Dr McDeal title What is my business worth?

Is there a “right” way to value a business? Or is it all just guesswork?

Valuation experts tie themselves in knots when they champion the latest “definitive” valuation technique. What may be right for one kind of business in a specific sector at a particular point in§ time may be completely wrong for another.

Profit has for many years been the most popular measure of value. By applying a multiple to a company’s sustainable profitability, you can derive a capital value (ie “How many years’ profit am I willing to pay for this target?”). In the last 10 years, the market has favoured a broad spectrum of definitions of profit: earnings (profit after tax), EBIT (earnings before interest and tax) and EBITDA (earnings before interest, tax depreciation and amortisation).

The preferred definition at the moment appears to be EBIT. EBIT multiples can range from as little as 3.5 times for a small contracting business to five or six times for a successful product based manufacturing business, to eight or nine times for a higher growth technology or business services company. Applying the multiple to EBIT gives you a “gross” valuation, out of which you must deduct any debt and onto which you should add any cash on the balance sheet.

So what factors influence the value of my company?

There is no 100 per cent accurate valuation technique. Large groups and private equity houses prefer to value companies based on cash flow over the period of ownership or investment. Particular industries develop their own “back of the envelope” valuations, which can be quite telling. Ultimately, the market is the only true measure.

There is a correlation between higher multiples and businesses with high growth, critical mass, good customer spread and strong trade or consumer brands. Businesses that are smaller, heavily dependent on an owner or a few customers and have “lumpy” project based fees tend to attract lower EBIT multiples as a direct reflection of their “riskier” profile.

So what is my business really worth then?

Conventional wisdom has it that it’s worth whatever a purchaser’s prepared to pay for it. Wrong! A company is not what a single purchaser thinks it’s worth but what several purchasers think, each having the same information on the business and fully aware that it’s in competition with other bidders to acquire the asset.

It’s dangerous for any adviser to proffer a valuation based on a business’ bare numbers, without having a good grasp of purchaser or investor appetite. If there is no interest among purchasers, the business will not be sold and therefore has no cash value at present. If so, groom the business for several years or concentrate on income over capital. Telling an entrepreneur close to
retirement that their business has no current cash value is never easy - but an unsuccessful sale or IPO is time consuming, distracting and costly.

OK, forget the sale, it’s a lifestyle business – then what?

A common obstacle to doing deals arises when the owners’ perception of value rests solely on how big a lump sum they require to generate the same income as they did when they owned the business.

A relatively small business with sales of £5m and profit before tax of £600,000 can generate the shareholders an income of £500,000 each year. However, the “market” value of the business may be £3.3m - reduced to £3m of “net” proceeds after capital gains tax.

In the current low interest rate environment, that cash may generate income of as little as £150,000 per annum. But the shareholders need £500,000, which means they need to achieve a cash value closer to £10m. Not a chance!

If the shareholders’ focus is on maximising income rather than de-risking and extracting a capital sum, they shouldn’t be considering a sale.

How about a good old fashioned MBO valuation?

The valuation placed by a private equity player on your business will be derived in a very different way to a trade buyer.

Trade purchasers will value a company on the basis of quantifying the synergistic or strategic benefits of making the acquisition and, frankly, how badly they want to do the deal.

Financial investors have no synergies or strategic benefits to extract. The amount that they can afford to pay for your business is linked to how much debt and equity finance your business can afford to support going forward.

This means that you rarely see the variances in valuation among competing private equity houses as you do with competing trade purchasers.

Some investors will gear the business up more aggressively than others or will be willing to see a lower return on their equity investment. Ultimately, however, the potential valuation will be capped by the strength of your business’ cash flow and its balance sheet. That’s not to say that private equity investors may not pay the highest price for your business.

No easy answers, are there?

Valuation is an art not a science. There is only one right answer: let the market tell you how much your business is worth. But do talk to the experts before you push the button on a sale or IPO to avoid disappointment. Valuation is very subjective: beauty truly is in the eye of the beholder - so make sure that your business is a stunner!

Creating a competitive tension between buyers can dramatically increase the value of your business, so always be wary of “sweetheart” deals, where you negotiate with a single purchaser.