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Business valuation is often described as a dark art. Indeed, get three different valuers to value the same asset and you will likely end up with three very different results. But this doesn’t need to be the case.
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Business valuations: Tips, tricks and traps
26 October 2021
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13 minute read
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Done properly, business valuation uses detailed financial and risk analysis to determine the appropriate valuation for a business. At its core, it’s about determining two key things, the same things needed to value any type of asset: return and risk.
Return in a business is the profit you make – what return can I expect from my investment? The part that most people refer to as art is estimating the risk of that return continuing. But I put it to you that using detailed risk analysis tools that consider macro-economic factors, industry drivers and business risk can provide an accurate risk score with an appropriate multiple – every time.
So what should go into a data-based risk analysis? The following terms are key:
• Multiple – What factor (based on risk) do I multiply the annual profit by to get the goodwill value?
• Goodwill value – The ongoing value of the returns produced by the business (not the underlying assets).
• Intangible value – Many businesses create substantial value on intangible assets like their brand, some unique intellectual property or a secret process.
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• Equity valuation – This is the goodwill value of the business plus any cash less any debt. In other words goodwill plus net tangible assets.
• Value drivers – In all businesses there are significant levers you can pull to improve value. Some work better than others and getting the order right makes a big difference.
One of the most difficult items to value for any business is intangible assets. An intangible asset is something that is not physical. Stock, plant and equipment are all tangible.
Assets such as goodwill, brand recognition, intellectual property, patents and trademarks are all examples of intangible assets. For most small to medium-sized businesses, these can be difficult to develop, taking many years to build up.
A prime example of this is intellectual property, which is often misunderstood and undervalued by mid-market business owners. Intellectual property is simply defined as “intangible creations of the human intellect” and is usually made up of proprietary knowledge, a productive new idea, methodology, process, secret recipe, invention or design.
It is quite common in the IT space to see businesses being purchased off the back of the intellectual property they own. Businesses that can achieve this successfully generally sell for maximum possible value.
But it’s not always technology. Many businesses have realised substantial value as a result of the commercialisation of their intellectual property or use of a particular process or methodology that has proven to be successful.
What makes any intellectual property valuable is the application with customers, the size of the potential target market and its uniqueness. Any business that can develop and document ownership of unique IP that is accessible and wanted by a significant target market should be hugely valuable.
Of course, just because something can be analysed methodically, doesn’t mean it’s easy to do. Which brings me to my tips, tricks and traps for valuing businesses:
1. Add-backs – Make sure you normalise the profit of the business. Remove any personal expenses, over or underpaid salaries to owners, excess super contributions, rent paid to a related entity etc.
2. Comparative sales – Unlike the property market this is very difficult to determine. No two businesses are alike, and the data is simply not easily available.
3. Valuation purpose – Are you valuing the business for sale, for a restructure, to sell equity to employees or for a legal case? All have different issues and risks and so the valuation can be different in each case.
4. Non-financial analysis – This is vital. Many focus simply on the financials (return) and while they are important, they only make up half of the picture. The other aspect is risk, and this can only come from non-financial analysis.
5. Stability of earnings (profit) – This is a big factor. Instability just adds to the risk. So-called boring businesses who just grow sales and profit year-on-year are more valuable.
6. Not all income is created equal – Recurring revenue (think SaaS subscriptions) is far more valuable than constantly having to make another sale.
But the number one piece of advice I give business owners? Begin with the end in mind. In my area of business – succession and exit planning – that means an extended timeline for planning and strategy. Having a goal that is five or 10 years out, not 90 days.
It takes time to build and increase value. The difference between equity (or long-term value that can be extracted when you exit) versus income is time frame.
Therefore, advise your clients to start early, know what their business is worth and map out what needs to be done to drive value higher and make the business more attractive for when they are ready to realise that value.
Craig West is the chief executive and founder of Succession Plus.
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