Blog - Top 10 things to consider when valuing a business
Friday, 26 April 2019
1. The past is important, but the future is everything
There’s no doubt that historic profitability levels of the business for sale should give an indication of the future, but it can’t be relied upon entirely. When valuing a business, you need to understand the direction of the business, and ideally this needs to be quantified using financial forecasts and budgets. Using a drilling analogy, is the business about to drain its oil well dry, or has it just tapped into an exciting and substantial new supply of black gold? Neither situation will be easily identifiable in historic sets of accounts.
2. How will the business cope without the owners?
If the goodwill of the business, such as the customer relationships and the manufacturing processes, are stored in the owners head then it’s a risk to the business for sale and will decrease its price. Similarly, if the owners stoically work every hour under the sun the buyer ought to factor this replacement cost into their calculation of the maintainable profits under their ownership. However, if you can share your knowledge and expertise with your teams in the run-up to a sale, it can be argued that no replacement cost is needed.
3. Don’t always believe the hype (i.e. sale agents – what is their ulterior motive?)
Business Transfer Agents have varying reputations – see my previous blog ‘Top 10 reasons to be wary of some business brokers.’ I’ve seen sales documents that have stretched the truth to breaking point and then beyond! They are typically paid the bulk of their fees on completion of a successful sale, so in any industry structured that way there will be some rogue operators. Be careful. When valuing a business, always do your due diligence on the information provided, particularly information which has not been subject to some sort of independent verification such as an audit. And if you’re selling a business, by all means apply some spin, but be truthful and upfront. Any mistruths will come out in the end and the chances are the buyer will walk away.
4. Comparing your business for sale to quoted companies
Just because the financial press reports that the global market leader in your sector sold out for a profit multiple of 20x this does not mean that your smaller business warrants the same multiple. Chances are that the risk and opportunity profiles of the two businesses are entirely different, meaning that a significant discount must be applied. As a very general rule of thumb, many SME businesses are valued somewhere between 3x to 6x profits, with some less than this and some more.
5. Don’t expect a buyer to pay for undisclosed income
This tends to occasionally apply to smaller businesses, whereby it’s inferred by the seller that maybe, just maybe, not all of the income has been declared in the accounts and been subject to tax. If so, walk away there and then. Deliberately avoiding tax is morally wrong, not to mention a criminal offence, and it’s impossible to substantiate. And, if the owner is being dishonest about this, it says a lot about their character and how they have run their business. What else might they be exaggerating or omitting to tell you?
6. Is the business reliant on any key customers or suppliers?
If the business for sale is reliant on a small number of customers or suppliers you need to get some reassurance that they will continue to trade with the business, and on what terms. By all means make an assumption when valuing the business, and stipulate this in any offer you might choose to make, but make it a requirement that before buying the business you will want to be introduced to those parties and get comfortable with the future.
7. What are the barriers to entry?
Businesses with higher barriers to entry are inevitably worth more as they tend to operate in a less competitive marketplace. An example of this are pharmaceutical companies spending vast amounts of money to research and market new clinically approved drugs. Such businesses have high barriers to entry and, as a result, the sector tends to command the highest profit multiples. Compare that with the accountancy profession. You don’t actually have to be a qualified accountant to market yourself as an accountant. You need little more than a computer and a website to get started. Of course, there is a massive difference between good accountants and bad accountants, but the barriers to enter are low and, as a result, the prices that accountancy practices command is relatively low.
8. How will technology disrupt the market in the future?
I mentioned in point 1 that the future outlook of the business is vital, and part of this will be based on the impact of new technology. We have already seen the impact of technology on large businesses like Kodak, Blockbuster and, more recently, HMV, who all failed to react to newly emerging technologies. The speed of technological change these days is lightning fast, and only getting faster, so a seller will always need to demonstrate to a buyer how they are future-proofing their business for sale.
9. What if political or economic circumstances change?
Who would have predicted 10 years ago that the Lehman Brothers would fall, or that the British public would vote for Brexit (I seem to recall Nigel Farage even throwing in the towel on the night of the referendum, only to pick it up again the next morning when the result came through!) or America being run by Donald Trump. It’s never easy, but playing devil’s advocate with these sorts of things is a vital part of managing risk, and such safeguards should, in turn, protect the value of the business.
10. What if tax rates change?
This last point probably applies more to business sellers than buyers. Most business sellers will, with careful planning, qualify for what is called Entrepreneurs’ Relief, which means they should pay tax at 10% on the gain they make from the sale of their business. In historic tax terms, 10% is low. Very low. But, it might not last forever. So bear in mind that if you’re holding off the sale of your business, and the tax rate increases in the interim, you will need to increase the business’ value to receive the same amount of net sale proceeds. As a result, maybe with hindsight you’ll find your smaller business today is worth more than your larger business tomorrow.
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Next month: Top 10 differences between the sale of company shares v business assets