For many business owners, their business is a major component of their overall personal wealth and in many cases will form a significant part of their retirement funds.
One of the biggest challenges facing business owners is understanding the value of their business, and the business drivers, to ensure that they always have their business ready for sale.
A purchaser will only pay what the business is worth to them. Recognising the basics of business valuation will ensure owners’ expectations are realistic and will help avoid disappointment and unnecessary stress during a sale process.
The main factors affecting the value of a business include the certainty of future profits/cash flow and risk. Valuers normally try to assess future profitability or “maintainable earnings” and then apply a capitalisation rate to calculate value.
A capitalisation rate is effectively the rate of return an investor is likely to demand to invest in a business within a certain industry and based on the profit and risks of the business.
The capitalisation rate reflects the degree of certainty of the business’s continued profitability or, in other words, the degree of risk that the expected future profit may not be realised.
This is usually reflected as a multiple of the net expected future annual profit.
For some sectors, valuation methods based on turnover have been established as ‘industry norms’, or ‘rules of thumb’.
These should be treated as an indication of value only, and in my view the application of this methodology is flawed in many cases.
The difference between the calculated business value and the realisable value of the business’s tangible assets is referred to as ‘goodwill’. Tangible assets usually consist of furniture, plant, equipment, vehicles and so forth. They may also include stocks of raw materials and finished goods.
A business is likely to be more valuable to a competitor than if it is sold to a party who will become another participant in the industry. This is known as strategic value.
This is because competitors can take advantage of synergies and economies of scale.
Competitors may be able to extract obvious savings in areas such as rent and personnel, which means that the profitability of the business for sale is significantly more as the competitor does not have to duplicate these costs.
In addition a competitor may be able to complement the business with aspects of their own business that enables additional market penetration of the products that are sold by the acquired business or vice versa.
Plan to maximise value
The key to unlocking the full value of a business is planning, and this means investing time and effort in preparing the business for sale.
Profitability and business risk
Profitability, matched by dependable cash flow, is an important element to consider when determining a business’ value.
However, not all businesses with the same profitability will have the same valuation.
The difference is usually risk. Some businesses tend to be more dependent than others on the business owner to achieve profitability.
This is a very important issue when trying to sell a business. A business that has robust systems and processes and that can easily be adopted by others is less likely to rely on a key person.
In addition, a business that has many customers versus a business that relies on a small number of key customers is likely to be considered less of a risk, as the loss of one key customer can have a big impact on the profitability of a business.
A business with a key supplier also has considerable risk as the business carries the risk of the supplier’s business including pricing, service, and delivery.
If the business has a regular and dependable positive cash flow, the business’s value is likely to be enhanced.
For some businesses, establishing a regular and dependable positive cash flow involves putting in place effective business systems.
In any event, for all small businesses, cash flow is of paramount importance. It is therefore an aspect of the business that all business owners should strive to improve in order to increase the value of their business.
It is important that businesses maintain reliable accounting records and can produce current financial accounts.
If it appears that a business’s accounting records are unreliable, or if the business cannot produce current financial accounts, any prospective purchaser is likely to discount the value of the business because of uncertainty about its real profitability.
When planning for a sale, the business records should correlate with what would be required in a due diligence process to be conducted by any potential purchaser.
Reviewing the business structure is important because the correct structure can directly increase the ‘after-tax’ value of the business.
Jeff Long is head of HLB Mann Judd’s business services division.
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