How to value a business

By Daniel Atherton

Business-Valuation

When I started the process of selling my business, one of the first things I wanted to know how to value a business and how much is my business worth?

Before this point I hadn’t given too much thought to how business valuations work.  With hindsight this seems strange as I could have told you every other statistic with unhealthy accuracy:  Profit, revenue, average order value, debtor days, work in progress, sales pipeline value – you name it.  But I didn’t know how to value a business.

The difference is those figures can be calculated very simply with a pencil and a scrap of paper if necessary (or, in my case, a spreadsheet featuring a self-indulgent level of complexity – and pretty colours), whereas the value of a business – the value of your business – is a much more subjective thing.

In fact – one way to explain how much a business is worth is as follows:

A business is worth precisely what someone is willing (and able) to pay for it – and what you’d be prepared to sell it for.

So arguably the only true way to value your business is to put it on the open market and see what offers you receive.

Having said that, there are some common methods to value your business which give you a starting point for negotiations and a rough idea as to what your business is worth.  What’s more, knowing understanding how to value a business can help you understand where the value lies and maximise your business’ worth.

Valuing your business

How to value a business and maximising your business’ value is something that I explain in detail in my guide to selling a business.  For now, I’ll give you a crash course with one of the most common business valuation techniques.

This method is based on the amount of profit that your company generates.  To value a business you multiply it’s annual adjusted net profit by a number; the profit multiplier.

Value = Adjusted Net Profit X Profit Multiplier

So if your company makes £100k profit before tax, then an indication of its value is £400k.

Looking at this from a buyer’s perspective, if they spend £400k on your business they will get a return on their investment of 25% per year (assuming the profit remains the same) – not bad, compared to bank interest rates.

Focusing on profit

The profit figure used to value a business is usually based on profit before tax.  You can also use the post-tax figure, but this would mean increasing the profit multiplier accordingly (we’ll talk more about profit multipliers later).

To make sure that your final profit figure is truly representative, we use adjusted net profit.

Adjusted net profit

Adjusted net profit is profit based on standard arm’s-length principles.

Essentially, this means you can’t just pay yourself a small salary in order to bump up the value of your business!

If you’ve ever watched Dragon’s Den, you may have seen the Dragons complaining about this to naïve business owners – it’s one of the most common mistakes that people make.

For example, a business is seen to be generating £30k profit.  After some probing, it transpires that the business hasn’t been paying the owner a salary.  As soon as this sum is taken into account, their profit goes down to nothing – and four times zero is zero!

Even owners of established businesses commonly take salaries below market rate.  This could be for tax reasons, or to improve cash flow.

Buyers will understand this, but will also expect it to be taken into account – which is why adjusted net profit is used.

Revisiting our example, let’s say that the salary you pay yourself is a bit below market rate for the job you do.  Therefore, the adjusted net profit is reduced from £100k to £80k per year, and this would alter the value of your company to £360k.

On the other hand, as the business owner you may pay your self a salary which is above the market rate for the job you do, in the case the adjusted profit of your company will increase once this is taken into account.

Introducing EBIT

Another figure that might be used is your company’s earnings before interest and tax – or EBIT.

Imagine your company has been trading for a while, and you’ve built up good cash reserves which have earned you interest. Your buyer won’t be concerned with the interest because it has not been generated from company trading. So this figure will also be removed from your profit calculations.

Adjusting our example again then, we might say that £4k of your profit is from interest on reserves. The EBIT figure will be £76k, so your company’s value is now £304k – £96k less than when we started!

Once again – if your company has loans and an overdraft then you’ll be paying interest.  In this case the interest that you have paid for the year will be added back meaning your adjusted profit will increase.

…and EBITDA

Another variation of this is earnings before interest, tax, depreciation and amortisation – or EBITDA.

It works on exactly the same principle as EBIT, but also excludes any financial adjustments to your profit for depreciation and amortisation (similar to depreciation, but for intangible assets rather than tangible assets).

What profit multiplier to use

Once you’ve arrived at the adjusted net profit, you need to consider what profit multiplier to use.

In the example of how to value a business, I used four (which is not uncommon), but profit multipliers can vary – anything from two upwards depending on the company, market and economic climate.

Below are some things to consider when deciding what profit multiplier to use:

  • There may be conventions for your type of business – try to research trade press, or make enquiries with other similar companies that have been through the sale process.
  • The lower the perceived risk, the higher the profit multiplier (and vice versa).
  • The more sustainable the profit is (or is perceived to be), the higher the profit multiple (and vice versa).
  • Small businesses typically have lower profit multipliers than PLCs because they are seen as a bigger risk, and shares can’t be traded as readily. This is one reason that large companies buy smaller companies; the small business will be valued at a higher rate once it becomes part of a larger organisation.

A good business broker should be able to give you an idea of a profit multiplier that is appropriate for your industry in the current market.

Other things to consider

Before you set a multiplier and look at how to value your business, there are other factors to consider. I’ve covered these in much more detail elsewhere on the site, but here’s a brief overview:

Using all of this information, as well as your personal knowledge of the company and your industry, you should arrive at the right multiplier. This will allow you to work out exactly how much your business is worth.

Just don’t forget – whatever the value of your business, it is only worth what someone is willing (and able) to pay for it.

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  • http://batman-news.com Jaston Rodrigues

    This is a rather intriguing read…i have just one query that i believe was not covered. How do you value a buisness that has not yet broken-even (i.e. business that is not yet churning profits per say)

    • http://sellingyourbusiness.com/ Daniel Atherton

      Great question Jaston.

      This article focuses on valuing a business based
      on its assets or profit generating capabilities which is typically the
      case with lifestyle or smaller businesses. In this context a business
      that has not yet broken even is only worth it’s net asset – i.e. the value of stuff it has less the money it owes.

      Conversely,
      start-ups businesses that are built to raise funding in order to scale
      and eventually turn huge profits operate on a burn rate. They raise
      rounds of funding in their early stages which gets spent (burned) whilst
      developing to a position whereby they can make huge returns or be sold
      to a bigger player. For these businesses the valuation is often
      extrapolated from the funding they have already received – i.e. if they
      have sold 10% of the company for £1m then the whole is worth £10m.

      This
      still raises the question of how these businesses are valued when
      seeking this investment. In essence this is the same as principles as this
      article covers however rather than the profits being generated
      immediately they are expected to come down the line. Because of the
      delays and uncertainties regarding the future profits start-ups are
      considered high risk – however if/when they do come off the returns are
      usually worth the punt. Think Facebook, Twitter, LinkedIn et al.

      I hope this helps… Expect more articles on start-ups and valuations soon.

      Daniel Atherton

  • Rana

    how does a Brand used in your business is valued at this point of time. Which may be more valuable than you actual assets and profits.

  • PJ

    Hi, Like most comments I found this very interesting, I have a specific question about valuation based on how much revenue a company brings to the potential buyer, i.e. the potential buyer is in the same business and can easily absorb the additional requirement of the new business without the need for additional staff, if the business for sale brings 650000 in additional income to the potential buyer, how can the business be valued. This 650000 is in fact net income due to no outlay on staff etc.

    • http://sellingyourbusiness.com/ Daniel Atherton

      Hello PJ,

      What you’re describing sounds like a strategic purchase (rather than just an investment one) and this is best understood with an worked example:

      Imagine a business generates revenue of £650k and then – once all the direct costs and overheads are paid for – a profit of £100k. In a pure investment acquisition the buyer will often justify the price based on a multiple of the net profit/income. However if the acquiring business is in the same industry and already has most/all of the fixed costs then they may well be able to extract much more profit from the same £650k revenue. It may be that they can remove fixed costs from the business they acquire (they may already have an effective back office team that can handle the extra capacity) as well as being able to achieve greater economies of scale with the additional buying power that £650k revenue brings.

      With the example above it may be that they can generate £400k profit from this revenue – effectively making the business four times more valuable to them.

      Other examples of strategic purchases are when a business wants to enter a new geographical territory, acquire a new part of their existing supply chain, gain intellectual property that they can leverage or perhaps take a competitor out of the market. Another example is when a public listed company acquires a private limited company to increase their share price over night.

      The challenge for the seller is that these strategic benefits only come into play when the business is acquired by an organisation that is in a position to achieve them. It makes the business much more attractive to the buyer – but they will be keen to take as much of this benefit for themselves as possible rather than just paying extra for the business. With knowledge of the strategic benefits the business would bring to the buyer (and some astute negotiation) a seller may be able to negotiate a better valuation, however the best way for the seller to take advantage is to find two (or more) potential buyers that would enjoy the strategic benefits – and let a bidding way break out!

      In answer to your specific question – are you sure that all of the revenue would go straight to the buyer’s bottom line? Would there not be ANY costs associated with the extra 650000 business? If not then it sounds like you’re in a great position…

      You’ll find more on all of this in the free online guide to selling a business (http://sellingyourbusiness.com/guide/).

  • Mingailė Rats

    When I need to value a business – I refer to financial company. Selling a business is a responsible step, therefore each detail must be considered.

 

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