As anyone who has ever watched the BBC’s Dragon’s Den will know that wrongly valuing a company is one of the most common mistakes made by entrepreneurs when looking for investment or a profitable sale.
This is because such valuations are, by their very nature, an inexact science. Ultimately, a business is worth only what someone will pay for it, and not a penny more. That said, taking the following factors into account will help to guide your valuation process.
Examine the accounts
The obvious starting point for anyone wishing to value a business is the historical accounts. Whilst there are a number of different techniques for determining a value from company accounts, the most widely used is the profit multiplier method.
Simply put, this involves multiplying adjusted net profit by a pre-selected amount, the level of which varies according to business sector. Adjusted net profit is simply a figure for profit before tax, which also takes into account any contributions which the owner may have been making to the business.
For example, many entrepreneurs pay themselves a salary below the market rate in order to boost their profits in the early years of a business. Adjusted net profit takes this into account, assuming a market rate of salary for the owner.
This figure is then multiplied by a ratio ranging usually from one to five, depending on accepted practice within the sector concerned.
If using this method, it is important to ensure that the adjusted net profit figure being used is not unusual for the business, and does not omit important details from the business’s accounts which will affect the valuation. For example, if adjusted net profit has largely remained within a narrow band of values over a many years, but rose or fell dramatically in the last financial year, then consider whether this is an aberration arising from short-term factors or the start of a lasting trend.
Similarly, if the business has copious cash reserves, this should also be taken into account when determining valuation.
Of course, raw financial data can only tell one so much about the appropriate valuation of a business. Two companies operating in the same sector can be generating similar profit levels, but may have sharply divergent potential for future growth.
Potential for growing profit, as well as existing profit, will be important to any prospective buyer. It is important to factor in such intangible considerations, particularly as they concern the strategic position of the business, its customer base and the skills and experience of members of staff.
A business’s strategic position may be affected by its geographic location, as well as its unique selling point and the level of competition in the marketplace. If you can prove to the buyer that your business generates a high level of repeat business – that a significant portion of your custom are regular, loyal customers – that adds a durable quality to your business sheet.
Similarly, the skills and experience of existing staff, particularly if they are bound into the business through long-term contracts or confidentiality agreements, must be taken into account. None of these factors will be evident from the bottom line, but can have a significant effect on valuation.
Last but not least, any valuation should reflect your personal investment. If you’ve spent a significant amount of time and money establishing the business, any buyer will be able to avoid such expense by ‘piggybacking’ on your hard work.
This should be factored into the value of the company.
You will no doubt have some level of emotional attachment to your company. This is normal. However, it’s vital that you don’t allow your sentimental attachment to cloud your judgment when it comes to valuing the business.
Remember that a business is only worth what a buyer will pay for it, and that if you want to sell, you may need to be hard-headed about the amount you are willing to receive.
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Category: Startup Advice