Business Owners: A Brief Guide to Valuing Your Small Business

 

 

Thinking of selling? Or just curious to know the value of your business in case you do decide to put it on the market at some point?

Many business owners are well-wide of the mark when placing a value on their prized asset. They overvalue it and under-prepare for their exit, believing in a huge potential for their business that buyers unfortunately don’t see.

Your business is only worth what someone is willing to pay for it! 

Having an inflated price fixed in your head can seriously hold up your exit strategy. Awareness of the factors considered in determining business value will help you avoid nasty surprises when you do take the plunge.

Some factors are obvious; others not so. Some you have control over; and others you don’t.

Understanding what influences business value enables you to take informed actions to increase it in the coming months or years.

Below is a boiled-down guide to ten of the most important considerations…

1. Reasons for selling

Why are you selling the business? If you’re forced to sell (and this is known by the buyer), the value of the business naturally falls.

Selling due to owner illness is a good example where you are in a poor bargaining position when it comes to selling. 

Try to give yourself as long as possible to negotiate before you sell; rapid, forced sales will ultimately be detrimental.

2. Size of business

With all other things being equal, smaller businesses are often viewed as higher risk than larger, more established companies.

The very fact that the business has more employees and generates higher revenues may be seen as a sign that it is strong. After all, it must have survived difficulties in the market in the past and possesses the people and processes that have created an environment for growth.

A larger business tends to indicate stability — and prospective buyers like to see this.

3. Longevity of the business

How many years has your business been operating?

While potential is a very important factor in determining value, so is a strong track record over many years. 

If you can demonstrate years of strong performance, steady cash flow, and an established loyal customer base generating stable recurring revenues, you are ticking many potential buyer boxes.

Businesses that have been trading for a year or two are far higher risk, even if they are performing well. They may be simply riding the market or a particular trend.

4. The nature of your business’s assets

If you run a manufacturing business, your tangible assets are much greater than most office-based businesses and this is a factor in its value.

If everything else is equal, building ownership, hardware, machinery, and stock make a business much easier to value than one where intellectual property is the main asset.

In reality, the value of a business depends upon many other factors that office-based businesses may score well with (such as customer loyalty, IP, brand strength, etc.)… so this factor needs to be balanced against the others mentioned here.

For a simple ‘asset valuation’ of your business, add up the tangible assets, subtract the liabilities, and that’s it!

5. The key financials: EBIT

What are your business’s earnings before interest and tax (EBIT)?

Any prospective buyer will want to know this figure as the most common basis for calculating the value of a business.

It essentially puts a figure on your profit. This includes all the expenses in the business, except interest and income tax expenses.

Another way to put it is: the difference between operating revenues and operating expenses. 

A multiple of EBIT is a common method of valuing a business. For example, a 3 times EBIT multiple for a business with an EBIT of $400,000 gives a $1.2M valuation.  Or a 5 times multiple on an EBIT of $500,000 gives a valuation of $2.5M. 

What is considered a ‘normal’ EBIT multiple to use for valuation purposes?

This will vary between industries and is affected not only by the factors listed in this article, but also by market sentiment. For example, in a ‘bull market’ when there are a lot of buyers, valuations are higher and a business could attract a buyer willing to pay a 10 times EBIT multiple. That same business within a different market environment, with a less bullish sentiment many only attract a 3 times EBIT multiple. 

Clearly, timing matters.

6. Future performance & projected cash flows

While past performance can demonstrate financial stability (very important), it’s future performance potential that will get buyers’ eyes lighting up.

It’s important to be able to show growth potential. With this in mind, how well does your business attract new customers and boost cash flow? 

Is it retaining customers effectively so that cash flow and revenue remain healthy — or are customers dropping off the back as quickly as new ones are loaded onto the front?

7. Your specific industry sector

Your industry sector is important for two main reasons.

Firstly, selling your business at a boom time for your industry will naturally be beneficial over selling it during a depressed time. If you’re in the mining sector and the industry takes a hit, the business value is likely to decrease. Similarly, a prolonged drought might affect the value of your business if you’re in the agricultural sector. 

For more of an idea on your specific industry, speak with us or a business broker experienced in your industry sector. You will be able to access data about recently-sold businesses to get an idea of valuations in your sector.

Secondly, some industry sectors have industry-wide ‘rules’ that do not necessarily apply to other sectors. For instance, the number of outlets is usually key for a real estate agency business; and customer numbers are key for a mobile phone company.

8. Structure of the deal

The way the sale is structured may affect the price you sell for. Flexibility to fit in with the needs of the buyer may help you command a higher overall price.

There are different ways to structure a deal, affecting the amount of tax payable and the debt service: an ‘all cash’ sale will usually mean a lower value than seller financing.

Here are some basic guidelines:

• Seller financing: businesses sold without any seller financing generally sell for 10% to 15% less.
• Stock sale/Asset sale: selling stock means a single capital gains tax for you but the buyer may prefer an asset sale to reduce income tax.
• Allocation of sales price: consulting expenses are tax-deductible to the buyer so they may value a business more with a high allocation to consulting; you, as the seller, may want to limit the allocation to consulting because you will pay the ordinary income tax rate on it. 

9. The cost of access to capital in the market

When interest rates are high, investors borrow less. It’s the rule of the market. 

This naturally has an effect on the value of your business as there are fewer potential buyers; and any interested parties may drive a harder bargain than when capital is cheaper and more available, as the perceived risk is higher.

10. Other ‘intangibles’ in the business

The value of any business will also depend on other more subjective, intangible factors. These may change with the perceptions of different buyers and may be harder to quantify:

• How crucial is the owner to the success of the business?
• Is it located favourably?
• Is the business highly dependent on a few customers?
• Are customer and supplier relationships strong and likely to last?
• Is the management team and staff strong — and likely to stay if the business is sold?
• Does the business have intellectual property of great value (trademarks etc.)?
• Are systems, processes, and procedures clearly defined and documented?
• What is the business’s reputation in the market?
• Is it favourably placed against competitors?
• How marketable is the business?

Focus on what you can control!

Now you have an idea of the main factors involved in valuing your business, what are the next steps?

Beyond being prepared and making sure that all your paperwork is in order (including cash flow statements, historical and projected profit and loss statements etc.) make sure you have an exit strategy planned. 

This should be flexible enough that you are not in the position of HAVING to sell for less than you would like.

Focus on the factors that you can control rather than those you cannot. This will help you get your business into the best possible health for when the right opportunity comes along.