Sell your Business E-Book Extract Part 6 – Valuation Overview

Posted on Aug 18, 2015

To create an effective exit strategy, it is vital to understand how businesses are valued. An accurate valuation allows the business owner to make a realistic estimate of the profit from a sale, and whether this is going to be sufficient to meet future needs.

 Valuation Intro

To create an effective exit strategy, it is vital to understand how businesses are valued.  An accurate valuation allows the business owner to make a realistic estimate of the profit from a sale, and whether this is going to be sufficient to meet future needs.

There is a common misconception that valuing a business is a simple financial calculation that is done with a great degree of certainty.  This is not the case

The valuation of a business is extremely complex because of the diversity of companies, industries and individual business performance that need to be considered.

The true value of a business is what any potential buyer is willing to pay at any particular point in time, and this fluctuates depending on whether the settlement involves cash, shares or debt financing.  Other factors that affect the price are timing of payment and the workout involved.

Through years of R & D, some companies have developed IP, packaged it and built it into a recognised brand name. In this case the valuation mechanism needs to not only value current sales, but also to take into account the past development that will generate sales in future years. An investor who buys this type of company will reap the rewards of the previous investments into R & D.

Valuation Methodologies

There are ten commonly accepted methodologies for valuing a business.

Most commonly used are; book value; adjusted book value; discounted earnings; discounted cash flow; income capitalisation (np b4 tax); sales multiple; earnings multiple; price/earnings

The two most popular valuation methodologies used are a straight multiple using EBIT (Earnings before Interest and tax), and Discounted Cash Flow (factors in future income at a discount to today’s value).

Most micro businesses that are sold to an owner/operator are sold for 1 – 2 x profits but buyers will sometimes pay a higher multiple depending on the accepted industry benchmark and the strategic fit with other business interests.

Over a period of time, an industry usually develops its own rules of thumb by which a business is valued and this is a useful benchmark when selling to an owner/operator.

If we look at one particular industry and take two companies with similar sales and profit performance for the last year, one might justifiably pay more for one business than the other for the following reasons:

  • One business may appear to rely on the directors and owners, while the other appears to rely on numerous staff members. If the reliance is spread across the entire workforce, a potential buyer takes over a business with a higher chance of success
  • One may be a start up company and the other may be an established company with a 5 year trading history
  • One of the companies may have spent a considerable amount on R&D that will lift future profits
  • One may have developed long term contracts that ensures profitability in future months and years, whereas the other may have to rely on winning contracts or work on a weekly basis
  • One may have an easily identifiable and loyal customer database and the other may have a high turnover database
  • One of the companies may have developed a product that is positioned in a growth market and the other may not
  • One may be in a better geographical segment
  • One may have a more recognisable brand
  • One of the companies may have developed a worldwide patent that locks the brand into immediate worldwide distribution
  • One company may dominate a niche whilst the other is a smaller player with less competitive advantage in a wider market
  • One business may be a strategic fit to the buyer’s existing business, which will improve the profitability of that existing business

There are also intangible reasons why two businesses may be valued differently.  One may have strong internal systems when the buyer arrives, one may appear more professional or one may negotiate a better deal based on future profits rather than historical performance.

So clearly, two businesses with the same recent sales and profitability but different potential may be valued at different ends of the spectrum.

Whilst it is tempting to think that all valuations are based on sound business principles, past performance and future potential, one need look no further than the high tech crash of 2000 to see that emotion plays a role in determining the value of a business.

Throughout the 1990s global investors, large and small, invested enormous amounts of money in risky start up businesses whose own financial projections showed little chance of becoming profitable.  Inevitably, by the early 2000s, major corrections took place on stock markets and the focus for investors went back to businesses with solid financial performance and a proven track record.

Despite this, it is important that business owners understand that when they are presenting a valuation to a potential buyer, they are not selling just the book value of the business, but also a vision for its future growth.

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