This post will describe in outline the various techniques you can use to arrive at a guidance value for your business – either for sale now, or for what it could be worth in two to five years’ time should you implement a certain growth and preparation strategy.
In further posts in this series, I will explain how you can maximise the value of your business, and the various stages in the process of selling a business.
The most important point to remember is that the true value of a business is what someone will pay for it, and that this will be different for each buyer and type of buyer. By and large, buyers fall into three main categories:
- strategic buyers
- financial buyers
- asset strippers.
The strategic business buyer will be interested in the return on investment obtainable from the business through synergies with their current business, e.g. reduction of staff and overheads. This is the best type of business buyer as they will value your business largely ignoring indirect costs.
The financial business buyer will be interested in the return on investment they could receive from the business if it were to run on the same basis as it does now. Note that although the strategic buyer will be more flexible on the price they are prepared to offer, they may well negotiate on the same terms as a financial buyer in the absence of competition.
The asset stripper will be looking at the value of your business assets on an individual basis, and will not be looking to the future other than at the price at which they can sell the individual assets. This post will not cover this type of buyer, as they will normally only be involved in distressed sales.
Business valuation techniques
Whatever type of buyer they are, prospective buyers of a business will use various business valuation methods. Some of the most commonly used techniques are described below.
1. Multiple of earnings value
This is the most universally used business valuation method and is often the point of reference for other techniques. It is based on the earnings a buyer will be able to extract from the business before interest, tax, depreciation and amortisation (EBITDA). The valuation of the business is therefore a function of the EBITDA and a multiplier.
The multiplier used depends on both the industry sector and the size of the business being valued: the larger the business turnover, the higher the multiple. For example, and as a very rough guide, the multipliers for a typical professional services business range from 1.0 to 1.9 for one with an annual turnover of less than £400,000 to 6.0 to 8.0 for one with an annual turnover of £5 million to £10 million.
The adjusted net earnings will depend on the type of buyer. For a financial buyer, for example, the figure is adjusted to reflect the owner’s takings and benefits less the cost to the new buyer of employing a replacement general manager. For a strategic buyer, the adjusted net earnings figure is further adjusted to take account of the savings from which the buyer could reasonably benefit.
2. Multiple of turnover valuation
This method is often used for serviced-based or consultancy businesses that generate regular ongoing revenue from an existing client base. As the name suggests, it simply calculates the value of the business as a multiple of its annual turnover. In some cases, the turnover will be adjusted to reflect just the turnover that is derived from the contract agreements or regularly repeated client needs.
Again as a rough guide, the typical ratios for consulting businesses range from 0.7 to 1.3, depending on the size and strength of the ongoing business.
3. Net book value
This is used mainly for manufacturing or engineering sector businesses where there are relatively significant tangible assets in the form of machinery and/or buildings. It looks at the net book value, which is the sum of your assets less your total liabilities. This figure is then adjusted to reflect the current economic reality, taking into account items such as the real current value of your fixed assets, the value of your debtors to the purchaser, and goodwill.
4. Forward-looking business model value
This looks at the future business model that a buyer might reasonably expect to apply. A reasonable annual growth in revenue and costs is projected, based on your current operation but adjusted to reflect the current position in the economic cycle and the costs that a strategic buyer will incur compared with those that a financial buyer will incur. We also add in the acquisition costs the buyer will incur, and then look at the return based on the fact that most buyers will aim to recover their investment within three years.
5. Simplified discounted cash flow value
This method is based on the sum of the dividends forecast over a certain period of time in the future, plus a residual value at the end of the period. The value today of each future dividend is calculated using a discounted interest rate, which takes account of the risk and the time value of money. This method is usually the most complex way of valuing a business, as it depends heavily upon the assumptions about long-term business conditions.
We use a simplified calculation model for the discounted cash flow valuation, based on a number of key assumptions.
The above descriptions of the main valuation techniques are necessarily brief, and do not explore all the variables that can and should be taken into account. For more detailed information or specific advice, call me on 020 7099 2621.
Asking price considerations
When you are deciding on your bottom-line negotiating position and your asking price, it is worth considering the type of investor your business may attract. The value of a business to different individuals or companies will vary, depending on their sales objectives, their level of marketing presence and expertise, and whether they are financial or strategic buyers.
You may achieve a better deal value if you accept a deferred payment or earn-out arrangement. This effectively allows the buyer to finance the business acquisition initially, and will also show the buyer that you have confidence in the future potential of the business. However, you will also need to have confidence in the buyer’s ability and intentions to grow the business.
For professional services companies, the value of the business will be mainly based on the prospective buyer’s perception of the goodwill, which can vary significantly. To maximise the level of goodwill, you will need to demonstrate the stability of the sales, their level of contractual obligation, and the consistent quality of service as a means of maintaining them.
Whatever asking price the business is advertised at, the purchaser will expect to negotiate this downwards. Therefore it is worth pricing the business slightly higher than your expectation for the final deal value.
My next post in this series will explain how you can maximise the value of your business.
In the meantime, for further information or advice on this topic, email me or call me on 020 7099 2621.
This information was correct to the best of my knowledge and belief at the time it was posted. It is, however, written as a general guide, and is not intended to apply to specific circumstances. The content should not, therefore, be regarded as constituting legal advice and should not be relied on as such. Accordingly, I recommend that specific professional advice be sought before any action is taken.