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Realising the true value of your business

Saturday, January 26, 2008   By Mike Reddy

 

When small business owners approach me as they regularly do to discuss plans to sell their business it is because they usually have little idea on its worth and are hoping to get an idea from me. Or it is a reality check on their own hopes and dreams.

It's clearly an advantage to have an objective idea of what it is worth. Back in law school we were taught that a fair value is what an able and willing buyer is willing to spend and an able and willing seller is willing to receive. There is a little bit more to it than that but that will do for today!

I guess the main difficulty with that theory is that it assumes perfect market equilibrium. That is to say it is assuming that both parties are no more desperate than the other. However my observation in business is that this assumption is rarely valid. Usually the vendor is more passionate about concluding the transaction than the purchaser. Or they certainly give this impression.

For that reason I often see the case where sellers discount their business value (much as they discount their goods and services) in order to complete the sale. It is as though the seller is determined to undervalue the efforts that have gone into building the business in the first place. On the other side of the coin there is occasionally the situation where a vendor has unreasonable expectations on what the business is worth. It is a fallacy to think that someone will purchase the business at a value calculated to reimburse an owner for the time and effort that has been put into the business if it does not have the profitability and cash flow generation to go with it.

I am therefore always surprised that very few business owners have ever seriously considered getting an accurate valuation. Considering the return for the sale of the business is often cited as a primary reason on why they invested in the first place, I am perplexed on why so many owners decided to keep their head in the sand.

A survey reported by CFO.com found that only 12% of business owners had ever had a formal valuation done! Guessing the value to put on your biggest asset is really risking your future.

I have spent a number of years valuing businesses and have been asked to attend court on numerous occasions as an expert witness. There are a number of different valuation methods and particular ones may be more appropriate than others depending on the type of business.

As an example it would not be appropriate to value a service oriented business based purely on the value of its physical assets. The real value would be in the firm's intellectual property and goodwill, components which we usually refer to as intangibles. In fact in most businesses these intangibles can equate to a significant part of the overall valuation.

For this reason a number of factors need to be taken into account to ensure that the valuation is both accurate and useful. Notwithstanding what valuation method is used it will certainly need to be consistent with the available hard data, particularly your current and past financial position. I have always used historical information over the last three to five years.

Some valuation methods focus on financial data such as profit levels, asset value, cash flow and debt carried by the business. Other factors are not so cut-and-dried. The valuation might incorporate financial projections for the next three to five years. It might consider intangible assets, such as intellectual property like patents and trademarks, brand names and goodwill. You also need to consider the context. Your own company may be doing very well but its value will be diminished if it is part of an industry that is in serious difficulty or in decline overall.

There are more than a dozen different valuation methods. The crudest methods operate by rule-of-thumb or multiples (what the stock market refers to as a price earnings ratio). For example, landscape businesses are estimated to be worth 1 to 1.5 times their "profit" plus the value of their capital assets. However, multiples only give a rough, industry wide ballpark figure for business value. They do not necessarily give the real value of a particular business. other accurate methods include the balance sheet approach, which basically subtracts business liabilities from assets. The adjusted book value method is similar but uses current market value rather than purchase price or depreciated value.

Retail and manufacturing businesses are generally assessed according to the value of their assets because they tend to store large amounts of value in their inventory or capital assets while service company valuation is based on the capitalisation of income valuation method, which places a heavy emphasis on intangible assets. It's also possible to calculate the value of a private company by comparing it with an equivalent public company and making appropriate adjustments. Business value can also be estimated by anticipating cash flow over a three to five year period and adjusting that into current dollar terms.

A current valuation can be important at times other than sale. There are numerous business and legal situations that require a detailed valuation, among them: when considering a merger or acquisition; when seeking investment capital; when buying out a partner or implementing an employee stock ownership plan. A properly determined valuation inevitably enters into less pleasant activities such as shareholder disputes and divorce settlements also. Tax minimisation planning can involve business value, for example in developing estate plans and gift transfers.

A valuation can also indicate how your business compares to its direct competitors. If the value is below that of competitors it should be a prod to focus you on building more value into your business. This will improve your outlook in terms of succession and estate planning.

And to be honest, if the reason I was going to sell a business was because I was counting on it to realise my retirement dreams I would rather be disappointed five years beforehand and still have time to do something about it rather than at the time I approached a broker and announced ny retirement.

With this many potential situations requiring a business valuation it's important to have an up-to-date professional estimate of the real value of your business. To get a valid and commercially useful valuation you will need to work closely with a professional who has experience in the area. Your accountant already has a good understanding of your business and might be able to advise you on which valuation method will be best suited to your business circumstances.


Mike Reddy is a Chartered Accountant, business coach and advisor helping businesses in Sydney, Melbourne, Brisbane and Gold Coast to easily increase their profits and cash flow. He is currently President of the North Sydney Chamber of Commerce, a Regional Councillor for Sydney North East and a member of the Institute of Chartered Accountants Sydney leadership team. As well as advising businesses, Mike presents business development seminars and webinars and is regularly contacted by the media to comment on small business matters. You can connect with him on Facebook, Twitter and Google+.