Determining the value of the business is one of the most difficult things the owner will be required to do, and the seller will be required to verify. There are several reasons why a fair and accurate assessment of business worth is required, ranging from determining a selling price to raising investment capital.
Rules of thumb, guesstimates, and average industry multiples are great if you can afford to walk away from tens of thousands, hundreds of thousands and in some cases, millions of dollars!
The problem with these simplified valuation methods is that they assume the value of your business is going to be the same as the average. The reality is, all individual businesses are highly unique (even franchises), and the price that one similar business sold for is not indicative of the value of another business.
There are just too many variables which significantly impact business value.
To accurately determine the value of a business requires a professional appraisal which carefully reviews a wide variety of qualitative and quantitative business attributes. It doesn’t matter if you are buying a business or selling a business, a professional business valuation is an investment which not only provides clarity on your position but can provide you with the ammunition to negotiate a significantly better deal.
What Is Business Value?
Theoretically, business value (also known as Enterprise Value) is the price at which a business is likely to change hands between a willing but not anxious seller and a willing but not anxious buyer. Business Valuation Specialists know this as the “Fair Value” of the business. The Enterprise Value includes all of the assets and goodwill of the business used to generate its cash flows.
Practically, it is important to realise that the value of a business will be perceived differently by different parties. This is because buyers and sellers have different motivations and will have a differing assessment of the risk and growth profile of the business. Some buyers will see value and opportunity where others will not.
Ultimately a business is worth what a buyer is prepared to pay for it. However, when it comes to negotiating the final sale price, understanding what the fair value is along with the factors that influence and detract from business value is crucial to getting the best deal.
Therefore, to be able to negotiate the best deal it is highly beneficial to have some sort of understanding of the attributes that drive business value and how they interact with commonly used valuation methods.
Knowledge is power, and having an understanding of business valuation theory as well as each the degree to which each of the individual drivers of value impact your business value, provides owners and potential buyers with considerable advantage throughout all stages of the sale or purchase process.
For example, from the business owners perspective (the vendor), having an understanding of value and value drivers provides the ability to promote and enhance the business value driving attributes and less emphasis on those that detract from value;
For Buyers Having an Understanding of Value and Value Drivers Provides:
- The opportunity to address those attributes which detract from business value;
- Justification and support of the asking price of the business;
- Surety that your asking price is realistic in the current market; and
- Ability to negotiate with confidence.
For Sellers Having an Understanding of Value and Value Drivers Provides:
- Objective and independent opinion on the fair value of the acquisition;
- Guidance as to initial offer price;
- Identification of the attributes that may have strategic value; and
- Ability to negotiate with confidence.
For business owners who are perhaps working towards a planned future sale, knowing what drives the value of the business well ahead of a sale can provide very valuable insights into how they can positively influence business value and make the business more attractive to buyers in the lead up to the sale.
Business Valuation Basics
Business value may be calculated using a large number of accepted valuation methodologies although some methods are more ideally suited to particular situations.
- Some of the more common approaches include;
- Capitalisation of Future Maintainable Earnings (CMFE);
- Discounted Cash Flows (DCF);
- Net Asset Backing; and
- Replacement Value.
When determining which valuation method is the most suitable, a business valuer would normally consider key business attributes such as:
- The trading history of the business and stability of its profits;
- The level of assets used to generate revenues;
- The growth trajectory of the business (start up or long established); and
- The purpose of the valuation (some methods are more rigorous than others and therefore better suited where additional detail is required).
This information will determine which method best suits the situation. Most small businesses are sold using some form of a multiple of profits approach with the most popular method of small business valuation being the CFME method.
Under this method Enterprise Value (Business Value) is calculated using the following formula.
Adjusted Profits x Capitalisation Rate = Enterprise Value.
As you can see the valuation formula has two main components, Adjusted Profits and the Capitalisation Rate. Therefore to increase business value, simply increase the adjusted profits, the capitalisation rate, or increase both. A brief overview of each is detailed below:
When selling a business a buyer will be very interested in how much profits the business generates, this is because they will try to figure out how know long it will take them to earn enough cash flows to repay their investment.
The historical results of the business will be analysed and used as a guide to predict the likely future earnings of the business.
It’s important to know that most business valuers will add back and deduct various non-cash items along with non-commercial, extraordinary or private income and expenditures such as private use of motor vehicles, fines, one off costs, related party transactions, etc. The process of adjusting the profit and loss to reflect the true earnings of the business is known as the normalisation process. Theoretically, the adjusted profits will be representative of the minimum earnings of the business in future years and will also take into account any evidenced growth trends.
The capitalisation rate is also known as the Multiple or the Multiplier. The capitalisation rate is impacted by a variety of factors which fundamentally relate to either the risk profile of the business or its potential for future growth.
The risk profile of a business must be considered from the buyers perspective. Theoretically, the capitalisation rate is representative of the number of years a buyer is prepared to wait to be repaid for their initial investment from the profits of the business.
For example a capitalisation rate of 3 essentially means that the buyer expects to wait only 3 years to repay the purchase price. A capitalisation rate of 4 means the buyer is prepared to wait 4 years for the payback of the initial investment.
As you may imagine, higher multiples are only acceptable to buyers when the risk to them is less.
On the contrary the higher the risk associated with repayment of the purchase price, the lower the capitalisation rate they will be prepared to pay.
The risk profile of a business (in the minds of a buyer will be influenced by factors such as:
- Will the business continue to generate revenues after the current business owner leaves?
- Will the staff stick around?
- What happens if their key supplier goes out of business?
- Is key intellectual property protected?
- How reliable are the profits and what % of revenues are recurring?
- Are key licences and contracts transferable?
- The overall scale of the business revenues;
- Are new technologies or imports threatening the industry?
- Are there any contingent liabilities to consider?
- For location dependant businesses – is a long term lease in place?
- What systems and processes are in place?
- Does the business generate positive cash flows;
- How liquid is the equity in the business.
- How differentiated are the products or services?
The Capitalisation rate is also heavily influenced by the businesses ability to grow. Businesses with significant potential to scale up their operations quickly are held in high regard by buyers and so attract higher Capitalisation rates. Buyers will be looking for attributes such as;
- A growing market;
- Current % of total available market share;
- Ability to significantly scale up operations;
- Cross selling and product development opportunities;
- Commercial reach and ability to influence;
- Ability to access new markets.
Fair Market Value
The courts definition of “fair market value” is the price a willing but not anxious buyer, acting at arm’s length, with adequate information, would be prepared to pay to a willing but not anxious seller of the shares or assets in question. This means that if all information on the asset in question is provided to an interested party and the seller is logical and forthright in the sale of their asset. The fair market price is the price agreed between both buyer and seller on that day.
The statement mentions that both the buyer and seller should not be anxious in relation to the sale of the asset. Implying that they should be logical and forthright when approaching this transaction. From the outset, it’s important to note that the business owner may be the least capable person of deciding how much the business is worth, as they may have personal and emotional ties to the asset in question that will not allow them to look at the transaction in a clear objective way.
Additional to this, there may also be buyers that are not acting objectively towards the transaction and may significantly under or over value the business. (Please note it is extremely rare to find a buyer that overvalues a transaction). The reality is that most of these types of buyers waste time and energy of the parties and their representatives involved. The best way to deal with this type of problem is to put a qualifying system in place that weeds out time wasters. Business brokers specialise in this type of service.
The term adequate information is used in the above statement. What is adequate information? In the case of business sales this may reflect historical and current financial information, current operations covering supply arrangements and customer arrangements, advertising etc… (for clearer understanding of what type of information is usually supplied please read the article in relation to business profiles).
When the owner or prospective purchaser is in an objective mindset and has reviewed all of the available information then they will be able to proceed to applying a valuation to the asset.
Initially it is important to determine the bottom value of the business. This is generally regarded as the current market replacement cost of all the plant and equipment and stock involved in generating income (intrinsic value). That is, if the business was to start again, would a new owner still have to purchase all of the stock, plant and equipment the business currently holds.
Goodwill is the component of price above the intrinsic value of the business. The next steps will help in determining if there is any goodwill value in addition to the intrinsic value associated with the asset. To do this the seller/buyer must consider risks associated with running the business. That is what are the risks associated with the business?
Risks include key employee risk (including owner/s), supply risks, customer risks, economic risks, technological risks, systematic risk, market risk and tenure risks. (There may be additional risks associated with the business not mentioned in this article)
Key Employee Risk
– is risk associated with key staff members or owners. There are a number of components to this risk. The first is how much does the business rely on key personnel (including the owner)? Would it be difficult to replace them without detriment to the business? Can they easily be replaced at a fair market rate? Are they being paid the fair market rate now? Will any negative / positive answers to these questions affect the profitability of the business?
– is risk associated with supply arrangements. There are a number of components to this type of risk. What choice of suppliers are available? Are supplier terms transferable to the new owner? If they are not transferable will that increase working capital required? How will this affect the value?
– is risk associated with customers. There are a number of components to this type of risk. Are sales distributed evenly amongst the customers? What percentage of sales do the top 5 and top 10 customers hold? Do the biggest customers choose the business due to price, quality, customer service or convenience? If the business lost the two biggest customers would that significantly change the profitability of the business?
– is risk associated with the economy. There are a number of components to this risk. How effected is the business in relation to local, national or regional economic conditions? How likely are economic conditions to change? Will this effect the profitability of the business?
– will products or services offered be eliminated through technological innovation? If yes, when is this innovation likely to occur? Will technology help the business to grow? How technologically driven is the business? How technologically driven are the competitors? Does this require further investment into equipment and training? Will this affect the profits?
– this risk is associated with the systems that the business currently employs. Are these systems affective? Are these systems easily transferable? How much of the business is systemised? How much requires executive decisions? Are there better systems available? How easy is it to learn these systems?
– This is risk that is associated with the market the business operates in. The first thing to consider is where does the business conduct its operations? Manufacture, wholesale or retail. How many competitors are there in that market? Is there anything that differentiates the business from the competitors?
– this is risk associated with continued tenure. Are the premises currently leased? How long is the lease guaranteed for? Is the business paying fair market rate? Will the business have to move premises soon? What are the additional costs associated with moving or creating a new lease or paying fair market rate? Will this affect the profitability of the business?
Once the risk set has been determined it is useful to look at the likelihood of these things changing in the immediate future. That is, what is the likelihood the business will become more or less risky in the coming years? Once all of these risks have been identified in respect to now and the immediate future the next step is to determine the profitability of the business.
Different businesses are sold on different profitabilities. There are many measures of profitability some of which are Net profit, EBITDA, EBITD, EBIT, PEBITDA, PEBITD and PEBIT.
(Please find further clarification of these terms on here).
Each one of these terms attracts a slightly different valuation technique.
Rule of Thumb Method
One of the most widely used forms of business valuation is based on the rule of thumb method that determines value according to a standard for businesses in the same industry. Every industry has benchmarks that industry insiders use to gauge the value of the businesses. The problem is that the benchmarks are based on industry averages and don’t take into account the extenuating circumstances of any given business. So, while the “rule of thumb” method is good for approximating the value of the business, the seller/buyer will need to rely on other methods to determine its final value.
Book Value Method
The next most popular method is the book value method. Book value of a business is based on the accounting records and is determined by subtracting the company’s liabilities from its assets. The result is the owner’s equity (book value). Adjustments are then made for things that aren’t reflected in the financial statements like intangible assets and market factors.
Earnings Capitalisation Method
The earnings or income capitalisation method is based on determining an annual rate of return necessary for taking on the risk of the investment. Most business owners would recognise this as some multiple of profits. This is an approach to determine the return an investor would wan to hold your asset in the market place when compared to other assets. The return is the inverse of the multiple. That is a 3 times multiple means a 33.33% return on investment. Rates of return vary according to the amount of risk involved. According to this method, the value of the business is determined by the size of the investment necessary to earn the required rate of return when it is compared against the business’ earnings.
The easiest way (but not necessarily the most accurate) to determine the capitalisation rate is to research other businesses for sale. Look as listings on the internet to get an idea. You can also approach a broker for an appraisal or enlist the services of a valuer to give you a more accurate price.
Business brokers and valuers have a historical database of past sales that they can compare the business too. They also have the expertise of the industry to determine what price is likely to be achieved for the business. They make adjustments to values in relation to the current market.
Finally, the value of time has to be taken into consideration. How long does the owner want the business on the market for? There are many components to this question. The longer the business is on the market the more likely the owner will have to drop price to meet the market. It is not useful to set a high price for your business and reject prospective purchases only to have to approach them again at a later date. This can send them a signal that the business is less valuable and lead the buyer to a lower offer. If however, the business fits into a small minority and the appropriate price can only be achieved through a longer process then this approach should be used. This certainly might be the case if you have a large value business.
In summary the valuation must take into account the following:
- The time to sell the business.
- The risks associated with the business.
- Type of business.
- Historical and current information of the business.
- Likely future expectations of the business.
Why Is Business Value So Important When Establishing Your Asking Price?
Obviously, if you under-value your business you are more likely to get more buyer interest, however are leaving a valuable chunk of equity on the table. For example, if you price your business at $250,000 but don’t properly consider its strategic value to a competitor, you may be leaving $50,000 or more on the table.
On the contrary, if your asking price is significantly greater than the business’s fair value you will likely attract far less buyer interest and substantially reduce your chances of closing a deal. In a competitive business sales market can you afford to miss potential buyers?
More often than not a significant departure between the asking price and the fair value of the business (established using accepted valuation methodologies) will lead to either a downgrade in the initial offer following completion of the due diligence or the buyer simply walking away from the deal.
What Is Strategic Value?
Essentially, there are two kinds of business buyers, financial acquirers and strategic acquirers. A financial buyer is a buyer who is looking to purchase a business based on the cash flows generated by the current business model. A financial buyer will negotiate based on the fair value of the business.
The strategic buyer however is motivated by other factors and sees the business model from their unique existing position in the market. Strategic buyers often look to leverage the vendors business model in a way that helps the buyers existing business to; sell more products and services, increase its margins, eliminate the competition or access new markets. Strategic buyers will typically pay more than the fair value of your business as they stand to make more from the acquisition.
Business Valuation Summary
If you are serious about selling or are about to make an offer to buy a business we recommend engaging a business valuation specialist to professionally appraise your business.
Obtaining a business valuation is a critical first step in helping you to understand your fair value position and provide guidance to help you to negotiate a deal on the best possible terms.
Knowledge is power.