When it comes time to sell your business the question “what is my business worth?” remains an important one 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, 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 grassroots 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 suppliers 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 business valuation 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.
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.
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.
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. You also might be eligible to get entrepreneurs relief on the sale of your business.
7. You might need a valuation 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. Be aware that generally giving the same details to two ‘experts’ is likely to get you different valuations from each and remember that key to getting an accurate and good valuation is 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.
8. Avoid the mistakes most sellers make & increase value
Being able to calculate and understand an accurate valuation of your business is one thing, the next major question is how do you increase your valuation and get the highest valuation possible that is justifable to the market and potential buyers.
If you’re an ambitious business owner then there’s often a dichotomy about growing a business, in that day-to-day management decisions should also be looking at the end game… you leaving it.
This isn’t about actively seeking exit (though an offer would be nice!), it’s about maintaining an operational and management focus on what makes, cement and enhances the value of your business. The key to this process is understanding and eliminating the intrinsic importance of you, the owner-operator.
Business owner-operator dependency is a problem
Yes, if you’re the owner of a business and when you walk, the value walks. The SME deal process is bedeviled by vendor’s (owners/entrepreneurs) being so critical to and embedded in their own business that buyers get a sense that the value will disintegrate one second after completion and vendor is gone.
Furthermore, the vendor often fails to understand the huge impact on the value that relates directly to this issue. Ask any seasoned observer of the SME deals market to name one major obstacle towards success, and a consistent response will be owner-operator dependency.
Goodwill transfer is the solution
Yes, plan ahead and implement a strategic process that extracts you from your business. Think about transferring personal goodwill into business goodwill, so that you eventually become surplus to the essential requirements of your business;
- Personal Goodwill relates to the individual rather than to the business;
- Business Goodwill relates to the brand reputation or trading characteristics that represent a particular business, regardless of who the owners are
By transferring the goodwill, you are reducing owner dependency and reducing the acquisition risk profile. Not only will you provide the buyer market with a less risky, higher value proposition, but by removing yourself, you’re removing one of the primary obstacles to achieving a deal of any kind.
Examples of goodwill transfer
|Business Function||Personal Goodwill||Business Goodwill|
|Sales||Generated by personal contacts||Generated by reputation of brand, location, pricing|
|Management||Decisions based around owner and/or their micro management||Autonomous team can continue after departure of owner|
|Marketing / Advertising||Focus on the individual||Focus on the brand|
|Process||Not systemised, remains in owners head||Systemised, documented, transferred|
|Agreements||Loose collection of agreements, personal relationships||Formalised agreements between stakeholders and business|
|Referrals||Generated via personal relationships and networks||Driven by formal, commercial relationships|
Take the holiday test
If your business is so all-consuming that you struggle to get away for a proper holiday, then it’s probably suffering from a heavy dose of owner dependency. Alongside the transfer of goodwill, set yourself an incremental holiday test that proves (to you & the buyer) your business can survive and thrive without you.
Take unexpected days off. Whatever holiday you took last year – take more this year and again next. Structure the business so that it no longer relies on your blood, sweat and years. Ultimately, why not aim for a pre-sale, breathtaking sabbatical – a two month Andean Trek with Ben Fogle or 6 weeks fly-fishing with JR Hartley? Then watch from a distance, as your valuation moves nor
Actions points for increasing your business valuation
In summary, here are some action points to follow in making your business not only survive without you but thrive and in doing so be able to achieve the highest valuation possible.
- Conduct an Operational/People Audit that Does Not Include You
- Address the Gaps and Start to Build a Strong Management Team
- Support Staff Development by Implementing Training Program
- Financially and Contractually anchor Key Staff
- Introduce Management to Key Business Contacts
- Remove Fear of Failure Culture (Brace Yourself for Mistakes)
- Systemise as much Process as Possible (Download what’s in your head)
- Take unexpected days off (The Holiday Test)
- Remove Yourself as the Go To Contact
- Learn to Trust & Delegate
- Take that Sabbatical
Bonus: Thoughts on business valuation for early-stage companies seeking investment
One of the most common questions we get asked at Angels Den is how do I value my business? Valuing your startup is a tricky concern. The reason this question comes up so often is because there is no simple answer. The valuation dictates how much equity you need to sell in order to get the funding you require. However, there is a fine line between holding onto a large share of your business and setting the valuation so high that it puts off all potential investors.
The bottom line is that your business is worth as much as an investor thinks it’s worth. But in order for you to come up with a valuation in the first place, you need to consider the following five things.
The hard truth is that until your business is post-revenue, it isn’t worth that much. Unless you’ve proven your revenue model and that there is the market demand then the investment is little more than a punt. This means that if an investor does want to finance your pre-revenue startup, they’ll tend to want a decent chunk of equity.
The best thing to do is actually to follow the lean startup model or bootstrap to MVP until you can prove your revenue model, at which point you can raise a lot more capital at a much higher valuation. We read with amazement that one of our American business angels values all pre-revenue companies at $100K, if he likes the idea he would give it $50K for 50%. Hmm?
The more innovative your idea and the harder it is to replicate then the more valuable it is. Furthermore, if you can demonstrate that you have an unfair advantage in the marketplace and have protected that unfair advantage, then it will increase the value of your startup.
A good investment opportunity is not just about the idea but the founders’ ability to execute that idea. If you’re a serial entrepreneur or have Richard Branson on your management team, then the investor will be more confident that you will deliver on your promises. This means that the team’s previous experience will have a direct bearing on the value of your business. To have such people investing their time and energy attracts a premium.
Now comes the task of coming up with some real numbers. The best place to start is seeing what companies in your sector have been valued at. If you are operating in a growth sector, then you will see much higher valuations than if you’re in a depressed sector.
For example, at our Tech Club it us unusual to see a startup valued for LESS than £500,000. The chances are you won’t be worth as much as a more developed competitor, but if your revenue and performance are similar, then you can use that competitor to justify your own valuation.
Although valuing a startup is a bit of an art, there is also some science involved. Investors like to see that assuming your calculations are correct there is the potential for high-growth and a good return on their investment. This can be done by taking your predicted EBITDA for the second year in which you make a profit and multiplying it x2. So let’s say you expect to generate £400,000 then you can warrant a revenue valuation of £800,000.
Also having an idea of what other businesses in your sector have exited at will give an investor a good indicator of what kind of return they can expect on their investment (if all goes to plan). But note that only one in a thousand startups meet or exceed their revenue predictions in their planned period. This is why being able to show traction will make your startup so much more valuable from the perspective of a potential investor.
Of course, if you cannot show traction you could still find you funding, but you will probably have to give away a larger slice of equity. The secret is knowing when to stop being small, seeing the competition stealing your business and knowing when to raise capital.