If you’re considering buying or selling a business, it’s essential to know what the business is worth.
The challenge is what you may think a business is worth, and what the other party thinks its worth, are usually two different figures. If you’re selling your business, you’re likely to be disappointed if buyers don’t see the potential you do. For example, a café for sale at $300,000 included a purpose-built wooden floor with the café’s name etched in the middle. The floor alone cost $100,000 but nobody else saw any value in the floor. The worth of a business hinges on how much profit it will make, balanced by the risks involved. But past cash flow, profitability and asset values are only the starting points. It’s often the hard-to-measure factors such as key business relationships and goodwill that provide the most value.
There are four basic criteria which affect the value of a business.
Circumstances of the sale
The reasons for selling a business can affect its value. A forced sale is likely to drive down the value. For example, an owner-manager who is struck by ill health may have to accept the first offer that comes along, but a business owner who is ‘just testing the waters’ may get a higher price through lengthy negotiations.
Tangible versus intangible assets
How tangible are the business assets? A business that owns property, machinery or stock-in-hand has tangible assets that will have some re-sale value, making the business easier to value. Many businesses have almost no tangible assets beyond office equipment. However, their intangible assets may have significant value such as a well-respected brand, customer goodwill, intellectual property and potential for growth. These intangibles can be harder to value and your accountant may be able to give you guidance with these.
Years of operation
The longer the business has been operating, the better the track record, cash flow and loyal customers who provide repeat business. Be wary of businesses for sale that have only been trading between one and two years, as they may be experiencing current popularity but the market may be about to turn away, such as bars and cafés.
Remember, the true value of a business is always what someone is willing to pay for it. To arrive at a figure, buyers use various valuation methods, usually just to give a sense of reassurance that they are not paying too much. The main methods are as follows:
Add up the assets of a business, subtract the liabilities, and you have an asset valuation – nice and simple. So, if a business has $500,000 in machinery and equipment, and owes $50,000 in outstanding invoices, the asset value of the business is $450,000. As a buyer, you could decide to just buy the assets of a business rather than take over the business as a going concern. This way, any outstanding debts or tax payments are all payable by the previous owner. Use an asset valuation if you own or are interested in, a stable, asset-rich business. The starting point for an asset valuation is the assets listed in the accounts. This is known as the ‘net book value’ (NBV) of the business. You then refine the NBV figures for the major items, to reflect economic reality. For example:
- Property or other fixed assets may have changed in value.
- Old stock may need to be sold at a discount.
- Debts to the business that clearly aren’t going to be paid.
Intangible items, such as software development costs are usually excluded.
Price earnings ratio
The price earnings ratio (P/E ratio) is the value of a business divided by its profits after tax. For example, a company with a share price of $40 per share and earnings per share after tax of $8 would have a P/E ratio of 5 ($40/8 = 5). When valuing a business, you can use this equation: Value = Earnings after tax × P/E ratio. Once you’ve decided on the appropriate P/E ratio to use, you multiply the business’s most recent profits after tax by this figure. For example, using a P/E ratio of 6 for a business with post-tax profits of $100,000 gives a business valuation of $600,000.
What P/E ratio to use?
Deciding on an appropriate P/E ratio to use is not easy and you’ll have to justify your choice of P/E ratio to a potential buyer or seller. Some industries have ‘standard’ P/E ratios for valuing a business, so ask your accountant if there are industry averages you can use.
Entry cost valuation
Rather than buy a business, you could start a similar venture from scratch. An entry cost valuation reflects what the process would cost you. To make an entry cost valuation, calculate the cost to the business of:
- Purchasing or financing its assets.
- Developing products or services.
- Recruiting and training employees.
- Building up a customer base.
This allows you to make a comparative assessment. Suppose you calculate it would:
- Cost $500,000 to buy the set-up equipment.
- Cost $50,000 a month for overheads.
- Require 12 months’ trading to get a customer base.
So a business that already has all of this is worth at least $1.1m ($500,000 for equipment and $600,000 overheads for 12 months). You can now factor in any cost savings you could make, such as use of better technology, setting up in a less expensive area or other cheaper alternatives.
Industry rules of thumb
In some industry sectors, buying and selling businesses is common. This has led to industry-wide ‘rules of thumb’ which are dependent on factors other than profit. For example:
- Turnover for a computer maintenance business or a mail-order business.
- Number of customers for a mobile phone airtime provider.
- Number of outlets for a real estate agency business.
Buyers will work out what the business is worth to them. Take the example of a computer maintenance business with 10,000 contracts but no profits. To one buyer, the business may be worth comparatively little. However, a larger competitor may pay $100 per contract to buy the business because it could merge the two businesses and make larger profits.
The key source of value in a business may be something that can’t easily be measured. Putting a value on intangible assets isn’t easy because that value can vary depending on the nature of the assets and the industry. Get advice from your business advisers, Chamber of Commerce or industry association. Some examples:
- Strong relationships with key customers or suppliers. For example, if a business holds a licence or distributor rights across Australia for a product expected to be successful, the business’s value will increase accordingly.
- Management stability. If the owner-manager or other key people are going to leave, the business may be worth far less. For example, the profitability of an advertising agency may collapse if a key creative person leaves. Similarly, if key salespeople leave, they may take important customers with them. Any written agreements or incentives to retain key employees could add value, but they could also damage the value if a potential buyer intends to bring in a new team.
- Intellectual property ownership. If the business owns the rights to patents, copyrights or trademarks, these will add value to the purchase price of a business. For example, if you’re selling a patented invention, you can value your business higher than a similar business selling an unprotected product.
- Get expert advice. Talk to your accountant about possible valuations of your business.
- Search online for similar businesses that are for sale to get a feel for the market.
- Ask your accountant if they have past examples of similar businesses for sale and what they sold for. Remember that ultimately, your business is worth whatever someone will pay for it.
- Review the IP Australia website for steps you can take to protect and enhance the value of intangible business assets such as trade marks and designs. If you’re buying a business, check what intellectual property they have protected.