We recommend that all business owners understand the principles of business valuation and how to accurately determine the fair market value of their business.
Salespeople like business brokers are not well suited to providing an independent business valuation – their agenda (to persuade you to give them your “listing”), can dramatically distort the valuation they are willing to agree to.
Being able to accurately value a small business yourself is a vital skill. It will form the basis for your decision of the price to market it at (if you are selling), it will arm you with the knowledge you need to discuss your business with investors, buyers, lenders, brokers and advisors, and it will give you a great deal of confidence during negotiations.
It will provide the basis for you to increase the value of your business and make it more likely to sell, by understanding the levers that these outcomes, and how to change them.
Finally, it will allow you to understand which buyers will pay more for your business, why, and how to find them.
VALUING YOUR SMALL BUSINESS
There are so many factors that come into the valuation of a small business. Most online guides simply list all of the different valuation methods. Instead, we’ve distilled this area down to its core concepts, with five videos (and accompanying blog posts) explaining one theme each, to give you a comprehensive understanding of the business valuation process as it applies to different small businesses.
Using these concepts you will be able to come to an accurate valuation of your own business. The videos and details below are a great place to start.
Before we start let’s clarify the different terminology you will come across to describe a company’s profitability. We especially need to clarify what is meant by terms like “Seller’s Discretionary Earnings” and EBITDA, in order to compare apples with apples when looking at comparable data.
PRINCIPLES OF BUSINESS VALUATION
Now let’s get to the crux of it. The value of a business is the sum of its future cash flows. So why are there so many different valuation methods? And what about assets – how do they affect the valuation?
This video distils the science of business valuation down to its core principles and explains how they fit together. It covers the Discounted Cash Flow (DCF) method, and how this valuation relates to a multiple of a company’s earnings, and payback period. It explains why the PE Multiple method is the most important approach for small businesses, and how asset valuations should be used when asset values exceed the sum of future cash flows.
If the PE multiple of a business is so important in its valuation, how do we know what multiple to choose? Similar businesses can be a useful guide. If we know the prices that comparable businesses have sold for, as well as some details about their size and profitability, this can provide a good indication as to the PE multiple to use. There isn’t much data available in the UK on small businesses, but there are some extensive sources on US small businesses available for free that we can use as a starting point. These data sets also provide other interesting details including deal structures, valuations by size, and how long businesses took to sell.
Remember the caveats around this data, especially the potential for selection bias and the fact that these are sold businesses, which means they rank highly in the factors that make a business more saleable, such as systematisation and stability (see below). If you bear this in mind when applying comparable data to your own business, the data will be very helpful.
RULES OF THUMB
In some industries there are specific Rules of Thumb that dictate the valuation formula to use and even the specific PE multiple to apply. If the business you are valuing is in an industry with a widely-accepted Rule of Thumb, it’s critical to know this and apply it in your business valuation. For example, some industries in which the businesses typically hold freehold property have valuation rules of thumb that include the value of the property. Other industries have specific valuation rules of thumb based on their total revenue, instead of their profit.
While most profitable businesses will be valued according to the sum of their future earnings, businesses whose assets outweigh this value will be valued according to their asset value. There are also some hybrid valuation methods (earnings + assets) that are sometimes applied in capital-intensive industries or businesses that hold a lot of stock.
It’s useful to note that after an acquisition, from an accounting perspective, the entire purchase is made up of only tangible assets and the theoretical value of “goodwill” – the latter representing the majority of the sale value if the seller has achieved a good multiple of earnings. It’s sobering to remember that this goodwill is purely theoretical. A good case must be made by the seller for the buyer to buy it. If a buyer is going to pay more than tangible asset value for a business, then he has to really be confident in the future earnings that he is buying, and the opportunity that this represents.
VALUATION In The Context Of Selling
By applying these concepts you will be able to determine an accurate valuation range for your business.
But this is just the valuation range. Getting the best price for your business within this range (or even higher), depends on how well the sale process is handled, and on some critical characteristics of the business itself. Crucially, many of these same characteristics determine the likelihood of the business to actually sell, as we will see next.
WILL IT ACTUALLY SELL?
While a company’s size and its industry are important in dictating the overall valuation range, the key characteristics of the business itself will determine its specific valuation. Businesses with more favourable characteristics will simply be worth more than other businesses of the same size and in the same industry. But more importantly, these businesses will be more likely to actually sell.
Remember one of the caveats about comparable sales: these are businesses that have actually sold. Given that most small businesses advertised for sale do not sell, only the most saleable businesses make it into the comparable data sets. In order for these data and valuation multiples to be applicable to your business, it must not only be in the same industry and the same size, it must be saleable.
What Makes A Company Saleable?
Our experience as investors, our conversations and interviews with buyers of businesses, M&A experts and former business brokers all confirm the same characteristics that make a business more saleable. Besides size (larger businesses are easier to find buyers for), the #1 characteristic that makes a business more saleable is automation. This is made up of multiple factors and goes by different names, but the core principle is always the same:
Those factors that give confidence to the buyer that earnings will continue after the acquisition (automatically), will add value and make the business more likely to sell.
There are multiple components to this, each with their own elements, briefly including:
a. Systematisation (the ability of the business to continue without its owner)
b. Stability / Reliability (recurring revenue)
Some people describe this simply as “trust”. But rather than being an intangible feeling that the seller merely hopes to inspire in the buyer, this trust can be engineered by demonstrating the automation of the business and the fact that it will continue to be successful after the acquisition.
Secondary factors that make a business more valuable and more likely to sell are:
2) Financial Performance
3) Well-Executed Sale Process
The financial performance of a business includes factors such as profitability and growth. Since profit is one of the two components in the PE Multiple valuation formula used to determine the valuation range above, it is obviously important. Loss-making businesses are difficult to sell for more than the value of their assets, so healthy profitability is key. The buyer is paying for future earnings, after all.
Steady positive revenue growth is a good sign also, especially if the industry is also experiencing positive growth. Businesses in a growing industry will be lifted by the rising tide, and this will push their valuations higher within the range, and make them more likely to sell. Extremely rapid growth is not always a good thing, especially for young businesses where the trajectory is less predictable. Besides issues around the predictability of erratic earnings, the buyer has to fund this growth, which can require significant investment into working capital and / or facilities, depending on the industry.
Note that the financial performance of the business itself is secondary to all of the characteristics that contribute to its automation. The ability for a buyer to trust that its performance will continue is actually far more important than the performance itself. A highly profitable company that is extremely dependent on its owner will be much more difficult to sell, and less valuable, than a less profitable company that is fully automated.
"This process is best handled by the owner him or herself."
And finally, the third factor that will have a significant impact on the final sale price of the business, and the likelihood of sale, is the execution of the sale process itself. If the sale is managed well, particularly if multiple willing buyers are found, the result will usually be successful both in terms of the actual sale and the price & terms achieved. Although people often believe that M&A consultants or business brokers will be best placed to achieve this, industry insiders know that this is often not the case. Stories abound of brokers mishandling their clients’ business sales, often to disastrous effect. This process is best handled by the owner him or herself. If a broker is used, the result will be much more successful if the owner is very knowledgeable about the opportunities and pitfalls in the sale process, and manages the broker very well throughout the process.
"If a broker is used, the result will be much more successful if the owner is very knowledgeable about the opportunities and pitfalls in the sale process, and manages the broker very well throughout the process."
The sale process involves every step from setting the right asking price, to highlighting the best features of the business, to communicating well and negotiating effectively. But the most important factor in the successful handling of a sale is finding the right buyers. Instead of a scatter-gun approach, it is much more effective to focus on the buyers who will derive the most value from acquiring your business, as we will see next.
Finding the Ideal Buyer
.Would the ideal buyer be the one who is most likely to actually buy your business? Or the one who would pay the highest price?
Both have merit. Thankfully, we don’t have to choose, because there is one category of buyer that is actually best in both of these categories: the “strategic buyer”.
This is why the traditional methods of selling a small business don’t work
A strategic buyer is one who can derive even more value from your business than other buyers can, because your business provides a strategic advantage to his existing business. To a strategic buyer, your business is worth more than fair market value.
This is why the traditional methods of selling a small business used by business brokers (advertising it on business-for-sale websites; sending out an email to their own mailing list) don’t work. This scatter-gun approach isn’t targeted, and it isn’t effective.
Instead, a completely different approach is needed. To sell a small business effectively, the focus must be on targeting the people most likely to actually buy it. In most cases, this will be a strategic buyer.
Learn more about selling your business to a strategic buyer.