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Know your true worth: Top 5 ways to value a small business

know your true worth

By Nicky Tatley

Working out the value of a business is never easy, but it is a vital element in the selling process.

After placing to one side any emotional bias about the worth of your enterprise – for many, selling a business is akin to letting go of a cherished “baby” – there are a few key tangibles (and intangibles!) that can be measured to reach the most accurate valuation.

It’s certainly true that the time-scale for preparing to sell a business should be a matter of years rather than months. The most saleable enterprises have been built up into great shape over a long period – those that fetch less than the owners hoped for tend to be put on the market in a vulnerable position, perhaps due to financial difficulty, illness or personal problems.

And having a fair idea of the possible market value of your business, at any given time in it’s life-span is a sensible idea, although not as vital as keeping a regular check on the balance sheet. Keeping an eagle eye on your profit and loss statement and the current market conditions should be your own internal system for knowing when it’s time to retire.

A savvy business owner must have a clear notion of what creates value in their particular business, beyond assets and liabilities. We spoke to Andrew Cagnetta, CEO at Transworld Business Brokers who feels strongly that intangibles are key drivers:

“For me the bottom line is the bottom line. Profits trump everything in valuation. I could care less about assets if they don’t drive profits. So it is incredibly important to know the value drivers…like intangibles. It could be location, price, products, vendors, customer mix, name, website, marketing, niche….it could be a combination of them all, like a good recipe. Leave one ingredient out of a good cake and it will fall flat.”

It seems a fair assumption that the value of different types of business will be measured in different ways, but Cagnetta feels that it’s a matter of perspective:

“I am not sure the measures change, but the multiples certainly do.   What would you rather own – a landscaping business that makes $500,000 where you have to wake up at 4am, run five crews of blue collar workers with issues like weather, equipment failure, tardiness, labor shortages, etc….or a distribution business that makes $500,000 that is open Monday to Friday, 9-5, has four office workers, low inventory, and a niche clientele.  The easier it is for a new owner to acquire the business and continue the earnings stream, the more valuable the business.”

It may be tempting to try and crunch the numbers yourself, and there are several online business valuators you can try, but most professionals are wary of them. Cagnetta is more philosophical than most:

“I wouldn’t rely on a website to predict what a business would sell for, but then again a $25,000 valuation may not get you close either. I guess that is why they say business valuation is an art not a science.  It’s hard to have a computer spit out art…although that day is getting closer to reality. ”

Despite the artistry involved in coming to a realistic valuation, there are a few key steps that help you create the whole picture. Here are our top five:

EBITDA (Earnings before Interest, Taxes, Depreciation, and Amortization):

This method is a rough guide to assessing a company’s profitability, and thus its ability to repay interest or debts. The formula ignores depreciation and amortization (all payments for tangible and intangible assets), and focuses on revenue (exclusive of interests and taxes) minus expenses to arrive at a basic ballpark figure. In reality, this figure gives a just a hint of what a business is worth, and negotiations will centre on things like perceptions of competitive advantage and the list of established clients.

Cash Flow

A small business is often valued at between two and four times its cash flow – calculated as EBITDA plus the elective salary and benefits enjoyed by the current owner. Given that up to 80 per cent of a business’s purchase price is usually financed, potential purchasers will want to assess how well the cash flow supports the debt repayment whilst offering an investment return and providing the owner with a reasonable salary. Calculations will reveal a break-even point in such arrangements, and outcomes significantly above that level will have a positive impact on the business’s selling price.

Financial leverage

The net value of a business is often highly dependent on its perceived post-purchase financial leverage. This can be positively or negatively influenced by factors such as the value of business’s tangible and intangible assets, the prevailing business climate, the purchaser’s credit rating, and the quality of the post-purchase leadership.

In the case of two equally profitable enterprises, one may have upgraded equipment with little need for further capital expenditure, whilst the other may feature outworn equipment in urgent need of replacement. The business with state-of-the-art resources will, of course, command a higher selling price.

Recurring income streams in the form of annual subscriptions, contract renewals, and business agreements which link clients to company products or services form the best evidence that your business has long-term prospects. Such fiscal infrastructure is hard work to put in place but, far more than intermittent receipts of substantial cash sums, clearly demonstrates a potential buyer would secure a business in good financial health.

Deal Structure

A practical assessment of business value can often be influenced by the precise structure of the deal, changing the taxation status and debt servicing accordingly. When the seller receives a full cash settlement, the valuation will be lower because of the high cost of equity-associated capital. However, where seller financing is provided, this can positively impact upon the purchase valuation by as much as 10 to 15 per cent.

Exit Strategy

The potential value of a business to a buyer may depend, in part, on their envisaged exit strategy. A purchaser’s assessment of the cash flow potential during any planning window may include an assessment of the sum allocated for sale of the business at the conclusion of that time period. As a result, the current purchase valuation would be higher or lower depending upon the potential buyer’s assessment of the exit strategy outcomes.

At the end of the day, the true value of a business is the cash sum a buyer is willing to pay in the current market, but if you get the right figures in place – you’ll get yourself in the best position for negotiating a better deal.

• • •

Nicky photoNicky Tatley is the Managing Editor of BusinessesForSale.com, the market-leading directory of business opportunities from Dynamis. Nicky manages content across all titles in the Dynamis stable, as well as well as being a regular contributor to other industry publications, both print and online.

 

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