The real value of a business can be very different to how the owner values it according to some personal benchmark – Dennis Mattiske outlines the business valuation process and how it can help to improve performance and profit for the sake of improvement, as well as for selling it or for attracting investors.
How much is your business worth? It’s an important question that business owners often find very difficult to answer. In theory, it should be fairly simple as it is probably the business owner’s most important and valuable asset. Surely, therefore, they should have a pretty good idea of what it’s worth?
Yet most business owners struggle to come up with an accurate figure, and if they do it might be wishful thinking. Some like to believe that their business is worth whatever sum they think they need for a comfortable retirement. Others answer that they don’t need to know yet – they’re not planning on selling the business any time soon.
But there are many reasons for business owners to regularly value their business other than the obvious one of sale. A valuation requires consideration of many of the factors that govern the success of the business. These include how well the business is performing, what its potential is, and what opportunities are being missed.
If the business isn’t performing well, and if it has little potential, its value will be low. This usually gives business owners a strong incentive to improve its performance, both operational and financial, which in turn will improve its value.
A valuation is, in itself, a useful thing to have but it’s important to use the valuation process, and the consideration of all the factors that go to make it up, as an incentive to improve the business.
It makes good operational sense to value a business regularly, even once a year. A formal valuation may be time-consuming, but a valuation that provides a focus for performance can use assumptions and estimates and therefore be much less onerous and less expensive.
Once a valuation has been undertaken the first time, the same bases and assumptions can be used each year. The aim is to create a benchmark valuation process so that factors affecting the performance can be highlighted and evaluated on a regular basis.
Business owners should therefore understand the basics of business valuation so their expectations for the business are realistic and they can take steps to ensure the business is operating well and can reach its full potential, not just when it’s time to sell.
An accountant can help with a current valuation of the business, as well as identify ways of increasing the value that are specifically suited to the business. Business owners can then undertake the process themselves each year, to help measure their success and growth, until such a time as when they do want to sell.
Understanding the value of their own business also allows owners to move quickly when acquisition opportunities arise – they are more likely to know what the real value of the opportunity is to their own business.
Profit and Sustainability
One of the most important factors in determining value is profitability, as long as profitability is matched by dependable cash flow. An increase in profit will generally lead to an increase in value.
Some of the steps that can be taken to increase profit include:
improving gross margins
improving debt collections
reducing stock levels
reducing staff by improved processes
better deployment of staff (such as salesmen out selling rather than sitting in the office)
increasing product range.
However, this doesn’t mean that all businesses with the same level of profitability will be valued at the same amount. For example, there may be a successful restaurant in a small row of shops in an inner suburb. The newsagent next door is equally profitable. However, the restaurant’s profitability is closely related to the owner’s personal skill as a chef and the time he or she spends working, while the newsagent is profitable because there is a train station nearby and commuters buy newspapers on the way to work.
In the marketplace, the restaurant is probably worth less than the newsagent, despite the same level of profitability. The reason for this is, with the departure of the restaurant’s present owner it’s more likely that the profitability of the restaurant will suffer. The business owner needs to be able to show the quality and skills of the rest of the staff, the contribution they make to profit, and the lack of reliance on his or her own personal efforts.
Thus, while profitability is important, it is the expectation of continued profitability from the business structure itself, rather than from the ability of the present owner, that is most important.
This can come as a surprise to many small business owners who have worked hard to build up the long-term profitability of their business but, in doing so, have become personally closely associated with the success and profitability of their business.
It is a particular problem with professional services businesses where the reputation of the owner is closely associated with the business’ success. So the owner needs to reduce his influence on the profitability of the business in order to maximise its value. For example, by establishing a management team, improving formality of management, introducing customers to others in the business and keeping records of customer contacts, and excluding the owner’s name from the business.
A business that has good systems, is well located, enjoys a long-standing reputation and has few immediate competitors should be able to maintain its profits, and such a business would usually be said to have a low risk of earning those profits.
Because of this low risk, the value of the business will be higher than that of a business where there is a high risk that the profit may not be sustained. The future profits of a business that has just started will be high risk, as will a business that has a low barrier to competitors entering the marketplace or a business subject to seasonal or weather fluctuations.
So, if a business valuation identifies factors that would put the earning of profits at risk, steps need be taken to minimise the effect of those factors in order to enhance the value of the business.
The value of a business is often expressed as a multiple of the profits of the business. The lower the risk of earning those profits, the higher the multiple. For example, the value of a business in a particular industry may be four times its earnings before income tax (EBIT). And so the business would be earning 25 percent on its value. A more risky business may only be valued at three times EBIT, representing a 33.3 percent return on value.
The measure of profit used in the valuation calculation must exclude any ‘abnormal’ income and expenses, as well as interest. In some cases it can also exclude depreciation and amortisation of fixed assets. But it must include a deduction for the commercial remuneration paid to the owner.
Often the driver of the owner’s remuneration is to minimise tax, and bears no resemblance to a remuneration that would have to be paid to an employee undertaking the same tasks. In other cases, businesses are run at a level where the owner’s remuneration is acceptable to that owner but would be unacceptable to someone else. So in valuing a business consideration must be given to the time and effort put in by the owner (and owner’s family) and an adequate reward must be identified.
In the process of doing this, it’s common for the business owner to realise that their reward really isn’t sufficient and they then look at ways to increase it. These include employing others to do more of the administration tasks, delegating management to others, introducing more efficient accounting processes, and working more &lsqu
o;on’ the business rather than ‘in’ the business.
The difference between the calculated value of the business and the total value of its tangible assets, such as stock, debtors, and plant and equipment (less creditors) is the business’ goodwill. If the calculated business value is less than the tangible assets, the goodwill is negative. So goodwill is not something that is calculated directly but is the result of the calculation above.
The value of goodwill is enhanced by improving the business value through factors such as those referred to earlier, including handing over management to others to reduce the owner’s personal association with the business.
If it appears that accounting records are unreliable, or if the business can’t produce current financial accounts, any prospective purchaser is likely to discount the value of the business because of uncertainty about its real profitability or even its legitimacy. It is therefore important that a business maintains reliable accounting records and can produce current financial accounts at any time.
As mentioned earlier, in looking at profitability, adjustments are commonly made for extraordinary items of income or expense and for expenses that are discretionary or personal to the business owners. For example, if there are motor vehicle expenses or overseas travel expenses for the benefit of the business owner, they would be added back in determining profit. Therefore, such expenses must be readily identifiable.
The availability of financial analysis of sales by customer, product, and geographic location, can also enhance value where the analysis points to a ‘low profit risk’ due to a good spread of customers or wide product base.
The sale of a business may generate a capital gain that is subject to capital gains tax (CGT). After valuing the business, owners should make sure they know what liability there may be for CGT and seek advice on how it may be minimised, as this will make the business more attractive in the marketplace.
It may be prudent to change the structure sooner rather than later to avoid an increasing impost of CGT as the value of a business increases with time and improved profitability.
* Dennis Mattiske is a partner with accountants and business and financial advisers HLB Mann Judd, Sydney.