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Yield is Everything: If the valuation you are given for your business sounds too good to be true...

Don’t be misled.  Whilst it's our job to get the best price for your business, we also see it as an important part of our job to give you a realistic view of the value of your business before you engage us.

There are more than a few business brokers who employ the following not very sophisticated tactic to persuade business sellers to ‘sign up’ with them:

“Well, Mr Jones, I’m delighted to tell you that we think your widget business is worth [‘megabucks’ - more than you dreamt possible – more than the annual sales value – more than 5 times the adjusted profit].  Now please sign on the dotted line, pay me £[Lots] as an upfront fee and we’ll get on and sell it for you".

Business owners are sometimes misled by this approach for obvious and understandable reasons but the old adage applies - if it sounds too good to be true, it very probably is.  However, once you have agreed to place the business with the broker and if you have also been persuaded to pay substantial upfront fees you are ‘stuck’ so beware.

There is a sound reason why private businesses, which are big enough to be making a genuine profit, after paying the costs of management, sell for between 3 and 5 times the expected annual cash flow (before tax).  It’s called ‘Yield’.

One way to explain this is by contrasting a business valuation with a commercial freehold property valuation.

The annual yield on a commercial freehold property, let for a number of years to a tenant with a decent covenant, is widely acknowledged to be somewhere between 9% and 12%.  This means that the rent, as a percentage of the value, should be between 9% and 12% or in simple payback terms, ignoring inflation, the owner expects to recover the amount he has paid over a period from 8 to 11 years.  The yield is a measure of the underlying risk associated with investing in a commercial freehold.  If you think about it, not much can go wrong with a commercial freehold, especially when the tenant is responsible for just about anything that might happen.

Now contrast this with the risk associated with purchasing a private company.  How reliable is the income stream likely to be compared with a lease?  To the extent that the business has tangible assets, how much could be recovered from these if the business had to close down?  What about other costs of closure?  Etc etc.

So this is why the annual yield on a private company needs to be between 20% and 33% (hence the valuation is between 3 and 5 times the expected annual cash flow).  The market deems that the risk associated with the expected annual cash flow and underlying asset value of a company is typically a lot more than that associated with a commercial freehold.

Who could sensibly disagree?

Sometimes brokers, trying to persuade you to sign up with them, will say that your business is worth more because of buyer synergies (ie the buyer will be able to make more profit than you have been able to as a result of economies of scale etc).  However, since buyers generally take the view that their synergies belong to them and not to the vendor this is not usually correct.

So how can you genuinely increase the value of your business ahead of a sale?  It can be done, but I'll address this in future articles.

Anderson Shaw has offices on the outskirts of Stratford-Upon-Avon and provides business broker and corporate finance services for clients throughout the Midlands and the UK.

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