“If I sold my business next month how much do you think it could be worth?”
A question I am often asked by small business owners who will happily discuss this at length. Yet, they generally don’t know how to work out the value of their business to a potential buyer. It is complex to calculate and can be affected by many issues but I will attempt to cover the key methods of business valuation and have provided a framework below to produce a valuation suitable for an owner managed SME business.
Business Valuation Methods
There are a number of valuation methods available including some specialist methods for specific sectors.
These methods include:
(i) Net asset valuation. This is popular for asset-based businesses such as property companies and those which are loss-making or have ceased trading. In these cases, there is more value in the sale of the assets than in the short/medium term future income stream.
(ii) Discounted cash flow, which is mainly used for valuing minority shareholdings where the shareholder has no influence on the income received from the company. The value is based on the predicted future cash flow from predicted dividends. This is generally more appropriate to quoted businesses where a formal dividend policy exists.
(iii) Profit based valuations. These are suitable for small company valuations where a major shareholder can influence the dividend policy. The basic calculation uses a multiple of profits.
(iv) Revenue-based valuations, which have traditionally been used to value professional firms. The basic calculation is a multiple of recurring profits.
(v) Start up comparison. A calculation is produced to estimate the cost of setting up a similar business to the one being valued.
(vi) Similar business. This method assumes that the value of a similar business can be obtained and adjusted to estimate a value.
Professional valuations are generally produced only for significant events such as business sales, share sales, etc. and are relatively expensive to produce. They often use more than one method (e.g. (i), (ii) and (iii) above) and take a value from within that range. Outlined below is a simple valuation which can be produced on a spreadsheet in a relatively short space of time with a few key assumptions.
A Simple Valuation Framework
Where the majority shareholding in a small business is being sold and the business is a going concern, the profit based valuation is probably the most appropriate. Whilst there are numerous ways to do this, a common approach is to multiply the profit before tax by a suitable multiplier and adjust for surplus cash or debt, so:
Enterprise Valuation = adjusted profit x multiple +/- cash/debt
The profit figure used is often the EBITDA (earnings before interest, tax, depreciation and amortisation) from the most recent year's statutory accounts. This will then be adjusted for any anomalies such as the owner's earnings which may be greater or less than the commercial salary for an equivalent manager.
The multiple will generally be between 2 and 8 depending upon the perceived quality of the profits. Better quality profits are found in businesses which, for example: are of a significant size, have systemised operations, recurring revenue and are not reliant any specific individual(s).
The cash/debt figure is the excess/deficit of cash in the business after settling all current financing arrangements (overdrafts, loans, etc.)
Business Valuation Example
A business had an EBITDA of £260,000 last year and a multiple of 5 is deemed appropriate. However, there was an unusual one-off bad debt of £20,000 in the year and the owner’s remuneration is £30,000 less than the equivalent market rate for a manager.
The adjusted EBITDA is £260,000 + £20,000 - £30,000 = £250,000
The base value is therefore £250,000 x 5 = £1,250,000.
At the end of the year there was a loan of £200,000 outstanding to the director, an overdraft of £75,000 and excess cash of £25,000 in the bank.
The Enterprise Value is £1,250,000 - £200,000 - £75,000 + £25,000 = £1,000,000
A basic multiple of profits valuation is relatively easy to produce using the framework above and some broad assumptions. It might not reflect the final sale value achieved, but it does provide a benchmark to measure progress against.
Talk to your Finance Director (aka FinanceHead!) and ask them to help value your business (and how to add value too!). Contact Michael Cartwright with your business valuation query and he can guide you to the right FinanceHead for you!