There are many reasons owners seek business valuations - buying out a partner, death of a partner, a divorce, or for estate planning. Quite often it's because they plan to sell. The process of working out a selling price is not simple, though, and for small businesses it often proves to be more complicated than expected.
Ultimately your business is only worth what someone else is willing to pay. However, here are some approaches to valuations:
1. Capitalisation of future maintainable earnings – this method looks at the annual profit the business is achieving and then applies a multiple that takes into account opportunity and risk.
2. Discounted cash flow method – this method focuses on future cash flows and the expectation of realising those cash flows over time.
3. The Net Asset backing method – this simply values the business at the net worth of the assets less the liabilities.
4. Industry formulas – these tend to be specific to certain industries and may value at a multiple of revenue or profits.
The profitability of the business is a main focus. Lower profits will often be reflected by a lower valuation. If the business is running at a loss it raises the question of whether it represents anything of value beyond any break up value.
A typical small business could be the sum of its assets. These typically include plant & equipment, trading stock, debtors and goodwill. These assets are relatively easy to value with the exception of goodwill. An agreed value can be reached for plant or stock. Goodwill is much more difficult to value. Its inherent nature is that it is an intangible asset. It may be the most valuable component of your business, but you can't see it on paper. Goodwill is the component that sellers and buyers will negotiate harder on.
In order to raise your goodwill for a sale you need to ensure that you can demonstrate what will reflect its value. Does your business have a good reputation? Maximising goodwill value is like making the intangible, tangible.
What is someone paying for when they buy your goodwill? The answer is your future profits and free cash flow. Goodwill in effect is a premium paid in excess of the tangible asset value. It is an amount that a buyer willingly spends to access your established and future profits and cash flow. Depending on the kind of business you have, a buyer may be prepared to pay somewhere in the range of one to three times your future profits in goodwill.
Some of the things that can make your goodwill more tangible include:
- an identifiable brand
- customer lists
- documented operating systems
- key staff retention
- supply agreements
- leases of premises
- marketing materials and advertising presence
- websites and social media accounts
- positive testimonials and online reviews
A history of operating profits will usually be the clincher. Too many small businesses operate their business simply with a tax focus. They want taxable profits to be as low as possible. But when they want to sell their business they may struggle to explain why it is so valuable. The reality is that in many cases they have invested years of their life in a business asset which they have progressively devalued.
If you are contemplating the future sale of your business then you need to start building the business. Instead of simply focusing on profits or lowering your taxable income, operate it with a view to maximising the value of your hard earned business asset.
Preparing a business for sale may be a three to five year project. Not doing what is necessary in the three years prior to sale may cost you many tens of thousands of dollars in unpaid business value.