Editor’s note: This is the third in a five-part series.

Regardless of whether you plan to sell your business soon or 30 years from now, documenting your financials is smart business. To be profitable now and when you sell, you must not only generate revenue, you must generate a positive cash flow as well.

Part 1 of this series looked at documenting your business assets as well as some strategies for growing your business. Remember, you can be paid only on what you can document. The most important factor in determining the worth of your business is your net profits and the amount of positive cash flow that your business generates.

Net profits, not revenues, matter most

One of the biggest mistakes that agents and brokers make is looking only at revenues rather than at how much they profit after expenses.

For example, one very successful agent was making the rounds on the speaking circuit explaining how he was earning $1 million in commissions. When questioned about his expenses, however, he had more than $950,000 in expenses.

To determine the worth of your business today, begin by determining your average net business profit (this is your income less all business expenses) for the last three years. You can either look at the net amount reported at the bottom of your Schedule C or the net amount reported on your business tax return.

You can legitimately add back depreciation, lease payments, conference attendance, etc. If you’re unclear on what is allowable, check with your tax professional for the current guidelines.

It’s critical that you also have accurate data on how many transactions you closed each year, the number of listings you took, and the costs associated with closing each deal.

Ideally, it’s best to record this separately for each of your clients, including those you work with but who do not transact with you. This can be done easily with a smartphone, iPad or tablet PC. Each time you spend any money to market a listing or to take out a buyer, note it in your CRM (customer relationship management system).

If this is too much hassle, the other approach is to take your total expenses for the year and to divide them by the total number of clients with whom you worked during the last year. It’s important to track both the clients who closed transactions as well as those who did not.

The reason is simple: When you can identify the profit holes in your business that fail to generate closed deals, it’s much easier to stop doing these activities and focus on what is profitable.

Profits are not enough

While profits are critical, equally important is having a positive, consistent cash flow. Consistent cash flow is critical because it’s required to pay the bills each month. If your business has major swings in income from month to month, it would be smart to look at adding new revenue sources that can even out your cash flow now and in the future.

For example, a real estate business that relies exclusively on the sale of single-family homes will usually not be as valuable as a real estate business where the owner also has monthly revenue from doing property management.

For owner-brokers, your business may be more valuable if you have a steady cash flow from desk fees as opposed to commissions only. This varies tremendously based upon the nature of your business and the types of property that you handle.

Can you withstand a full audit of your books and records?

The Internal Revenue Service regularly targets businesses that report their income on a Schedule C rather than as a partnership or corporation. Consequently, having accurate books is critical now and at the time of sale.

If you are going to sell, it’s important that your books can withstand a full audit. This means having all the supporting documents. One of the best reasons for going paperless is that you have a digital transaction of everything you do.

Whether it’s the IRS or your buyer’s certified public accountant, expect them to drill down into every minute detail before they pay you a dime for your business.

Determine your price

What’s your business worth? According to BusinessTown.com, here are some basic guidelines:

1. Eight to 10 times net profit
The maximum you can hope to obtain for your business is approximately eight to 10 times your profit. To obtain this amount, you must have a dominant market share and history of a high, long-term (five years or more), predictable income. Your business must be able to generate this income without relying on you as the rainmaker.

2. Five to seven times net profit
If you have an established business, good market position, some competitive pressures and a buyer who has strong skills who can successfully step into your shoes as the rainmaker, then you can probably obtain approximately five to seven times your current profit.

3. Four times net profit
If you have strong systems, market dominance and low dependence on you to be profitable, your business is worth approximately four times your net profits.

4. Two to three times net profit
If you have an established business with good market position, strong competition, and heavy dependence on your skills or your purchaser’s skills for success, your business is worth two to three times your net profits.

5. One times net profit
If you are a sole practitioner selling to another sole practitioner, in most cases your business is worth one year of net profits.

6. Whatever you can get
If you sell to someone who really wants your business or who is uneducated about how businesses are valued, negotiate hard to get whatever you can get.

What else does it take to sell your business? See Part 4 of this series.

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