Selling your Business
When thinking about buying a business it is also important to think about an exit plan or selling your business. A good starting point when preparing an exit plan is to understand how much your business is worth. This could be a formal or informal valuation.
You may wish to seek advice from a qualified professional business valuer. Even on an informal basis, you could get an idea of the value of your business by reviewing businesses in your industry that have sold.
In looking at these comparable businesses, review the multiple of profit, earnings before interest, tax, depreciation and amortization (EBITDA), and research the range of multiples at which they were sold.
To determine where you sit in this range, review your Business Attractiveness and Exit Readiness Scores. The higher your scores and the closer you get to the top end of the range, the higher likelihood you will achieve your business value when selling your business.
Business valuation principles
All business owners should understand basic business valuation principles. They need to be able to approximate their business value so that they can make a realistic estimate of the profit from selling your business, and whether this is going to be sufficient to meet future needs.
There is a common misconception that valuing a business is a simple financial calculation that is done with a great degree of certainty. This is not the case.
The valuation of a business is extremely complex because of the diversity of companies, industries and individual business performance that needs to be considered.
The true value of a business is what any potential buyer is willing to pay at any particular point in time, and this fluctuates depending on whether the settlement involves cash, shares or debt financing. Other factors that affect the price are the timing of payment and the workout involved.
Through years of Research and Development (R&D), some companies have developed Intellectual Property (IP), packaged it and built it into an established brand name.
In this case, the valuation mechanism needs to not only value current sales. It must also take into account the past development that will generate sales in future years.
An investor who buys this type of company will reap the rewards of the previous investment in R&D.
There are more than 10 commonly accepted methodologies for valuing a business. These include;
- book value
- adjusted book value
- discounted earnings
- discounted cash flow
- income capitalization (net profit before tax)
- sales multiple
- earnings multiple, and
- price/earnings ratios.
From our experience in talking with business brokers and strategic buyers, the most commonly used valuation methodologies are a straight multiple using EBITDA and the methodology Discounted Cash Flow, which factors in future income at a discount to today’s value.
Most micro-businesses that are sold to an owner/operator are sold for 1–2 times profits. But buyers will sometimes pay a higher multiple depending on the accepted industry benchmark and the strategic fit with other business interests.
Over a period of time, an industry usually develops its own rule of thumb by which a business is valued. This is a useful benchmark when selling your business to an owner/operator.
If we look at one particular industry and take two companies with similar sales and profit performance for the last year, one might justify paying more for one business rather than the other for the following reasons. One business may:
- Appear to rely on the directors and owners, while the other appears to rely on numerous staff members. If the reliance is spread across the entire workforce, a potential buyer takes over a business with a higher chance of success
- Be a start-up company and the other may be an established company with a five-year trading history
- The companies may have spent a considerable amount of capital on R&D that will lift future profits
- Have developed long-term contracts that ensure profitability in the future months and years, whereas the other may have to rely on winning contracts or work on a weekly basis
- Have an easily identifiable and loyal customer database and the other may have a high turnover database
- The companies may have developed a product that is positioned in a growth market and the other may not
- Be in a better geographical segment
- Have a more distinct brand
- The companies may have developed a worldwide patent that locks the brand into immediate worldwide distribution.
- A company may dominate a niche whilst the other is a smaller player with a less competitive advantage in a wider market
- Business may be a strategic fit for the buyer’s existing business, which will improve the profitability of that existing business.
There are also intangible reasons why two businesses may be valued differently. One may have strong internal systems. One may appear more professional or one may negotiate a better deal based on future profits rather than historical performance.
So clearly, two businesses with the same recent sales and profitability but different potential may be valued at different ends of the spectrum.
Vision in business valuation
Whilst it is tempting to think that all valuations are based on sound business principles, past performance and future potential, one needs to look no further than the high-tech crash of the year 2000 to see that sometimes emotion rather than simple financial calculations plays a role in determining the value of a business.
Throughout the 1990s, large and small global investors invested enormous amounts of money in risky start-up technology businesses whose own financial projections showed little chance of becoming profitable.
Inevitably, by the early 2000s, major corrections took place on stock markets and the focus for investors went back to businesses with solid financial performance and a proven track record.
Despite the book value of a business, it is important when selling your business that business owners understand when they are presenting a valuation to a potential buyer they must also sell a vision for its future growth.
Author: Kathleen Dale, Business Advisor and Founder of Compass Business Advisory.
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