What's a Business Really Worth?

The answer is ‘what someone’s prepared to pay for it’ and that is only known when it’s actually tested. It’s no different to the value of a house.

Business owners too often delude themselves by what they think their business is worth, without knowing the reality. That delusion can come from how hard they’ve worked to get it to where it is today, how proud they are of the business, what it’s turnover is, how many people it employs, how many years it has been in existence, how much they have invested into it, possibly even family origins, and so on. The problem is, a buyer does not regard all of those aspects as relevant to the business’s value and even then, may have a different perspective of the same fact.

The delusion can be made worse by timing. Many owners plan to sell down or out at a time that suits them personally (e.g. ‘had enough’, retirement, wanting cash for something else), for that only to represent poor timing in terms of the sale price of the business (e.g. market or economic downturn, higher interest rates, difficulty of obtaining finance, disadvantageous exchange rates, legislation changes that are adverse to the business or industry, uncertainty during election periods). If the objective of selling a business is to maximize the (after tax) sale price then the timing should not be determined by any particular event in the life of an owner but by market conditions as well. That makes it more difficult to maximize the sale price but the approach is more fundamentally sound. We try to avoid selling investment property or shares when the market is down and the same should apply to the sale of business equity.

The third difficulty (and it may seem strange) is a rule of thumb that many businesses are thought to be worth a multiple of EBIT (earnings before interest and tax) or EBITDA (earnings before interest, tax, depreciation and amortisations), averaged over the last three years, plus the value of net tangible assets (tangible assets less liabilities) at the time of settlement. This can cause two problems: 1) Using such a broad rule of thumb can cause inaccurate expectations for the owner/s, and 2) The final value of net tangible assets often ends up being significantly different (often less) than is originally thought, once analysis and negotiation is concluded. An alternate rule of thumb valuation formula, prevalent in professional services businesses ((e.g. finance brokerages, financial planning, real estate, accounting firms, law firms) is to apply multiple of revenue (top line). This has less complexity but still comes down to a negotiation over what that multiple should be as well as the sustainability of the top line revenue itself.

Another problem in estimating the value of a business is thinking that there is a common approach to the sale process … there isn’t. Every sale is different. What happens with retained earnings? Who owns the debtors and has responsibility for the creditors? How will stock be valued and at what point? Who is responsible for staff entitlement liabilities? What happens with doubtful debts? When will the purchase price be paid and how? Are there any claw back provisions after the sale point? The way each of these questions is treated has a significant impact on the value of the business and the reality is they can each be treated however the parties decide, with the impact on business value being affected by every single one of them.

Another issue is the associated costs of selling a business. Commission to a business broker or intermediary, legal fees, accounting fees and capital gains tax (if applicable), added up, can amount to a significant amount of money, all of which reduce the dollars in the pocket of the owner/s. Certainly, the better a business is set up for sale prior to going to market the lower these costs are likely to be but they will still exist.

Some businesses are either passed down to next generation family members and that is outside the scope of ‘selling a business’. That’s fine providing it is a chosen approach rather than the last resort. Further, equity in a business is sometimes sold under discount to next generation family members or to longer term / key employees. Nothing wrong with that, of course, but it’s important to ensure at least two things are considered: 1) the capital gains tax implications of the future sale of that equity tranche (given it was discounted), and 2) formalising the opportunity of further equity purchases for each person if that is to be the case (rather than leaving it as an unconsidered option, which could cause future confusion or disappointment).

An extended point from the previous paragraph is that it’s healthy to explore the option of key people buying into a business at any time. Some owners have a resistance to this or don’t even consider it as an option. There is no reason, per se, to resist this as possibility. Too often the resistance is due to fear of reduced control over the business, guessing that the potential buyers won’t be able to obtain the necessary funds, not wanting to declare more information about the business (including financials), or a reduced ability to sell the whole business further down the line. All of these points of resistance are flawed. Control over the business is maintained providing more than 50% of the equity is maintained. If funds cannot be sourced to purchase the equity the payment can be via foregone dividends until the purchase price is covered. Being more transparent with business information is more often a healthy approach to take. And a clause can be included in the shareholders’

agreement obligating minority shareholders to sell if/when a suitable buyer of the whole business comes along. Further, key people who own part of the business, even a very small part, are less likely to leave the business and more likely to perform at an even higher level.

Because of all of the above, it’s obviously crucial to set a business up well for sale. Fortunately, many of the ingredients of running a business well are are the same as those that maximize its sale value. Those ingredients include (but are not limited to) the following:

• Proper governance, structure and controls
• Integrity of data per se
• Accurate and comprehensive database
• Effective CRM (client relationship manager)
• Effective marketing program
• Demonstrable solid market / demand
• Brand recognition / brand strategy
• Solid business reputation
• External advice / support
• Demonstrable succession planning for key people within the business
• Effective processes and systems
• Proper and appropriate contracts with key suppliers / clients / employees
• Protection of intellectual property
• Continuous improvement approaches in place, including those to increase business efficiencies
• Solid risk management practices in place
• No skeletons in the closet
• Demonstrable dividend / profit distribution policy
• Effective training and development programs
• Demonstrable high level of staff engagement
• Demonstrable high level customer experience
• Accurate, timely and comprehensive financial reporting
• Commercially sensible figures within financial reports
• Consistent benchmarking and use of it to improve business performance
• Measurement of key business metrics, including lead and lag indicators
• Effective and efficient workflow / operations
• Suitable premises and equipment
• Effective and upto date I.T. systems and approaches
• Effective stock management
• Absence of inordinate dependence on any one person (or people) for the business’s success

But, again, a business can be very well run, by ticking most of the boxes above, and still have limited appeal to potential purchasers for other reasons, e.g. dwindling market/industry. Or there just might not be any buyers around at the time of an intended sale through no fault of anyone.

It would be ludicrous to suggest that the value of a business should be ‘tested’ by going to market, just to find out. That could obviously cause damage on many fronts. But simply running a business ‘thinking’ it’s worth $x without any marketplace verification is just as ludicrous. The best is to be aware of what comparable businesses are selling for now and the trends over say the last two years. We value property according to comparable recent

sales and the same approach should be taken to business value.

One last important point. Astute business owners know the return on capital being generated by the business. To strike profit only as a percentage of the net equity (equity less loans) invested into the business is too limited. Profit should also be struck as a percentage of the market value of the net equity so that it can be compared to alternative investment opportunities the owner/s could take. If profit is 20% of the net equity invested into the business but is only 5% of the market value of the net equity then the business is not generating an adequate ROC to the owner/s on the latter benchmark. This comparison can not be made in the absence of estimating the business’s value.

So, there are several lessons from this article:

1. Business owners should know, as accurately as possible, the market value of their business, each year.
2. Valuing a business is part science and part not. It always comes down to market forces.
3. Running a business well not only leads to profitability but to saleability.
4. A well run business in a dwindling market is still losing value.
5. Timing the sale of an equity sale should take market conditions into account and not just personal events in the lives of the owner/s.
6. The costs of selling a business must be factored into its value.
7. Return on capital should be calculated frequently, on both fronts outlined above.