Expert: David K. Staub - 9/5/2007

Question
My wife is in the process of being bought out by her partner in their LLC.  The business has lost money in 2005 and 2006.  So far 2007 is also a loss, but only about 1/2 as much.  Her partner wants to move to a more expensive facility and is willing to buy my wife out.  How do I calculate the fair market value of the business.  The business is a personal training studio and they own several pieces of fitness equipment.  They also have a small client base and some projected revenues in thenext 3 months.  She made an offer of the value of the equipment minus depreciation, but I don't think that is a good way to calculate the business worth.  There are projected revenues and the client base which are also assets of the business.

Answer
Valuation of any business is as much an art as it is a science, and the issues are even more acute when the business has consistently lost money.  Generally, business valuations are based upon looking at several different methods of valuing the business and combining the results to reach a final valuation.

Assuming that "the value of the equipment minus depreciation" is roughly equivalent to the current value of the used equipment, your wife's partner is offering what is known as "liquidation value", which is one method valuation experts use to value a business.

Another method, discounting future cash flows, often yields a higher figure and is, in many cases, the one that I find most accurately represents the true value of the business.  Where you have steady earnings with consistent growth patterns, projecting future cash flows may be relatively undisputed, but where you are projecting that monthly cash deficits will turn into positive cash flow, it is much more likely that the assumptions underlying the calculation would be challenged.

A third method is the use of comparable sales.  In some cases, these comparables are based on "rules of thumb" that are common in the particular industry.  This method is useful when a buyer is purchasing business primarily for the revenue stream (rather than net cash flow), either because the costs are "sunk costs" which are in the past or because the seller's costs of providing the services are not really relevant to the buyer (perhaps because the buyer has certain economies of scale not available to the seller).  For example, companies that install and service home alarms are usually priced at a multiple of "recurring monthly revenues", with the result that even a company that is consistently losing money still has a valuable asset in its customer base.

Ultimately, however, it boils down to what the buyer is willing to pay and what your wife is willing to settle for.

I agree that there would seem to be some value in the customer base over and above the value of the equipment, but based on your facts, it seems unlikely that the "small client base" and "some projected revenue" adds much to the liquidation value, given the history of losses and the move to a more expensive facility.  Other factors may also affect the value, including whether the other party has the right under the LLC's operating agreement or relevant state law to simply close up shop and open a new facility on her own.  In that case, your bargaining power may be pretty weak.

I hope this explanation helps.