Business Valuation – Assets Don’t Dictate a “Basement” Price

Far too often business buyers and brokers rationalize the purchase price of a cash negative business by the value of the fixed assets available for sale.  The argument goes that if the value of the tangible assets is X, the business must be worth at least X because, even on the rainiest day, one could sell these assets to recoup the initial investment.

That is a valid argument only when you have no interest in making money.  If you are in the business of making money you must severely discount the value of these assets for the fact that they are not income producing, are illiquid and come with an opportunity cost.

Buying a business is a risk versus return proposition.  The purchased assets must generate a rate of return greater than the buyer’s weighted average cost of capital or the assets will cost money rather than make money.

Consider again the cash negative business with a substantial fixed asset base and the buyers that justify an offer price based on the resale value these assets.  Have these buyers considered disposal costs?  Carrying costs?  Is there even an active market for the resale of these assets?    How quickly can they be converted to cash?

I will not argue that a business with breakeven cash flow and a purchase price fully collateralized by the fixed assets presents minimal risk.  But, I will argue that in most cases it offers minimal return.  Risk and return are not mutually exclusive concepts.  The available rate of return on an investment must exceed the rate of return of all other investments with the same risk profile in order to entice investment.  If a similar return can be achieved elsewhere with less risk then why would any knowledgeable investor assume the greater risk for less return?  This is the concept of opportunity cost.

Now you may argue that the intrigue of the discussed cash negative business with the purchase price fully collateralized by the assets is the potential of the assets to eventually generate a return in excess of that available through other investments.  This may be a valid argument.  However, you must consider why these assets have potential.  Is it because of what you bring to the table as the buyer or what the seller brings to the table?  If you as the buyer create the potential for the assets then why are you willing to pay the previous owner for this potential?

The seller must bring additional value to the table in excess of the resale value of the fixed assets in order to justify the full resale value for the assets.  Examples include: customer lists, vendor relationships, a talented workforce, management team, distribution network, research and development, etc.  If there is no additional value offered by the seller then why should you purchase the fixed assets?  Why not purchase a similar set of assets elsewhere (possibly cheaper) with the same ability to produce the desired rate of return?  (Hence, your leverage for requiring that the fixed assets be discounted)

Risk, return, opportunity cost and asset marketability must be considered in union with each other in order to properly evaluate the suitability of a potential business acquisition.  When doing so, one will quickly ascertain that the fixed assets of a breakeven or cash negative business do not dictate a “basement” price that a buyer should be willing to pay for the business.  If there is no return being offered by the seller to entice an investment in the assets (either monetary or other intangible value) then the buyer should discount the assets.  If not, what entices the purchase of these assets?  The opportunity to lose money each year?

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