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“There’s a saying that ‘valuing a business is an art and not a science,’” says Gareth Smyth, group managing director at commercial real estate agency Hilton Smythe. “And, well, I agree.
“Unlike valuing a house, where you can compare to the two-bed semi next door, valuing a business isn’t quite so straightforward.”
Business buyers don’t just pay for location and bricks and mortar; they also pay for staff; equipment; brand reputation; and revenues, profit and liabilities.
“There are a handful of techniques for valuing businesses, from P/E [profit/earnings] ratios to discounted cash flow,” says Smyth. “But how can the small-business owner make sure they are not overegging the pudding when selling without a degree in corporate finance?”
Valuing the business is all about setting a price that will find willing buyers without selling yourself short for your efforts over the years. Easier said than done.
Businesses are usually, but not always, valued by a multiple of profit. Other models exist, though, and valuation experts sometimes combine methods to suit the business’s peculiarities.
A multiplier of earnings, applied to the annual profit, is generally set according to an industry benchmark as well as the particulars of the business itself.
Based on profits recorded in previous years’ trading a buyer can quickly calculate how soon they can get a return on their investment. “Most buyers of small businesses are looking to make a return on their investment, usually in a time frame of two or three years,” says Smyth. “What does this mean, you ask?”
“Well, put simply, it means that if a buyer pays £50,000 for your business, they will want to make that money back in two or three years’ time. In other words, your net profit – i.e. the money you’re left with after everything is paid out of the business – will be around £25,000.”
The discount rate is set according to the perceived level of risk, generally sitting between 15-25%.
This method suits businesses with stable cash flows.
A rule-of-thumb valuation often includes elements of several methods, depending on the particulars of the business and sector in question.
Top tips from a BTA: Gareth Smyth, group managing director, Hilton Smythe
1. You can gauge your asking price against other businesses on the market (on sites like BusinessesForSale.com), making a link on the turnover figure against your own.
2. A good agent will always talk you through their sold data too, so don’t be afraid to ask!
3. Ultimately however, a business is worth somewhere in the middle of what a seller is willing to sell for and what a buyer is willing to buy for – so leave yourself some room to negotiate
If the buyer can pick holes in the assumptions underpinning your valuation, then they’re less likely to meet your asking price. They may doubt your projections for the following reasons:
• Vulnerability to new competition: Particularly sectors with low barriers to entry, like ecommerce
• Vulnerability to disruptive technologies: For example, if you’re selling a traditional taxi firm in the age of Uber
• Vulnerability to changing consumer trends: If you’re reliant on a product or service where demand tends to go in and out of fashion
Conversely, a buyer is more likely to meet – or exceed, if a rival bidder emerges – your asking price if they spot ways to – such as:
• Cost-cutting: Simple ways of cutting operating costs without undermining service quality
• Improving performance: Entrepreneurs generally don’t want for self-belief and they may identify ways to boost standards
• Diversification: Opportunities for launching products or services that appeal to existing customers and/or might attract new ones
• Uniqueness: The business boasts something that competitors don’t – for example a software company with innovative proprietary technology
But few buyers will pay for potential, which is not empirically quantifiable.
You could set some wheels in motion to improve areas of the business in order to make it more sellable. To find out more about how to maximise your business value, read this.
However, you can burnish the credibility of your claims of ‘potential’ by making a portion of the sale price dependent on the achievement of certain financial targets, either sales- or profit-based.
There exists a concept called ‘illusory superiority’, a phenomenon identified in psychological studies whereby we’re prone to overestimating our personal abilities.
Given that your business is effectively an extension of yourself – you possibly started it, you moulded it to fit your vision – it’s easy to see why one broker told BusinessesForSale.com that “I’ve never come across a business owner who has undervalued their business.
Then there’s the emotive dimension: the feeling – even subconsciously – that the years of effort and financial investment should be reflected in the sale price. “If they’ve owned the business for many years or recently spent a lot of money fixing problems, it’s not uncommon for sellers to want to earn back some of that money,” a broker told us.
Sometimes sellers simply price their business at a level according to what they need to fund their retirement or next venture.
But the buyer isn’t interested in your financial or emotional investment or what you need to afford a holiday home in the south of France; they want to know how profitable the business is – and could be.
There’s a simple way to avoid the distortive effects of cognitive bias: appoint an independent expert to value the business – ideally one with experience in your sector.
FSB Financial Healthcheck has been providing unbiased, independent sound advice on personal and corporate finance for over 20 years.
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