Right… I’ll start with what everyone will tell you, which does indeed hold true: It is worth what someone is willing to pay for it! It’s basic supply-and-demand economics. However, I’ll go one further and say: It is worth what someone is willing to pay for it, combined with how good you are at demonstrating its value and selling it.
That said, we are all (well, mostly) rational human beings and like to see some logic and science brought to the party; especially when it comes to matters of investment. (Actually, we think we are rational, but research has proven that we actually make decisions with emotions – what you might call “gut feel”. There’s a lot of info out there about this… but I digress.) As this can be a “how long is a piece of string” question – mainly for privately owned companies - some logical calculations provide a good foundation, or range of valuations, to use when negotiating with interested buyers or investors.
It's worth highlighting that going through a proper valuation process in the context of a major investment or outright sale goes hand-in-hand with preparing the business for a sale. See my article on that here.
Now the technical bit. There are two areas to address when valuing a business:
1. Factors that affect the value, or perceived value, of the business.
2. Deciding on a couple of appropriate valuation methods, and applying them.
Factors affecting company valuation:
There will, of course, be some universal factors and some unique to a given company.
“Hard” factors
- Your numbers – value of owned assets, historical and projected profit and cash flows.
- Competitors - how much are similar companies worth?
- Length of time the business has been running for (longer = more reliable track record & forecasts = higher value)
- Customer value – what is the lifetime value per customer? How many regular orders do you get?
- Any patents or intellectual property that you own.
- Barriers to entry to your market, and the associated costs of entry.
- State of the economy.
“Soft” factors
- How motivated is the purchaser / what are their motivations to buy or invest?
- Is it a forced or ‘orderly’ sale?
- Strength of relationships with suppliers and customers.
- Does / can the business run without your involvement?
- Staff loyalty and individual or team skills (what is the level of supply of staff with the same skills and experience?).
- Reputation and brand name.
Appropriate valuation methods:
At the end of the day, the investor / purchaser wants to know what their return on investment will be. This can either be simply by way of buying the business at a price which they can make a profit on when selling on fairly soon after (typically the ‘net assets’ value), or by buying with a view to enjoying future profits and/or increase in net asset value.
1. Multiple of profits
For example, it’s not uncommon in some industries for businesses with a good record of profitability to be valued at either 3 times or 5 times annual ‘normalised profits’. This and the ‘discounted cash flow’ methods usually give valuations at the upper end of the scale, but there can be a lot of judgement involved, so it’s important to be realistic with judgements.
Be clear on what is being sold (what is the investor buying?) – i.e. a separable operation of the business, or the whole company? This normally means identifying the underlying profits of the continuing regular operations which are to be transferred. If you have properly prepared for the investment, it should be fairly easy to strip out any one-off income and expenditure. Having this month-by-month for the latest 12 months will give you a good idea of future performance and facilitate your financial forecasts. Within those forecasts, account for the financial impact of changes after investment or a sale. You’ll then end up with what are called ‘normalised profits’
Whether you use 2, 3, 5, or 7 times normalised profits as your valuation will depend on intangible things like the reputation or brand value of your business, in the context of industry norms.
2. Asset valuation
As mentioned earlier, this will be the value of your businesses’ ‘net assets’ – as shown within its accounts, on the Balance Sheet. Whilst Limited Companies are required to produce a Balance Sheet (aka Statement of Financial Position) by law, sole trader businesses are not. However, if you are a Sole Trader business with potential investment on the horizon, it would be surprising – to say the least – if you (or your Accountant) had never produced a Balance Sheet.
In terms of business valuation, this is the most basic form of it, and often under-values the business. This is because a Balance Sheet is required to show the fair value of a business, but, in the context of investment, it would be leaving out the intangible element of goodwill (basically the difference between what someone would pay for the business and its net assets).
3. Entry valuation
This valuation method looks at how much it would cost to set up the same business and develop it to the same point as yours. This includes both tangible (physical assets), and intangible (in-house skills and external relationships) elements.
4. Discounted cash flow
Accountants love this method because of the logic and maths used (the maths isn’t particularly difficult, just satisfying). If you’ve seen fairly steady or growing cash flows, this may be a suitable method to use, and actually give quite a high valuation (great to use as a starting point in negotiations).
It’s based on accounting for the effect of inflation on future cash generated by the business. As we know, things get more expensive as time passes (or, my preferred way of looking at it, per Robert Kiyosaki, that money becomes worth less), so £100 now is worth more than £100 five years from now. This is applied to the annual forecasted cash flows of the business, using a ‘discount rate’ – a percentage by which to reduce the cash flow by depending on the year in which it is expected to be generated. Again, judgement and industry norms play a part in settling on an appropriate percentage.
5. Rule of thumb
In some cases, there may well be an established industry rule of thumb when it comes to valuing a business. It may involve non-financial elements as part of the valuation, but any smart investor couldn’t ignore financials completely, regardless of an industry rule of thumb. You might already know what the rule of thumb is for your industry, or it may require some research and the input of a professional such as an Accountant.
Of course, these are just valuations to aid negotiations. As mentioned at the beginning – it will come down to what someone is willing to pay, and what you can agree so that both parties are happy with the result. To achieve that, you will most likely need a great Managing Director and Finance Director dream team!
Get in touch if you want help with your business valuation for sale, investment, or even employee share options. Fill in this form and we’ll review your case and get back to you.
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