What is your business really worth? (And how do you know?)

– 16-Oct-2012

You’re in business, approaching retirement.
You’re clear on your financial goal and lifestyle aims.
Will the sale of your business achieve the financial goal? Will you get the price you want?
Or....
You’re ambitious. You have found a business you think has good potential. You want to buy it. But you don’t want to pay too much.

Either way, you want to know, “What is the business worth?


The starting point for any business valuation is, how much profit does the business produce?

Note that by ‘profit’ I am not referring to the profit figure shown on a financial statement from the accountant. The true profit of a business—for valuation purposes—is the profit left after adjusting for non-business expenses and allowing for a market salary for the working owner(s).

Non-business expenses are those linked to the owners rather than the business. These include interest on borrowings, motor vehicle costs not directly related to the business, depreciation and extra superannuation contributions made on behalf of the owners.

The profit figure should be shown to be the sustainable profit it can produce. For example, if the owners do not take a salary, it artificially inflates the profits—and by extension, the valuation—of the business.

Don’t get caught out by this as a buyer. The value of the owners’ contribution needs to be brought to account. It is often overlooked when evaluating. That means the buyer pays far too much for the business.

Once you have determined the sustainable profits of a business after owner(s) salary, the next step is to value the business.

There are a number of different valuation methods.

In this article we will look at one methodology:  

 

Capitalised Earnings Approach.

The best way to determine a business's value is to work backwards from the proven, sustainable net profits of a business.

 

Sustainable profit

 For example, let's say that a manufacturing business has $200,000 in pre-tax profits (proven by tax returns for the last 3 full years and after the due diligence process), before allowing for the owner’s wage.

If the owner plans to work full time in the business, they need to include a fair wage for the work they do. Let’s say in this example that is $50,000. This must be subtracted from the net profit.

That leaves net profit of $150,000.

But we’re not finished whittling it down yet…

Next we deduct any interest, private motor vehicle or depreciation. Let’s say interest is $10,000, private motor vehicle costs are $10,000 and depreciation is $5,000. That total of $25,000 comes off the $150,000 figure, reducing it to $125,000.

That’s $125,000 of sustainable net profit.

You can then calculate whether that provides you with a reasonable return for your investment in the business.

 

Multiplier

Typically, small businesses will be valued at a multiple of the available sustainable net profit (net cash flow). For most small businesses the multiple is usually in the range of 1 to 3 times of sustainable net profit. As the size of the business and the profit increases this multiple increases up to the 3 to 5 times range.

The range or multiple will also depend on the type of business (e.g. the lower range for retail and higher for manufacturing). Some businesses command even higher multiples.

There are a number of other factors to take into account in determining the multiple such as:

  • Sound management
  • Well documented internal systems
  • Condition of plant and equipment
  • How long the business has operated
  • Location
  • Competition
  • Cash transactions
  • Litigation risk
  • Product and industry trends
  • Lifestyle offered

… and many more factors.

In our example, let’s assume the range has been determined at 2.5 times the sustainable net profit. This equates to a 40% return on investment. This would value the business at $312,500.

 

 

Whilst it’s important to follow a sound methodology for valuing a business, at the end of the day the value of the business will ultimately be based on what a willing purchaser is prepared to pay.

 

Buyers Beware!

If you are committing to an offer to buy a business, your accountant should perform a due diligence process for you. This involves reviewing the information on which the value is based, and checking that is actually correct.

For example, is the stated net profit sustainable? What multiple have they applied to the net profit in coming to their asking price? Is this multiple fair and reasonable? How does it compare to other business sales in the industry or of similar business types?

Due diligence is kind of like ‘an insurance’ in that the cost is small compared to the potential savings.

Don’t make the mistake of buying a business on gut feel or emotion. Just as you would get a property officially and independently valued before you purchase it, the same applies to a business, but even more so, because there are many more variables involved.

Sellers Prepare!

If you are positioning a business for sale, you should commence a Succession Planning process at least a few years prior. This will help you to focus effectively on those areas that will maximise the business growth and eventual sale value.

As your accountants we will guide you in considering all the factors that determine the value of the business and in the process we’ll identify those areas where improvements can be made prior to the planned sale.

The difference between the valuation of two businesses, where one has been properly prepared and groomed for sale, and one has been offered for sale without a Succession Planning process can be many hundreds of thousands of dollars, or more.

In lifestyle terms, that can be the difference between a retirement full of choices and a great lifestyle, and a retirement of survival and living very frugally.