Establishing the value of your business can be difficult. While well-known valuation methods can give you a rough idea, ultimately your business is only worth what someone is prepared to pay for it. The right approach to negotiating a sale can have a big effect.
There are several standard techniques that can be used to provide a benchmark valuation for your business. Using several different valuation methods can help you come up with a range of valuations for your business.
It’s important to realise that these valuations, and the amount a purchaser is in fact likely to be prepared to pay, may be substantially lower than the value you place on your business.
1. Multiple of profits
Profits are adjusted to eliminate one-off factors - such as exceptional costs. Any changes that might be expected after the business is sold are also factored in – for example, if the current owner has been working without salary and will need replacing with a paid manager. These adjustments provide an estimate of ‘normalised’ or sustainable after-tax earnings.
The valuation of the business is calculated as a multiple of these earnings. The multiple used is often in the region of four to eight times earnings, but depends heavily on the size of the business and its growth prospects. Smaller businesses tend to be valued using lower multiples.
This valuation method is commonly used for growing businesses with a track record of profitability.
2. Asset valuation
Your accounts will show the net book value of the business – total assets less total liabilities. For a sale valuation, these book figures need to be adjusted to reflect current values. For example, property or other fixed assets may be worth more or less than the book value. If the purchaser is likely to sell off assets, assets such as stock may be worth significantly less than their book value; there may also be extra liabilities such as redundancy payments for employees.
This valuation method is commonly used for businesses with high levels of assets (such as many property and manufacturing businesses) and for businesses that have poor growth prospects or are going to be wound up.
3. Entry valuation
This valuation method attempts to assess how much it would cost to create a similar business from scratch, rather than buying your business. The valuation includes the costs of purchasing assets, developing products or services, recruiting and training staff, and building up a customer base.
Entry valuation can help trade purchasers decide whether buying your business is the right option for them. For example, a pharmaceutical company might want to choose between buying a biotechnology business and investing more in its own research and development operations.
4. Discounted cash flow
Discounted cash flow valuation uses estimates of future cash flow to value your business. The further into the future the cash flow is, the more heavily it is discounted – as £1 today is worth more than £1 in five years’ time.
The value calculated is very sensitive to the discount rate used. Purchasers of small businesses typically use a discount rate between 15 and 25 per cent.
This valuation method can be used for businesses with stable, predictable cash flows going into the future, such as utilities.
5. Rule of thumb
Different industries also have their own rules of thumb that can be used to calculate a value. For example, many retail businesses are valued as a multiple of turnover. Other common valuation methods are based on the number of customers or the number of outlets.
Industry rules of thumb like these are often used in sectors where buying and selling of businesses is common. A valuation like this may well be used by a buyer who expects to significantly change the way your business operates – and to be able to achieve industry-standard levels of profitability.
The value of your particular business is likely to be affected by several factors:
Do what you can to make your business as valuable as possible.
Your legal adviser can offer specialist knowledge and negotiating skills to help you.