Valuing a business - fundamentals
If you are planning to sell your business or are considering your offer to buy a business, it makes good sense to obtain an independent appraisal of the business first. A business valuation is not a cost - it is an investment.
Business valuations provide invaluable insight into the real value of the business and enable buyers and sellers to better position themselves for the transaction and negotiate with confidence - knowledge is power!
What is business value?
Theoretically, business value (also known as Enterprise Value) is the price at which a business is likely to change hands between a willing but not anxious seller and a willing but not anxious buyer. This is known by Business Valuation Specialists as the “Fair Value” of the business. The Enterprise Value includes all of the assets and goodwill of the business used to generate its cash flows.
Practically, it is important to realise that the value of a business will be perceived differently by different parties, this is because buyers and sellers have different motivations and will have a differing assessment of the risk and growth profile of the business. Some buyers will see value and opportunity where others will not.
Ultimately a business is worth what a buyer is prepared to pay for it, however when it comes to negotiating the final sale price, understanding what the fair value is along with the factors that influence and detract from business value is crucial to getting the best deal.
Therefore to be able to negotiate the best deal it is highly beneficial to have some sort of understanding of the attributes that drive business value and how they interact with commonly used valuation methods.
Knowledge is power and having an understanding of business valuation theory as well as each the degree to which each of the individual drivers of value impact your business’ value provides owners and potential buyers with considerable advantage throughout all stages of the sale or purchase process.
For example from the business owner’s perspective (vendor) having an understanding of value and value drivers provides:
The ability to promote and enhance the business’ value driving attributes and less emphasis on those that detract from value;
The opportunity to address those attributes which detract from business value;
Justification and support of the asking price of the business;
Surety that your asking price is realistic in the current market; and
Ability to negotiate with confidence.
For sellers having an understanding of value and value drivers provides:
Objective and independent opinion on the fair value of the acquisition;
Guidance as to initial offer price;
Identification of the attributes that may have strategic value; and
Ability to negotiate with confidence.
For business owners who are perhaps working towards a planned future sale, knowing what drives the value of the business well ahead of a sale can provide very valuable insights into how they can positively influence business value and make the business more attractive to buyers in the lead up to the sale.
Business Valuation Basics
Business value may be calculated using a large number of accepted valuation methodologies although some methods are more ideally suited to particular situations.
Some of the more common approaches include;
Capitalisation of Future Maintainable Earnings (CMFE);
Discounted Cash Flows (DCF);
Net Asset Backing; and
Replacement Value.
When determining which valuation method is the most suitable, a business valuer would normally consider key business attributes such as:
The trading history of the business and stability of its profits;
The level of assets used to generate revenues;
The growth trajectory of the business (start up or long established); and
The purpose of the valuation (some methods are more rigorous than others and therefore better suited where additional detail is required).
This information will determine which method best suits the situation.
Most small businesses are sold using some form of a multiple of profits approach with the most popular method of small business valuation being the CFME method. Under this method Enterprise Value (Business Value) is calculated using the following formula.
Adjusted Profits x Capitalisation Rate = Enterprise Value.
As you can see the valuation formula has two main components, Adjusted Profits and the Capitalisation Rate. Therefore to increase business value, simply increase the adjusted profits, the capitalisation rate, or increase both.
A brief overview of each is detailed below:
Adjusted Profits
When selling a business a buyer will be very interested in how much profits the business generates, this is because they will try to figure out how know long it will take them to earn enough cash flows to repay their investment.
The historical results of the business will be analysed and used as a guide to predict the likely future earnings of the business.
It’s important to know that most business valuers will add back and deduct various non-cash items along with non-commercial, extraordinary or private income and expenditures such as private use of motor vehicles, fines, one off costs, related party transactions, etc. The process of adjusting the profit and loss to reflect the true earnings of the business is known as the “normalisation” process. Theoretically, the adjusted profits will be representative of the minimum earnings of the business in future years and will also take into account any evidenced growth trends.
Capitalisation Rate
The capitalisation rate is also known as the Multiple or the Multiplier. The capitalisation rate is impacted by a variety of factors which fundamentally relate to either the risk profile of the business or its potential for future growth.
For example a capitalisation rate of 3 essentially means that the buyer expects to wait only 3 years to repay the purchase price. A capitalisation rate of 4 means the buyer is prepared to wait 4 years for the payback of the initial investment. As you may imagine, higher multiples are only acceptable to buyers when the risk to them is less. On the contrary the higher the risk associated with repayment of the purchase price, the lower the capitalisation rate they will be prepared to pay.
The risk profile of a business (in the minds of a buyer will be influenced by factors such as:
Will the business continue to generate revenues after the current business owner leaves?
Will the staff stick around?
What happens if their key supplier goes out of business?
Is key intellectual property protected?
How reliable are the profits and what % of revenues are recurring?
Are key licences and contracts transferable?
The overall scale of the business revenues;
Are new technologies or imports threatening the industry?
Are there any contingent liabilities to consider?
For location dependant businesses - is a long term lease in place?
What systems and processes are in place?
Does the business generate positive cash flows;
How liquid is the equity in the business.
How differentiated are the products or services?
The Capitalisation rate is also heavily influenced by the businesses ability to grow. Businesses with significant potential to scale up their operations quickly are held in high regard by buyers and so attract higher Capitalisation rates. Buyers will be looking for attributes such as;
A growing market;
Current % of total available market share;
Ability to significantly scale up operations;
Cross selling and product development opportunities;
Commercial reach and ability to influence;
Ability to access new markets.
What is strategic value?
Essentially, there are two kinds of business buyers, financial acquirers and strategic acquirers. A financial buyer is a buyer who is looking to purchase a business based on the cash flows generated by the current business model. A financial buyer will negotiate based on the fair value of the business.
The strategic buyer however is motivated by other factors and sees the business model from their unique existing position in the market. Strategic buyers often look to leverage the vendor’s business model in a way that helps the buyers existing business to; sell more products and services, increase its margins, eliminate the competition or access new markets. Strategic buyers will typically pay more than the fair value of your business as they stand to make more from the acquisition.
