Have you ever thought how much your business is worth? This is something that has come up in my business recently, as we’re considering our next major step in business growth and how to fund it. If I’m perfectly honest, I hadn’t paid that much attention to the value of my business until now and I don’t think I’m alone. There’s a tendency for small business owners to just focus on the profitability of their business and forget about the value that they’re building.
As we discussed the potential value of the business, it reminded me of the number of methods available and the importance of understanding how the different valuation methods work. It can also help to develop an exit strategy should you decide to sell all or part of your business in the future, or if you’re considering third party investment from private equity or venture capital.
There are also many other reasons why you may need to calculate the value of your business but, whatever the reason, it’s important to remember that valuing a business is something of an art, albeit an art backed by science!
So what valuation methods are there?
Whilst there is a ready-made market and market price for the owners of listed public limited company shares, those needing a valuation for a private company need to be more creative. Various valuation methods have developed over the years, which can be used as a starting point and basis for negotiation when it comes to selling a business.
Earnings multiples are commonly used to value businesses with an established, profitable history. Often, a price earnings ratio (P/E ratio) is used, which represents the value of a business divided by its profits after tax. To obtain a valuation, this ratio is then multiplied by current profits. The calculation of the profit figure itself does depend on circumstances and will be adjusted for relevant factors.
The difficulty with using this method for private companies is establishing an appropriate P/E ratio to use as these vary widely. P/E ratios for quoted companies can be found in the financial press and one for a business in the same sector can be used as a general starting point. However, this needs to be discounted, as shares in quoted companies are much easier to buy and sell, and are therefore more attractive to investors.
Typically, the P/E ratio of a small unquoted company can be 30-50% lower than a comparable quoted company. Generally, small unquoted businesses are valued at somewhere between five and ten times their annual post tax profit. Of course, particular market conditions can affect this, with boom industries seeing their P/E ratios increase.
A similar method uses EBITDA (earnings before interest, tax, depreciation and amortisation), a term which essentially defines the cash profits of a business. Again, an appropriate multiple is applied.
Discounted cash flow is generally more appropriate for cash-generating, mature, stable businesses and those with good, long-term prospects. This is a more technical method that depends heavily on the assumptions made about long-term business conditions.
Essentially, the valuation is based on a cash flow forecast for several years forward plus a residual business value. The current value is then calculated using a discount rate, so that the value of the business can be established in today’s terms.
This method of valuation reflects the costs involved in setting up a business from scratch. Here, the costs of purchasing assets, recruiting and training staff, developing products and building up a customer base are the starting point for the valuation. A prospective buyer may look to reduce this for any cost savings they believe they could make.
This type of valuation method is most suited to businesses with a significant amount of tangible assets; for example, a stable, asset rich property or manufacturing business. However, the method does not take account of future earnings and is based on the sum of assets less liabilities. The starting point for the valuation is the assets as set out in the accounts, which will then be adjusted to reflect current market rates.
Industry rules of thumb
Where buying and selling a business is common, certain industry-wide rules of thumb may develop. For example, the number of outlets for an estate agency business or recurring fees for an accountancy practice.
What else should be considered during the valuation process?
There are a number of other factors to be considered during the valuation process. These may help to greatly enhance, or unfortunately reduce, the value of a business depending upon their significance.
Good growth potential is a key attribute of a valuable business and, as such, is very attractive to potential buyers. Market conditions, and how a business is adapting to these, are important; buyers will see their initial investment realised more quickly in a growing business.
External factors such as the state of the economy in general, as well as the specific market in which the business operates, can affect valuations. Of course, the number of potential interested buyers is also an influencing factor. Conversely, external factors such as a forced sale, perhaps due to ill health or death, may mean that a quick sale is needed and lower offers may have to be considered.
Business valuations may need to consider the effect of intangible assets, as they can be a significant factor. These, in many cases, will not appear on a balance sheet but are nevertheless fundamental to the value of the business. Consider the strength of a brand or goodwill that may have developed. For example, a licence held, the key people involved or the strength of customer relationships may also affect the value of the company.
The circumstances surrounding the valuation are important factors and may affect the choice of valuation method to use. For example, a business being wound up will be valued on a break up basis. Here, value must be expressed in terms of what the sum of realisable assets is, less liabilities. However, an on-going business (a ‘going concern’) will use one or more or a combination of the methods outlined above.
Perhaps the three most important things to remember when considering the valuation of your business for sale purposes are that:
Firstly, the true value is in the eye of the beholder. You need therefore to understand as much as possible about the buyer’s business and what they can expect to achieve as a result of the acquisition before you can understand the potential value of your business to them.
Secondly, there’s nothing like competition to encourage potential buyers of your business to pay top price, so always try to ensure that there’s some healthy competition between potential buyers and avoid locking yourself into negotiations with only one buyer before indicative prices have been agreed.
Thirdly, if you’re selling your business to a competitor, they are going to find out a lot about your business during the negotiation and due diligence stages so ensure that you are properly protected just in case the deal does not complete.
Teresa Payne is a solicitor and Managing Director of Connectionsb2b. She is also the owner of law firm, Parfitt Cresswell, as well as a director of a number of other businesses.