What's your business really worth? Is it really worth finding out if you're not intending to sell your business? Well, yes, actually it is. Conducting a business valuation has many benefits whether you're ready to sell up or not. In this article we dive into the details around both the process and the benefits of going through a business valuation exercise.
Why should we obtain a valuation?
There are a number of practical reasons for obtaining a valuation. Commonly it's needed when the business owner intends to sell their business or enter into a succession plan. In other instances, it can be required for taxation purposes in a corporate restructure, to support documenting a buy-sell agreement between business partners, arranging debt secured over the cashflow or raising expansion capital. We regularly see the importance of a valuation as a management tool, setting a baseline from which to measure progression and to sharpen the focus of the shareholders' attention.
What is a business valuation and how do you arrive at a number?
Broadly speaking, a valuation can be classified in two ways:
- Intrinsic valuation - an intrinsic valuation gives you an idea of the economic benefits expected to be generated from the business, taking into consideration the risks associated with those cash flows.
- Relative valuation - a relative valuation looks at the market to see how much people are buying or selling similar assets for to adjust it for certain differences, because we all know that it's very hard to find two businesses that are identical.
It might be helpful to consider these classifications in the context of property. If you're looking at a house, an intrinsic valuation will examine the rental income and the expected capital growth associated with the property, and then will discount these future cash flows back to today's dollars using a discount rate, which takes into account various risks associated with that future outlook. A relative valuation on the other hand, will look at comparative sales and then adjust them for relative size, views and quality of finishes. On that basis a relative valuation places less reliance on how you generate the cash flows to justify the price. It is more focused on how the market processes these assets relative to others.
What’s the right way to value an established small to medium-sized business? Is there anything that a business owner can do to impact the business value?
A small to medium business with an earnings history and a sound basis for an earnings forecast is typically suited to adopt an earnings multiple methodology. There are five key elements which drive business value and that number.
- Income – Income is your business earnings before interest and tax with adjustments made to normalise certain expenses like adopting a market rate salary for the owner, if the premises are rented by a related party, adjusting that and any personal costs that might be run through the business. All being equal, the higher the net income, the higher the valuation.
- Risks - The risks in the business that may impact the future business earnings. A whole range of factors need to be considered such as; external industry risks, financial risks such as concentration of sales to a number of customers, overhead controls, performance to some key financial ratios, competition, information systems, customer market and demand, and importantly, the reliance on the business owner. Key person risks is real and is priced into value by investors.
- Growth – Identifying where business growth comes from. Can you articulate that growth opportunity in a business plan? Do you have to chase growth in new markets or product innovation and is there a plan for this?
- Capital structure - An overlooked consideration by many owners is the capital structure of the business and a common myth we see is; the less I borrow means the business is less risky. In isolation that's true however, debt is cheaper than equity. A 100% equity funded business reflects that management is not necessarily managing their capital effectively and generating a reduced return to shareholders as a result. This means holding excess cash on the balance sheet that is not for a future purpose, such as an acquisition or expansion is actually suboptimal from a valuation perspective.
- Investment or reinvestment in return - Logically the more you reinvest in the business, the higher the earnings growth and so cashflow should increase. However, you need to consider how that cash reinvestment is working for you and the return that you should be getting on that money.
For example, say you reinvest $100 into your business and you generate extra cashflow returning $110 in a year. You've achieved a 10% return better than you get in the bank, right? However generally speaking, small businesses sell at a multiple of about three times earnings. If you're a 100% equity funded, you’ll need a return of about 33% on your reinvested capital just to break even in a risk adjusted sense, which means from a valuation perspective the impact of putting that extra $100 back in the business was a negative.
How does doing a valuation help business owners improve their business value?
To figure out how to improve the business’ value you really need to know where you are now to have a reference point and by going through a valuation process, you can form an unbiased view of value. Next, you need to consider if you're content with the current value as an indication of what you might achieve if you sold in the future, or if there's a gap to be closed in order to achieve a lump sum to provide a lifestyle you want in the future.
The risk assessment element of the valuation process is incredibly insightful and results in business owners having a heat map of where they can direct time and resources to be able to make a meaningful business improvement that will have a tangible impact on valuation. You can use a regular business valuation activity as a way to track your business value improvements to keep you and your business partners accountable for continuous business value growth, to assist you to achieve your shareholder objectives.
If you would like to arrange a business valuation or have any queries around how the process works, please contact your usual Mazars advisor, the author or one of our Team specialists via the form below or on:
Author: Angela Winton
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