Valuing a Business

There are many different approaches to business valuation when selling a business.  Here is a simple explanation of some of the more common methods.

Profit Based Valuation

This method is used for small business where the owner is very active in the business and the buyer is effectively buying a job for themselves.

Value = Plant and Equipment + Annual Net Profit before deductions of Interest, tax, depreciation, and salary of the owner. 

This method does not work for larger businesses.

Discounted Cash Flow Valuation

This method is used when there are medium term or longer predictable cashflows usually backed by contracts.  An experienced professional adviser needs to be engaged to assist with determining value using this method.

Capitalisation of Future Maintainable Earnings

This is probably the most common methods used where the annual profit is multiplied by a number.  Accountants often talk about the multiple when talking about this method.  If the future maintable earnings is considered low risk and set to increase then the multiple would be higher than a high risk decreasing future earnings.

Value = EBIT x (Multiple)

The multiple is usually estimated using similar industry transactions to gauge value.

Asset Based

This methods values the business on the assets at a liquidation value and carries no goodwill.  Typically distressed businesses or businesses facing insolvency might sell at these values. 

Rule of Thumb

Where there are a lot of businesses in an industry that fairly regularly sell, there is a rule of thumb in valuing these businesses.  Businesses like milk runs, news agencies, accountancy practices, legal practices.

Conclusion

Valuations are an excellent guide and there are professionals who can guide you on the value of your business.  But remember it is only a guide and when the effects of supply and demand kick in, it could mean more or less than the valuation.

The Straw That Breaks the Deal's Back

One inevitable challenge that comes up when I speak with business owners about buying their business is the issue of price. More often that not, deals do not go through because owners wish to sell for more than I'm willing to pay.

To close this gap, I put quite a lot of time up front understanding a business so that I am completely aware of what I'm buying - all the good things and all the spiders under the rocks. Every business has elements that make them successful and ultimately profitable but all business have risk areas which I try to clearly understand before I buy.

Quite rightly, entrepreneurs have put blood, sweat and tears into their businesses that they have spent years if not decades building and now is the time to get rewarded for their efforts.

On my side (or any buyer for that matter) I have a return on investment target that I need to hit to make the deal worthwhile but also allow some room to cover the risks of that particular business.

Take this example:

A business has revenues of $10 million, EBIT of $1 million, Working Capital (Stock + Debtors - Creditors) of $1.5 million. The business owner wishes to achieve a price of 4 x EBIT + working capital which means the total purchase consideration would be 4 x $1 million + $1.5 million = $5.5 million.

So immediately my return on capital(ROC) if I were to do this deal is around 18% pretax. Now if I were to use bank finance to fund the entire transaction that takes means I would take a loan of $5.5 million with interest costing around 10% or $550k per year which takes my Profit before tax figure to $450k giving a return of 8%.

Unfortunately that is not the end of the story. To take the risk elements of deal into account such as economic downturn, losing a customer, losing a supplier then I would forecast a drop in revenue and profit of say 20%. This means EBIT falls to $800k and if fully bank financed my profit before tax falls to $250k giving me an ROC of 14.5% and 4.5% respectively.

So you can see the dilemma. Those returns I can get investing in the stock market on blue chip companies or in commercial property or in some cases I'm just better off leaving my money in the bank and not take any risk and I would still beat the return on the above example.

The moral of the story for business owners - the business is only worth what someone is willing to pay. If you want to sell quickly, leave something on the table for the buyer and when the buyer finds those inevitable spiders, the deal will be good enough to take on that risk and the deal will get done.

Preparing your business for sale

To ensure a quick transaction, here is a list of things you will need to have ready at a minimum:

• A full set of Financials including a Profit & Loss Statement & Balance Sheet for a minimum 12 months. The more history you have the better.
• Any significant contracts you have in place with banks, suppliers, customers, employees & vendors.
• A copy of your lease (if you are leasing)
• Contact details of your Accountant & Lawyer with permission for our team to speak with them.

This will usually be enough for our team to make an indicative offer on the business.  Once you have accepted the offer on the business, a due diligence process will take place which will involve a more detailed look at the operation.  For this stage you will need to have ready:

• A customer list with a breakdown of % of sales they represent.
• A vendor list with a breakdown of % of purchases they represent.
• Company Constitution, Shareholder Agreements, Loan Agreements
• A list of Intellectual Property the business may own including trademarks, trade secrets, patents with supporting documentation
• Access to any computer programs including Accounting programs etc that is used to run the business

The transaction is undertaken once our team gains a complete understanding of the business; all the positives and the negatives.