How does Greg calculate what his small business should sell for?

QUESTION: Greg in California wants to sell his small business, which is a sole proprietorship. He asks for Dave's advice on strategies to get it sold and what to sell it for.

The normal way to value a small business is simply called a cap rate, which is a capitalization rate of the net profits. That means, as an investor, if I pay you a certain amount of dollars for a business, then I want to see a rate of return on whatever I pay you.

What kind of return do I want to make? In a mutual fund, I can get 12%. In real estate, with a little hassle, I can make 15 to 17%. There's no chance I'm going into a small business unless it's 20 to 25%. If I’m going to make 25% on my money, that means your business is worth four or five times your net profit. I mean real net profit, which is after a manager is paid if you are not there.

You say your profit is \$55,000 before a manager is paid. If you're in California and I'm in Tennessee, I would hire someone to run it because I'm an investor, and you wouldn't be there because you sold it. If I pay a manager \$30,000, then I would make a net profit of \$25,000 after a manager. That means your business is valued somewhere between \$100,000 and \$125,000, give or take.

How it's performed over the last few years doesn't matter. I'm not buying what it might do–I'm buying what it has done, because of what it might do. The person who wants to buy your business gave you a pretty close estimation. I would give you \$125,000 for the business, not the equipment. If you have \$50,000 in equipment and you want to close it, then you have \$50,000 in equipment. Other than that, the equipment is used to create the profit.

If you want to sell it, that's probably about what it's worth. All the different formulas being used there are coming up with about the same number. The investor who wants to pay you one-and-a-half times the profit plus the equipment is doing so because they want a higher rate of return, but they've got the equipment to fall back on to get part of their money if the thing fails. That's a more risk-management approach than I am using. They are trying to limit risk by doing that.

If you had the one and a half plus \$5,000 worth of equipment, that would really undervalue your business, I think. My method would give you a better valuation on it. If you had a lot more equipment, their method would give you a little more for the business.