Business valuation - how to value a small business

Whether you are a buyer or a seller, valuing a smaller, owner-managed business is something of a minefield.

It is a mix of subjective and objective assessments, calculations, and assumptions, all wrapped up in the emotional aspects that accompany any owner-managed business.   
And there is no way to get away from these emotional aspects. Often they have helped build the very business that is being bought or sold, and can’t really be quantified, or ignored. 
The business may have been built over many years and will inevitably include aspects of the owner's personality. Family members or close personal friends may be employed in the business, and key customers and suppliers will have become personal friends with the owners, at least to some degree.
So how much is a business worth? What is a reasonable valuation? 
Whether you are thinking about buying or selling a business, understanding how it should be valued, and how much the business is worth, is critical.
It is the single most important factor in determining whether the business will be financially viable moving forward. 
That means it is in everyone's interest - the exiting party needs to know that any deferred payments are safe, and the incoming party needs to know the business can afford the transaction, rather than be strangled by it.
Both parties need to walk away feeling content.  
Understanding how and why a valuation has been arrived at allows confidence and clarity when it comes to negotiations. 
It also allows for flexibility in those negotiations - discussing in what areas a valuation, or payment structure may be altered, and why.

Valuation mechanisms

There are several different ways to value a business, but most are not appropriate when it comes to valuing smaller, owner-managed businesses. 
If the business has annual sales of below c.£5m, then an approach like Discounted Cash Flow (DCF) or Price Earnings (PE) isn’t, generally speaking, appropriate.
They will crop up in internet searches, but don’t waste time trying to understand and apply what are reasonably complex calculations and concepts (and require full Corporate Finance support). 
When looking to value a business, what is most important (vital, in fact) is that you place net profit before anything else.
Many businesses like to put a huge amount of focus on their sales turnover. This is an important factor for several reasons (stability of income, spread of risk, potential for growth) but net profit is the number one driver.
Some people will use the term ‘revenue’ to cover many different things and for many reasons.  So, make sure that the term is clearly defined - essentially, are they talking about sales or net profit?
It’s the net profit that is typically used to establish the value of a business, particularly owner-managed businesses.
 ATN Partnership usually uses a blend of three different mechanisms to establish an acceptable valuation range. 
The first is a simple multiple of profit. The profit figure is adjusted so that it more closely reflects the cash income of the business by adding back any taxes, bank interest, depreciation, or exceptional items.
This is called EBITDA - Earnings (profit) Before Interest, Tax, Depreciation, and Amortisation.
You then simply multiply this number by a factor (the multiple) to arrive at a value.
In its simplest form, if the EBITDA is £50,000, then a multiple of 4 would give a value of £200,000.
The second mechanism is a multiple of weighted EBITDA in which we look at the EBITDA for the last three (sometimes five) years, but add more importance to the EBITDA in the last year, than that achieved in the first.
We then apply the same multiple indicated above to the weighted average EBITDA to arrive at a second value. 
If the Weighted Average EBITDA was £56,000, then a multiple of 4 would give a value of £224,000.
The last mechanism we use is an expected Return On Investment (ROI). In other words, what would an acceptable rate of return be, based on the business valuation?
The three valuation methods give a good idea of minimum and maximum valuations, providing an excellent starting point to establish if both parties are being reasonable in their expectations and allowing both vendors and buyers to establish early if it is worth progressing discussions.
This is the objective side of things. What, objectively, is the business worth? What is the number that a bank would accept as being reasonable if it was being asked to provide funds?
The aim is to arrive at a range, not a specific number.

The 'discussion' usually revolves around the multiple used, and what is, and is not, included in EBITDA.

Other valuation mechanisms

There are other valuation methods (beyond the pure Corporate Finance options noted above) that you may wish to consider. 

Our guidance would be to use these to amend an EBITDA/ROI calculation rather than a basis of value, i.e., justify valuing a business for more or less than its profitability suggests.
One method to consider is the value of the assets of the business, but this swings both ways.
If, for example, a gym has a suite of brand new, hardly used equipment, then you could easily argue that it is worth more than one that needs treadmills, machines, and water coolers replacing.
Replacement or replication is also a consideration, particularly where there is a buoyant market.  
Looking at creating a brand-new gym in an area where there is a ready market makes a lot of sense, but costs like acquiring equipment, recruiting team members, finding and setting up the venue, marketing, and advertising, may make buying an established business more viable. 

For the buyer & the seller: Budget is not a target, it’s a limit!

A business valuation is ultimately about establishing what the business is worth, against what a buyer is willing and able to pay.
A specific business may represent extremely good value, but if the amount required is beyond the budget of the buyer, then it is not a viable option for the buyer. 
As a buyer, you need to have a firm idea of what the maximum you are prepared/able to pay is, and not deviate - no matter how attractive the offer.
Remember that a budget is a limit, not a target
For the seller, You want the incoming party to be financially secure and confident. You want and need the business to survive after your tenure.
  • Want it to survive: because no one wants to see their life’s work destroyed.
  • Need it to survive: because you’ll have deferred payments that you want that business to be able to afford. 
We saw one business get into financial difficulty because the purchaser was seduced by how much he could borrow, not how much the business was worth!

Talk to us

If you would like clear, concise, and easy to understand help and advice on any issues that you are concerned about, then you can contact us on 01474 326224. Alternatively, visit our website, tweet @atnpartnership, or email us info@atnpartnership.co.uk.