firms, or even sole practitioners. This individual will know what to ask for. He/she will know how to parse the prior years' tax returns, and how to read between the lines of the financial statements. They'll be able to interpret the tax ramifications of the various possible deal structures that you and the seller might put together. There will be assets to be valued and transferred, liabilities to be assumed (or kept out of the deal), and contracts to be assigned, and you'll want an advisor to help you assess the economic consequences of these issues.

Any biz transfer (even for a smaller outfit) necessarily involves a number of contracts--at least if you're smart about it. An attorney with expertise in this particular area will be required, and that advisor at your elbow can probably suggest some names of lawyers with whom they've had good working experiences on prior deals.

Coming back full circle to your original question, this accountant or other advisor (again, one with some experience in this arena) can then help you to see what is a reasonable price for the business, can give you some tax-saving tips on how to structure the deal, and help you to navigate through the myriad negotiating points that'll invariably arise.

Best of luck!