Updated: Jul 8
Determining the value of a small business
Whether buying or selling a business it is prudent to have a clear basis as to its valuation. The methods outlined below give rise to a range of valuation perspectives, it would be expected that a final estimated value would be within this range. The actual value is ultimately the amount transacted at.
Multiples of earnings basis
This is a rule of thumb basis for smaller businesses. Differing types and turnover of businesses will have differing values in relation to the price stated/valued at.
Many small businesses will have a value at 3 to 4 times earnings. Logically this is the same as a payback of earnings to the purchase price, of 3 to 4 years. The multiple can drop to effectively zero where the business is performing badly and (as an example) the owner wants someone else to pick up liability for the property lease. At that point the new owner is effectively acquiring a liability.
With small businesses it’s also important to know the metrics being used to perform the calculation. Often terminology is used which is more relevant for larger and listed companies, as an example a PE multiple is the Price as a function of Earnings. However, Earnings are calculated AFTER Interest and Tax. Contrast this to small businesses where often the accountant (for the seller) will prepare a ‘Selling Statement’ which is prepared BEFORE Interest and Tax AND often adds back the owners’ earnings taken from the business.
Finally, to understand the general multiple used in the business category, inferences can be gained by similar businesses for sale, historical sales, business brokers and potentially your accountant. Note however, that this provides a general multiple of earnings which then must be assessed against RISK inherent to that particular business relative to other peer businesses, as an example a business that has a new competitor opening and selling the same generic product in close proximity, would affect the multiple given its impact on future earnings.
For small businesses that are economically trading (Viable) then often the Owners Benefits approach is used for determining the valuation negotiating point. Greater detail can be found on this websites article, here. Also, a short example valuation here.
Underlying Assets approach
As purchaser you could look to purchase the assets and trading liabilities of a business. Valuation of those assets and liabilities coming to a net value position.
This approach is often appropriate for businesses that have suffered trading difficulties and a prospective purchaser doesn’t want the risk of known and potentially unknown liabilities which come from buying the legal entity of the business.
As an example, a small sawmill has capital equipment, processed and unprocessed inventory and outstanding creditor invoices for that inventory. Other liabilities that are not part of the operational activity are left with the current owner, as an example outstanding taxes.
All assets to be acquired will need to be assessed as to their value. The written down values in the accounts (Net Book Values – Historical Purchase prices less accumulated depreciation) may not be a true reflection of the future economic life and value to operations… Property may never have been revalued in the accounts and so forth.
Another basis of this approach is to disaggregate a business that has freehold rather than leasehold property. As an example, a Building materials business is a different value proposition whether they own the land and buildings compared to leasing them. The trading business element should impute the cost of leasing the premises, and the landlord element (Land & Buildings) is worth its market value.
Set up / Replacement Value – Buy v Build value.
The approach here is from a ‘build’ the business perspective, to assess whether the ‘buy’ value is appropriately valued and the appropriate level of goodwill is included.
As an example, consider the following:
Buy - A business is for sale for 700,000, Sales are 1,200,000. Cost of Sales is 65% and overheads are 20%. Profit before tax is 180,000. The assets of the business are estimated as worth 150,000.
Build - It’s believed that overheads would be a fixed 240,000 per annum, the assets required would cost 150,000, cost of sales would be 65% of sales and sales would ramp up over 4 years proportionally until the 1,200,000 is achieved.
So which approach is best? Least costly? Is the Buy price appropriately valued?
Answer: It depends. On an after-tax basis the build basis will be marginally better after 4 years. However, there are inherent risks in the assumptions, especially around sales growth. On the buy basis an initial 700,000 would be required to acquire the business, on the build basis 150,000 would be required to buy the appropriate assets and a further 135,000 to cover the first-year loss. In year 2 the business would run a 30,000 loss and in year 3 become profitable. On a financing basis it will be significantly easier to fund a purchase an established business than finance the upfront costs and losses of a new business.
Hence, the valuation of an established business will reflect the current profitability and the time taken to build that customer base.
Other points / Issues:
Reason for sale
A business that is required to be sold quickly for personal circumstances can lead to a weaken negotiating position, and thus greater receptivity to a price below what would be expected over a longer sales period.
Dependency on a single client
A business will have increased risk if it’s highly dependent on a limited or single client, simply because that client will have significant leverage and can substantially impact the profitability/viability of that business. A lower multiple would be expected in such a situation.
Barriers to entry / Business stability
Businesses that have lower risk due to barriers to entry and generally highlighted through a long-term track record of stable income, are likely to have higher multiples attached to their profits.
Susceptibility to economic conditions
Different businesses are subject to economic conditions in varying amounts. Businesses focused on discretionary consumer disposable income can do well while economic conditions are favourable and then find a collapse in demand during a subsequent recession.
Tangible and Intangible assets
Tangible assets within a business that have resale value de-risk the valuation of a business as ultimately, they can be sold. Intangible assets depending on their materiality require appropriate insight as generally they are sunk costs that are not readily saleable to a third party. If they are integral to the business then they need to be assessed for future maintenance costs and technological obsolescence.
Note: Not all assets have value. As an example, in data warehousing old servers can be most costly to run and maintain than newer technology leased.
Non arms length transactions
If a business is being transferred to a person/entity that is ‘related’ then sufficient and appropriate evidence of its value will invariably be required for legal/tax compliance. Some examples are; Transfer of a business to a family trust, sale of the business or share of that business to a family member.
Hence, if the business is not being sold to an impartial and unrelated third party, then additional professional advice should be sought. Generally, a professional valuation would be required, your accountant or lawyer should be able to provide guidance on this as it will vary by Country/State/Tax jurisdiction.
And finally, after assessing the likely value of the business any purchase requires due diligence which is effectively testing /auditing the assumptions, business controls and underlying financial/operational numbers. If you’re on the sell side then you need to have all the information organised for a prospective purchaser.