How To Value A Small Business

Many people believe that valuing a business is difficult. There are something like 42 different methods to value a business according to the ‘leading’ business schools of the world. The fact is, it’s only worth what a buyer is willing to pay for it.  So for this article, rather than telling you about the 42 different ways to value your business, which would be a worthless exercise, we’re going to talk about the only method that counts.  The same method a professional buyer will use to calculate a valuation.  If you’re not on the same page as a buyer, you’ll just be wasting your own time and effort.


A typical business broker will give you an extortionate valuation, anywhere in the region of 10 - 40 times net profit.  The ONLY reason for this, is because their listing fees are based their valuation, and they know that by presenting such a high valuation you’ll naturally be flattered, and you’ll buy into their Bullsh*t.  


But let’s get real for a second, if you were an investor, would you spend your money on a business that gave you a 2.5% - 5% return?  Even a passive investor, with a cash to burn would baulk at some a poor return.  The majority of serious buyers want between 20% - 35% return on their investment from Day 1.  That means getting their money back within 3 - 5 years.  Buying a business carries a lot more risk for an investor, than the typical routes of  investing, areas such as investing in long term government bonds for example, so the returns have to be much higher to reflect that increased level of risk.


So how does a buyer value a business?


It’s simply based on a multiple of Pre-tax profit and liquidity of the shares.  The formula is ‘Valuation = (Profit x Multiple).

Let’s look briefly at an example of this in real life.

A Painting & Decorating Business:

Turnover:  £1,000,000

Pre-Tax Profit:  £100,000

Multiple:  2.5x

Valuation:  (£100,000 x 2.5)  = £250,000

These figures are averaged over a previous 3 year period, and the multiple for most types of small business is normally between 2 to 3.

One area that many business owners get wrong when valuing the business, is how they calculate their own salary & takings.  A business broker will typically advise a business owner to not consider their personal takings, or to only show a small salary.  


For example, in the business shown above, if the owner was working full time in the business, but only showing a £6,000 salary, it would probably show a perceived increase in profits for the business of say £30,000.  This would increase the valuation by £75,000.  However, the reality is, if a buyer sees this (which they will), they’ll either walk away, or they’ll simply adjust the valuation accordingly.  The other areas where a business will attempt to reduce their costs to boost profits, is in marketing.  Cutting the marketing costs has a delayed effect on the top line of the business, but an immediate effect on the bottom line, ie. Profits.  This is especially relevant in industries that rely on continued advertising to attract new customers, such as Tourism.  Sometimes that advertising might not reap benefits until 12-18 months into the future, but if a business cuts their marketing budget by say £50,000 per year, that will improve the valuation (initially) by £125,000.  In truth though, 12 months down the line, the business turnover will be hit heavily, whilst profits will follow suit.  This could mean a reduction in business volume by 50% or more.  


This is why the valuation is averaged across the previous three years.  One of the first areas a buyer will scrutinize, is the marketing spend.  By doing this, it can be compared to turnover in the following periods.  If marketing costs are reduced, impacting the sales turnover in a following period, this will post a red flag to any buyer, & is a clear sign of a badly run business.  The moral of the story is, it’s bad practice to do it, & doing it only benefits one person - the one with the motivation to increase your short term valuation.  It will cause irreparable damage to your business far quicker than you’ll ever find a buyer.  


In fact there’s a strong chance, when a buyer notices that your marketing spend has been reduced, they’ll just walk away from the deal & you’ll be left with a business that no longer makes the same amount of money that it did, before you entered the process.


When it comes to looking at your own salary, often times, it will either be far too high, or far too low.  When calculating the valuation, take away all of your salary & benefits from the business, and instead add in, the cost of a replacement.  So if you’re working full time in a managing director role, consider how much it would cost to employ a managing director to run the business instead.  This should be a competitive market based salary package, but don’t forget the other costs such as benefits package, company car, & national insurance costs too.

 

An important point to remember here, when considering the two types of sale, an asset sale, and a share sale.  In an asset sale, the valuation will just be the assets, & the profit multiple.  A share sale valuation will include the liabilities too.

The difference between the two is, if a buyer buys the shares of the business, they basically take over everything, and you walk away.  If a buyer buys the Assets, you as the previous business owner still must pay for the liabilities.


We hope you’ve received some value from this article, and some information that you can use to move forward toward your vision.

 

If you’re confident that selling your business is the way to go, or perhaps you’re undecided, it’s important to consider the significant amount of effort and resource you’ll need, to make it happen.  It’s a full time job. - The time investment alone is enough to put anyone off.  So imagine for just a minute, that you didn’t need to do all of this work.  What if this could be done over the next 3 - 5 years (by someone else).  Everything we’ve listed in this article, is what you’d need to do, if you were selling through a business broker, or direct to a buyer.


Unlike other private equity firms, our focus is on growing businesses at the smaller end of the market.  We’ve worked in, and grown our own businesses in the exact same fields you work today.  We’ve spent years coaching and supporting small businesses just like yours, developing their teams, and helping them to grow, but now, we’d like to help you.  


We have a solution for business owners that need to sell their business immediately, or for those who want to stick around for a few years.

If you’re considering the options to grow or sell over the next five years, read more about how we're helping others just like you. Click here to read about our unique approach to helping you get what you want with the YokeFormula™ for your business.

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