My regular reader will know about my traditional antipathy towards the vexed issue of business valuations.
That said, “what is my business worth?” remains the leading question for most business owners and so, at the insistence of a particularly persistent online business editor, I have jotted down some headline thoughts;
1. Preparation, preparation
This is an ongoing mantra of mine and one that I bore myself with on a regular basis because so much of the value of a business is shaped and enhanced by good preparation that it has to be included in any assessment on valuations. You’d be a schmuck to argue otherwise. If you’re thinking of selling your business, then the preparation process should have started yesterday.
2. Size really does matter
Well, it certainly does when considering the methodology and validity of valuing different sizes of business.
The differing factors involved when valuing public vs. privately valued companies, is like comparing apples to oranges.
Market liquidity, profit measurement, capital structure, risk profile, owner involvement can be very different and all play a role in making the valuation of private companies far more complex than the direct application of a public company price/earnings ratio.
Down at the grass roots of the SME market and the smaller, micro business is where it’s most difficult and pointless to search for a pre-sale valuation. The business is probably only generating a personal income for the owner and therefore it’s often a challenge to find a buyer, let alone drive hard on price.
With most owner operated businesses, the value is often driven by the motivation of the buyer and how much they’re prepared to pay and/or be able to finance for what is essentially, the purchase of an income and a job?
As a very general rule, these are privately owned businesses that generate super profits (i.e. more than just a personal income), have some kind of management structure and business goodwill to sell. For the sake of clarity, let’s say businesses generating >£500,000 in turnover.
This is a business upon which you can start to apply a set of diagnostics that enable you to drill down into an approximate value range.
It’s around these types of business that this article is now focused.
3. Applying the multiplier
The traditional method for valuing a business is the multiplier i.e.
[Net Profit of Business x Multiple of Sector = Valuation]
That sounds like an easy way to earn my valuation fee.
I’ll grab that well thumbed tome – “market sector multiples for dummies” – and see that most companies in that sector sell for 4x net profit, but research indicates that a similar company sold for only 2x net profit. I’ll go down the middle. Now then, a look at the P&L and £40,000 operating profit last year means it must be worth £120,000. Great, I’ll pitch that to the business owner.
Result? Grumpy ex-client and a long talk with myself in the bridge cafe (that’s the cafe they send losing contestants from The Apprentice TV show). The problem with this simplified explanation is that it doesn’t address what might be the true earnings of that business and/or variables that might affect the multiple.
It also takes a headline report when reported multiples can hide a multitude of ‘unknowns’. Therefore, the next step is to decide on an appropriate profit and multiple.
4. Finding the real profit
The audited accounts of some SMEs are not managed for bottom line presentation and therefore, the true earnings of that business are sometimes obscured.
To achieve an understanding about the true earnings of a business, you need to apply an ‘adjusted net profit’ calculation (“ANP”). The ANP welcomes back items and adjustments that are relevant only to the current management of the business and/or include exceptional and non-recurring items. These items are called ‘Add Backs’.
What are add backs?
The inclusion and justification of ‘Add Backs’ is often a key area of negotiation between seller and buyer, as every £ added back will then receive the multiplier effect.
Justified ‘add back’ items include;
- Directors’ costs such as PAYE, salary, cars, pension and health cover (but not dividends);
- Fees paid to additional directors or individuals who will not be involved in the company in the future;
- Other non-recurring costs can be added back, such as an exceptional bad debt or one-off costs that will not be repeated;
- Don’t overlook the fact that this process is not all one way. If the removal of the owner requires a replacement, then the ‘market rate’ cost of that replacement needs to be re-introduced to the ANP. Many advisors and owners forget that they’ve been paying themselves below market rate.
5. Calculating the multiple
Having established an adjusted net profit, you need a multiple.
The challenge here is to assess the many variables that can affect the multiple;
- Company Sector: Is it hot or niche?
- Financials: How is the business trading? Are the accounts in good order?
- Profitability / Margin: Is there a healthy margin? Are the profits vulnerable?
- Balance Sheet: How do the balance sheet ratios compare with sector norms? Any uncertainties?
- Owner Dependency: Is there a strong management team in place? Can the business survive the owner’s departure?
- Contracts: Another important factor in the stability and therefore the multiple. Does the company have any contracted income and therefore, forward visibility of earnings?
- Customers / Suppliers: Is the company reliant on a small number of either and therefore, hostage to their fortunes?
The vulnerability or otherwise, of these items, will play an important role in shaping the decision on a multiple.
You can take a sector ‘norm’, but it needs to be applied through the prism of an individual business and their idiosyncratic risk profile.
Lift the risk and increase the multiple.
Multiple rules of thumb
If all this appears rather complex and daunting, there are some very approximate rules of thumb you can follow;
– Multiples for SME non-listed companies can range from 1x ANP to 10x ANP;
– Owner run businesses tend to struggle to get above 2.5x ANP;
– Managed companies with ANP <£500k will generally attract 2x – 5x;
– Managed companies with ANP >£500k can aim for a range of 3x – 10x.
Balance sheet valuation
None of this takes into account the balance sheet. The majority of deals in this space are completed on the basis of a cash free, debt free structure, the remaining assets being viewed as the engine that drives the profit.
Determining an appropriate multiple for private companies will always involve a significant degree of opinion and subjectivity, as only quoted companies have valuations which are readily accessible and which have been established by the market.
6. Other factors
Google ‘how to value a business’ and you’ll find a myriad of different views, structures and “must try” valuation tools ….
This article is a whistle-stop journey through the basics of how to value a business using the traditional multiplier methodology. Dig a little deeper and you’ll find a wider range of issues that you might want to consider as part of your thinking process;
Asset Based Valuations: Important route if the business is asset rich.
Discounted Cash Flow: Helps to determine current value, using a future cash flow adjusted for time value. More technical and beholden to the vagaries of forecasts.
Industry Specific: You need to understand how each sector works and any changes taking place in that market space. For example, Insurance Broker valuations were traditionally based on income multiples, but have now shifted towards profit multiples.
Deal Structure: The real value of a deal can also become obscured by the structure of your deal. Not many cash deals in the market during last few years and therefore a final sale price may be undetermined as it will be shaped by a subsequent deferred and/or earn-out mechanism.
Tax Structure: All of the above is subjective, this point is crucial. Before going to market, instructing an advisor, getting excited …… get in front of a professional advisor and understand how different deal structures and will affect your tax position. Don’t go into any deal negotiation without clarity about this issue. That could really cost you.
7. Trust me, you might need an expert
OK, so every article needs a conclusion and this is it.
Unless you really, really, really need to know about the ‘pre-sale valuation’ of your business, forget it.
Give the same details to two ‘experts’ and you’re likely to get very different answers – see the article I referred to above.
Preparation, profitability, securing of earnings and getting the hell out of your own business …. that’s what drives value.
If still, you really, really, really need to know or just want some peace of mind or a document you can waft in front of the potential buyer, instruct someone with valuation ‘blood on their hands’. An expert who can provide the clarity and justification required to make it a worthwhile exercise.
Having seen the variables involved in this process, you can start to understand what impact different valuation decisions might have on your end price and expectation;
Low Multiple x Small ANP = not a lot, compared with;
High Multiple x Handsome ANP = life changing difference