Most business owners don’t know the true market value of their business. Certain well established rules of thumb can be used to establish a very rough ball park value for a business providing the assumptions underlying the rule of thumb are clearly understood and the resulting estimate of value is validated against other valuation techniques and commercial reality.
There are many ways to calculate the fair market value of a business but in the end a business is worth the disposable value of its net assets or the present value of its future cashflow, whichever is greater, subject to there being willing and financially qualified buyers in the market for that type of business when the business is offered for sale.
When a buyer pays more than net asset value for a business they are agreeing to pay for goodwill and it’s important to understand that there are two types of goodwill, personal goodwill and business goodwill. Personal goodwill vests in the owner of the business and walks out the door with the owner when the business is sold. Examples are where the owner is responsible for all sales, has direct personal relationships with all customers and suppliers, manages the finance of the business and makes all the key decisions himself. Business goodwill is where the owner of the business has put systems, procedures and people in place who can continue running the business day to day without input from the owner. Buyers are willing to pay for business goodwill but rarely pay for personal goodwill unless a detailed transition period is agreed where the outgoing owners personal goodwill is transferred to the incoming owner over an agreed and/or documented in a procedures manual.
If your business isn’t consistently producing a profit after you as the owner have taken home a market rate salary then your business is unlikely to sell for much more than the disposable value of its net assets.
If your business does produce a consistent profit over and above a market rate salary for you as the owner then one of the best ways to increase the value of your business is to understand the VCR formula i.e. V = C/R where V = business value, C = the sustainable annual cashflow your business will continue to produce and R = the internal and external risks to the business. Once you understand the relationship between value, sustainable cashflow and business risk you can start to pro actively manage cashflow and risk to maximise value when the time comes to sell.
If you are planning to sell your business then I recommend you print out “V = C/R” and “↑C & ↓R” in big letters and put them somewhere where you’ll see and take notice of them every day because the value you get when you sell your business will depend significantly on sustainable cashflow and the amount of risk the buyer believes may affect the future success of the business. The higher your sustainable cashflow and the lower the risks attaching to the business the greater the selling price will be.
Cashflow
For larger businesses cashflow is frequently expressed as Earnings Before Interest Depreciation and Amortisation (EBITDA) and for smaller owner managed business cashflow is usually expressed as EBITDA + the owners salary and all other benefits accruing to the owner annually such as pension contributions and any discretionary expenses paid for by the business which wouldn’t be continued after the owner has sold the business. This is commonly known as Sellers Discretionary Earnings (SDE).
Increased cashflow can be achieved through increased sales but be careful not to chase low or no margin sales just to grow your sales figure as that will lower your overall margin and could actually damage the value of your business. Increased cashflow can also be achieved by incrementally increasing gross margins, reducing operating costs and eliminating all non essential expenditure.
Business buyers frequently capitalise the sustainable cashflow of the business to calculate the value of the business to them and the capitalisation rate they use is heavily influenced by perceived risks to the business. Every Euro increase you can generate in cashflow and every Euro decrease you can make in operating costs will yield a multiple in terms of the increased value of your business when you sell.
Risk
To decrease risk you should put yourself in the shoes of a potential buyer. What would you want to see if you were looking to buy your own business?
Buyers typically want to see consistent financial performance over the last 3 years and up to date management accounts showing how the business is currently performing. They will want to see a well trained and experienced workforce, a diversified customer base, a diversified supplier base, an opportunity for growth and clear evidence that the business can continue after you have departed. Businesses which are too reliant on a small number of customers, a single supplier or the owner are very difficult to sell.
If you do a little each day to empower your staff, put systems and procedures in place, increase cash flow and decrease risk in your business you will significantly increase its value over time.
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