Determining the value of a business can be quite complex. In this article, we will cover some fundamental concepts that can serve as guidelines for estimating its worth. It’s essential to remember that potential buyers may use similar criteria when assessing the value of your business. Additionally, there is no universal formula for business valuation; instead, various models can be applied based on the characteristics, size, and risk factors of the enterprise.

Reasons for Valuing a Business

There are several motivations behind valuing a business:

• The business is available for sale.
• You are seeking investors.
• You intend to issue shares in your company.
• A bank loan is necessary for your business.
• There are changes in ownership or capital structure.
• The company is involved in divestments or acquisitions.

Factors to Consider When Valuing a Business for Sale

If you have decided to sell your small business, there are several key factors to consider beforehand.

Lease: If your business operates from rented premises, you will need to discuss current lease terms with your landlord. The lease can potentially be transferred to the new owner, or if it’s nearing its expiry, a new lease may need to be arranged. If you own the premises, you should think about selling them to the business that currently leases them from you.

Licences: Licences specific to your business, such as those required for restaurants and cafes, are typically included in the sale. Ensure you compile all documentation related to your current licences to include in the sales contract.

Stock: Will you include any remaining stock in the sale? If so, you will need to assess its value and incorporate it into the sales agreement.

Tax Implications: The sale of a business can create intricate tax issues, including GST calculations related to the selling price and considerations for Capital Gains Tax. It’s advisable to consult with an accountant who can provide guidance on these matters.

Contracts & Suppliers: Your business may have contracts with suppliers and customers, ranging from short-term orders to long-term service agreements. You must determine whether to transfer these contracts to the new owner or terminate them. It’s important to review the specific details of these contracts with your lawyer, including any termination clauses.

Business History: Key information influencing your business’s worth includes its operational duration, origin story, reputation, facility conditions, and whether its objectives have remained consistent.

Employees: Consider employee compensation, morale, job roles, and whether specialised skills are necessary for operations. A crucial factor here is whether the business relies on a few key individuals, indicating which skill sets are vital for its operation.

Legal & Commercial Issues: Potential buyers are unlikely to be interested in a business with existing legal or commercial complications. Factors such as ongoing legal proceedings, compliance with health and safety regulations, long-term contract status, and the presence of necessary permits, registrations, and licences will significantly impact the business’s value.

Goodwill & Intangible Assets: Does the business own specific intellectual property, intangible assets, or goodwill? The worth of intangible assets can greatly influence the market value of the business.

Financial Information: This includes profitability, working capital, consistent cash flow, the level of debt manageable through cash flow, recent annual turnover, and whether profits are increasing or decreasing. Additionally, it’s critical to determine whether there is adequate working capital to issue dividends to shareholders.

Types of Valuation Methods

A practical starting point for valuation is evaluating the business’s profitability in conjunction with associated risks. Other valuation methods include asset valuation, price-earnings ratios, and entry cost valuation. Various industry benchmarks can also provide insights for determining business value.

Capitalised Future Earnings Method

The capitalised future earnings method is a prevalent approach for valuing small businesses. When purchasing a business, you acquire both its assets and the right to all anticipated future profits—referred to as future earnings. These future earnings are then capitalised to assign an expected value, with the capitalisation rate often representing the expected return on investment (ROI), expressed as a percentage or ratio. A higher ROI indicates a more favourable outcome for the buyer. This method enables comparison between different businesses regarding potential ROI.

To calculate the value using this method, first determine the average net profit for the past three years while accounting for any circumstances that may hinder future profitability. Next, divide this average profit by the expected ROI, tailored to the sector and company specifics.

For instance, if the average profit is $100,000 and the expected ROI is at least 50%, the valuation can be calculated using the following formula:

Value or selling price = (100,000/50) x 100 = $200,000.

Multiples of Revenue Method

The multiples of revenue method is a valuation technique that identifies a business’s maximum worth. This takes annual revenue over a designated period into account, applying a multiplier to estimate value. This multiplier can fluctuate based on the industry and other variables, typically ranging from less than one to three or four.

In valuing small businesses, the lowest price someone would pay—known as the “floor” or liquidation value—is usually established. A maximum value, or “ceiling,” is also determined based on current revenues. The growth potential of the specific business can influence the multiplier: higher growth prospects might lead to a higher multiplier, particularly if there’s a strong percentage of recurring revenue and good profit margins. Conversely, a slow-growing business may see the multiplier set at one. Economic conditions and industry trends also impact this multiplier.

Earnings Multiple Methods

The earnings multiple method parallels the multiples of revenue approach and is often more suited to larger businesses. This method involves multiplying earnings before interest and tax (EBIT) to arrive at a multiplier. The multiplier is determined by dividing the stock price by earnings per share (EPS) for the price-to-earnings (P/E) ratio.

This method is easily understood, although its simplicity may be viewed as a drawback, as it condenses complex information into a single figure.

Asset Valuation Method

This method entails adding together assets, such as cash, inventory, physical property, equipment, and receivables. Liabilities, including bank debts and outstanding payments, are then subtracted to arrive at the net asset value. For example, if Raymond is interested in purchasing a manufacturing business that has assets worth $300,000 and liabilities amounting to $200,000, the net asset value calculated via this method would be $100,000—indicating the business is worth $100,000.

Goodwill may also be factored into the asset valuation method in addition to the net asset value. Goodwill encompasses aspects of a business that are not easily quantifiable, such as location, reputation, and history. It may not always transfer during a sale since it can depend on personal factors like the owner’s reputation or customer relationships, and may be excluded if the business is underperforming.

Discounted Cash Flow Method

The discounted cash flow (DCF) valuation method focuses on your company’s projected cash flows rather than those of other businesses. You will need to provide a cash flow forecast for the next three to five years and use a formula to calculate the present value of these cash flows.

Present value compares the business’s current worth in terms of anticipated future cash flows against the buyer’s current payment. This method requires a discount rate—which is the likely interest rate a buyer could receive from depositing funds in a bank. If the present value exceeds the proposed investment amount, it signals a favourable investment opportunity for the buyer.

Projecting cash flows may necessitate assumptions regarding future business conditions, which can complicate matters and introduce the risk of error. Therefore, this method is often best used alongside other valuation methods.

Summary

Valuing a business is not simplistic. Understanding business valuation is vital, whether you are selling, seeking investors, or restructuring. No single formula applies universally; varying methods are applicable based on a business’s size, risk profile, and industry context.

Numerous factors, such as leases, inventory, goodwill, financial records, and tax consequences, affect a business’s valuation. Common approaches to valuation include capitalised future earnings, revenue multiples, asset valuations, and discounted cash flow analyses. Each method has its advantages and disadvantages, guiding buyers and sellers in arriving at a fair price. Familiarity with these concepts can empower business owners to effectively navigate valuation processes, optimise their selling price, and attract suitable investors.