How to value a business: a guide for business owners
Posted on 04 Feb 2023, by admin
Knowing how much your business is worth is one of the first things people have in mind when they decide they might want to sell their business, after all it is usually one of the most important factors. However many owners do not know where to start and by what method they should be using to reach a potential value. This process is often obscured by many resources online that give you valuations that are certainly on the higher end of realistic and sometimes well beyond what is reasonable. In addition these tools normally do not explain how they reach their magical valuation number and thus leave you none the wiser on how to actually value your business and you have to then rely on the number they give you.
What we will try to do here is take the opposite approach as we believe it is much more useful to you. We will show you the methodologies that can be used to reach a valuation and what goes into that final valuation figure rather than skip to the end and just give you a number. Dexterity Partners off a Free Business Valuation with the aim of understanding exactly what your goals are and what you want to achieve so we can help you work towards your goals.
What is a Business Valuation?
Firstly, before we dive into the exact methods, some of you may be asking well what exactly is a business valuation, to put it simply it is an indication of what your business is worth. Usually this is in the context of what it is worth to an external buyer in the marketplace who is buying 100% of the shares of the business. So you sell the business and the value is what you get paid for.
Why Value a Business?
Another question you might have is why is having a business valuation important?
Well if you are selling your business then like any sale, a buyer will themselves have a price in mind and so you need to have one too.
How do you know if their offer is any good?
Maybe it sounds good but when you run the numbers it actually isn’t. When going into any sales process it is imperative you are both prepared and your opinions are backed by both numbers and facts. By having a business valuation this means you both have a value in mind and if done correctly, this is based on the numbers and facts of your business and not just made up out of thin air on personal opinion. This then puts you in a much stronger position when it comes to any negotiation.
At Dexterity Partners we develop a valuation framework early on in the process, before we talk to any potential buyers. This allows the seller to understand what the valuation is likely to be around, in our opinion, as well as how that number is reached using the facts and figures of the business. This also allows them to see how the value could change if the figures were to change. Then once engaging with any buyer it allows us to have a strong negotiating position to start from.
How to value a business
No matter what approach you take, the business value is going to be derived from 4 main factors, its size, how well it is currently doing, the future potential and finally other unique factors.
- So the size is straight forward, the bigger the business, usually the more valuable. This in terms of size of revenue
- How well the business is doing, the more profitable the business is then the more it will be worth.
- The Future potential, if your business has great potential then usually this would increase the value of your business. Part of this potential is how reliant on you is the business. A business that is fully reliant on the owner is not in as good a position as one where the owner is not a vital cog. The business has greater potential if it can operate without you the owner as that indicates a buyer that the potential is in the business itself and not sitting with the owner who will be selling.
- Other unique factors, these are potentially endless so it is a bit of a catch all category, but it is essentially, do you have something unique about your business that makes it more attractive and thus more valuable? perhaps it is a patent or trademark, a strong brand, some proprietary software? Whatever it may be it is something that makes you stand out against competitors and thus makes the business more valuable.
At the end of the day though in most businesses the most important factor is how profitable you are. We come across many types of business and a whole range of sizes and we also talk to buyers or all types, and what we always find is that profitability is key.
Yes the size of the business size matters, the potential matters and the unique elements matter but the level of profit being made is what they take most notice of and whilst the other aspects of the business impact the valuation, the profitability makes by far the largest impact on the businesses valuation.
How do you calculate the value of a business?
So, then we’ve explained the factors that go into a valuation but how do these come together to give an actuarial number?
So, the most common approach to valuation we see is using the following formula:
Normalised EBITDA x multiple ( general + specific characteristics of your business) + free cash less debt.
What this essentially means the valuation is equal to the profit of the business multiplied by a number (called the multiple – we will come onto this) and then add the cash in the business to the value but subtract any debt.
So, let’s go through each of these factors in more detail.
- Normalised EBITDA – this means Earnings before Interest, Tax, Depreciation and Amortisation. Hence the EBITDA acronym. So take the profit you made, add back in those 4 elements and you have the EBITDA. The normalised part basically means you adjust for any exceptional items. So in practice this usually means any costs that are in the business.
- Multiple – This what you times the EBITDA by. Usually in the 3-7 range but it varies for every deal, usually larger businesses will have a greater multiple than a smaller business. This is effectively the point of negotiation in most deals, the level of profitability is fixed and what the buyer and seller each believe the multiple should be is where the valuation differences come from. In the end this comes down to negotiation between both parties.
- Free cash – This simply means the cash in the business and the free part is just to say what cash is not needed in running the business day to day.
- Debt – If you owe money to someone then either you must pay it off or the amount will be deducted from the value. Note this is debt as in loans and does not mean trade creditors and the like they do not impact the valuation just as the trade debtors don’t.
What else affects the valuation of the business?
When this valuation is reached it is normally said to be subject to normal working capital. The standard approach usually requires looking at the normal trading pattern of the business, and what the stock plus debtors less creditors is in the usual course of trading. Then determining on sale, where the business sits in regards to usual trading and whether any adjustments need to be made to balance the differences.
For example, if at the date of completion, the debtor balance is double what it usually is but the stock and creditors are the same as the average then it will be adjusted for in the sale price. This works both ways, so if it is something that means the working capital is lower than expected then the deal value would be adjusted down or adjusted up if the opposite is true.
The future potential of the business can also have an effect on the valuation. For example, if you are selling a quickly growing business that is seeing revenue increase significantly each year then you could expect that rather than just looking at the past profitability of the business as a methodology for valuation.
There are different ways this can be approached, often using forecasts as well as earnout mechanisms for how you reach the valuation. However, in essence the idea here is that if the business has a very bright future with a much greater profitability possible in the future the valuation will reflect this rather than just the past performance.
Is valuation based on turnover a good value indicator?
In general no. The turnover of a business is important but the value normally comes down to the profitability. There are some edge cases where turnover is important, e.g. in fast growing businesses experiencing exponential growth where increasing turnover is more important than profitability for now. But it is very rare that turnover is used as a valuation mechanism rather than profits, as at the end of the day a buyer is wanting to buy your business as it will make them money in the long term and profitability is at the end of the day what makes the new owner money not turnover.
In some cases, turnover can have a small impact on the valuation, as a business with greater turnover usually has a greater ability to increase profit on a pure numbers basis, but if it does have an effect it will on a base valuation reached by looking at the profitability.
How much is your business worth?
At the end of the day though what your business is worth is what someone is willing to pay for it. There are methods that can be followed and factors to be considered but what someone will pay is subjective to them.
You of course want the best value you can get and basing your expectations on a logical methodology and approach, based on the figures is always the best approach and most buyers will do the same. But the exact number you reach and buyer reaches will inevitably be different and the true value is what both you and buyer deem acceptable, it always comes down to negotiation. Read more here How much should I sell my business for?
Get in touch
For further information and impartial advice, feel free to contact our founders at Dexterity Partners.
