To achieve the highest price on sale, you first need to understand what you can do to influence the outcome. You also need to know whether the advice you are receiving from your professional advisors is good advice.
Once you have a better understanding of how buyer value is created and the manner in which you can change your business to substantially impact its valuation, you might very well question the advice you have received in the past. We start this exercise by examining the way in which valuation formula work. In this way we can identify those aspects of the business which we can change which will have the greatest impact on its valuation.
Even experienced entrepreneurs have difficulty estimating a valuation for their business. While many will have been exposed to valuations of publicly listed corporations, such as 14 to 16 times EBIT, this can be very misleading if applied to a private corporation. Listed corporations pose less risk for the retail investor as they have greater disclosure requirements and, clearly, greater liquidity. Where the investor has lower risk, a higher multiple of earnings will be applied to a valuation.
Most business owners have a good understanding of what their business is worth. They will have their own financial records showing their business net worth, some understanding of valuation norms in their sector or had prior discussions about this matter with a professional advisor. After all, many will have spent years in business and have personal networks where the valuation of a business is a common topic of conversation. They will have known colleagues who have sold businesses, many of them successfully in their eyes.
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They may have had conversations with their banker, accountant and maybe even a business broker or undertaken a valuation to raise money or to buy out a shareholder.
Those who have a better understanding of valuation techniques will generally have a view on valuation based on some multiple of sales, some earnings or profit multiple or a formula commonly used within their sector based on some aspect of their trading volumes. While all these methods do reflect the underlying value of a business, they can be seriously misleading. The basis of what most owners’ think their business might be worth is based on what other people have done, not what they might be able to do. Very few business owners take the trouble to understand how business value is created or lost in the valuation process, nor do they set out to create a business ‘product’ which will attract the right buyer and provide a convincing argument on value for money.
In order to understand how to maximise the value of your business on sale, you have to understand the basics of how value is created and packaged. If you then want to actively increase the valuation, you need to be prepared to undertake a process of creating additional value which might take a number of years. While most business brokers know the fundamentals of valuation, few of them can advise you on how to best develop your business to create buyer value. At best, they help you do some window dressing but they rarely think that perhaps there is a fundamentally different way of thinking about what the business is and what it could do for a knowledgeable buyer. If you only think about what the business is rather than what it could be, you severely limit what the business could be sold for.
So forgive me if I cover the basics – but understanding where value is created is fundamental to getting the best price for your business.
How is the valuation of an investment determined?
Valuation is the process of estimating the monetary amount that the firm is worth based on its future expected returns. Valuation is a function of risk and return, and considers:
- the expected return from the firm
- the expected returns from other comparable firms
- the risks associated with the expected return
- any other relevant characteristics of the firm or the industry/geography in which it operates.
A more conventional definition of market value is:
The price that would be negotiated between a knowledgeable and willing but not anxious buyer and a knowledgeable and willing but not anxious seller acting at arm’s length within a reasonable time frame.
In the absence of an independent offer to buy the firm, the valuation of a private company is a highly judgemental process. Valuation models are each designed with different purposes in mind. The major valuation models are:
a) Asset based:
- Going concern value
- Realisation value
b) Industry specific based
c) Market value:
- Rules of thumb
- Earnings based
- Capitalisation of future maintainable earnings
- Discounted future cashflows
a) Asset Based Valuations
Asset Based valuations are really only appropriate in a few circumstances such as:
- Where a company is making continuous losses
- A company is close to liquidation
- Where assets are readily saleable and their tradeable value best reflects their ongoing value
Thus, for valuing a business which is a going concern, Asset Based Valuations are not an appropriate valuation model.