There is no perfect mathematical formula for valuing a private business – ultimately the business is worth what a buyer is prepared to pay. However, with a combination of science and art, applied by somebody who understands both the nuances of the financial statements of the business, and also the business sale process and the market, it is normally possible to derive a sensible guide price. As a point of interest, the simplistic business value calculators you can find online just don’t cut it – the number of variables at play are simply too numerous to be able to reasonably exclude human intervention in order to derive a sensible valuation. In our opinion a business broker (as opposed to an accountant) is in the best position to carry out this work, marrying the necessary technical knowledge with practical market experience.
As a starting point, let us assume that the business being sold is a profitable private limited company and that the vendor is selling shares in order to benefit from entrepreneur’s relief. The two fundamental pieces of information required to generate a valuation are 1) the sustainable level of cashflow going forward 2) an appropriate multiple to reflect the risk associated with the purchase. We will look at each of these in turn.
- Sustainable Cash Flow Going Forward
While the historic profitability of the business is of interest to a buyer as an indicator of future performance, the current year and the forecast for the subsequent year or two receive much more scrutiny – after all it is these years which will be providing the vendor with his return. A close surrogate for cashflow is EBITDA (earnings before interest, tax, depreciation and amortisation), adjusted to ensure that the business is covering an appropriate cost base. For example, directors often pay themselves little through the P&L preferring to distribute profits via dividends, and so an adjustment would be made to reflect the actual market rate for the roles the directors are performing. Similarly the owner might also own the freehold of the building the business operates from, giving it a ‘free ride’ and hence there would be a rent adjustment. One-off items can also typically be excluded. The resulting adjusted EBITDA is the sustainable level of cash a business can expect to generate going forward and is the first piece of the puzzle. You hear arguments about trade buyers being able to save much of the fixed cost of the business and therefore this should be added back to the bottom-line, but this is what the buyer is ‘bringing to the party’ not the seller. While,if they are keen enough, they may be prepared to share some of the synergy savings, this cannot be assumed.
- Appropriate Multiple
The multiple reflects the time period over which the buyer expects to recover his investment and is a function of the level of risk associated with the purchase. The multiple is very likely to be between 2.5 and 5, with the majority of businesses falling in the 3 to 4 bracket. Examples of factors that influence the multiple are:
- the market sector and the ease with which it consolidates
- the degree to which revenue is recurring and guaranteed
- the level of customer concentration or dilution
- the degree of expertise / relationships that reside with the departing directors
- the level of handover / involvement of the exiting directors after the sale
- the quality of the 2nd tier management left behind
- the geography and aesthetic of the business
- the degree to which the business is scaleable
- the point of differentiation of the business versus its competition
The list goes on and on but the principle is that anything that makes the purchase more risky reduces the multiple and vice versa.
Applying an appropriate multiple to the adjusted EBITDA derives a potential market value but this needs to be related to the balance sheet that a buyer will inherit. If the sale is a share sale, the buyer inherits a ‘debt free cash free’ balance sheet and the actual balance sheet needs to be adjusted to reflect this. External debt is assumed to be settled and any cash balance that is not required as part of normal working capital is deemed surplus cash and assumed to be added to the consideration at completion. This debt free cash free balance sheet identifies the level of Net Asset Value a buyer will expect to get as part of the purchase (and therefore by comparing to the guide price, what level of goodwill they are paying over and above the Net Asset Value). Freehold or long-leasehold property should always be valued and sold separately. If the sale is an asset rather than share sale, normally the business will be valued as though a share sale and then an adjustment made to the guide price to reflect the difference between the Net Asset Value assumed for a share sale and the value of the particular assets included in an asset and goodwill sale.
There are exceptions to the multiple of adjusted EBITDA calculation and the most common are discussed below:
Net Asset Value Valuation
There are occasions when the Net Asset Value exceeds the guide price calculated on the basis of a multiple of adjusted EBITDA. This implicitly means that the business is not generating a sufficient return to justify the level of asset employed by the business. An example might be a manufacturing business with a high level of capital equipment, during a period of recession. In this case a valuation tends to be based on a discount or premium to net asset value, according to how confidently the seller can demonstrate the business will ‘bounce back’ and the strength of the underlying assets of the business
The maths of the multiple of adjusted EBITDA valuation tend to break down at low levels of adjusted EBITDA. Take the example of a small business generating a profit of £50k but the director doesn’t pay him/herself via PAYE and hence through the P&L. If his role is valued at say £40k, the adjusted EBITDA becomes £10k. It then doesn’t really matter what multiple is applied, the result is not going to be a very big number. In such circumstances the business tends to be valued on a lifestyle basis, reflecting the fact that the purchaser will need to work fulltime in the business but in return are able to generate a decent income / ‘be their own boss’ / escape corporate life / a tedious commute / build something for the future / manage work around family needs etc etc. Valuing lifestyle businesses falls even further into the art rather than science category, although the majority probably sell for up to twice what the purchaser can expect to earn from the business in a year.
Anderson Shaw Corporate Finance Ltd (www.anderson-shaw.co.uk) is a 2 partner business, predominantly assisting owners in the sale of their business. We are always happy to have a no-commitment chat with anyone thinking of selling, including providing a free valuation to ensure a sale process will meet the seller’s needs.
(This article originally published on The Buzinesszone website:) http://www.businesszone.co.uk/decide/finance/real-world-methods-of-valuing-a-business