When I started the process of selling my business, one of the first things I wanted to know how to value a business.
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.
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.
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:
- The asset valuation method to value a business.
- Minority discounts, and how they affect the money you get.
- How your deal structure can affect the ‘real’ value you get for your business.
- Reasons why people sell a business
- Tax advantages of selling your business.
- Planning your exit strategy: how it can help you get a better value for your business.
- How much it costs to sell your business.
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.