It's a dilemma each business owner will face at one point. or another
It's a dilemma many business owners face at one point or another during their career: How does one estimate the economic worth of their business?
You might have been in business for 20 years without ever having to do it. You may only have been up and running for six weeks. At some point, you'll likely find a need to place a cash value on your company. Yet, it's unlikely you are a financial expert, so how do you find out what your business is worth?
Well, it’s simpler than you might think. But before we talk how, let’s look at why.
There are numerous reasons why you might need to value your business, including:
- The business is up for sale
- You are trying to attract investors
- You plan on selling stock in your company
- A bank loan is required against the business
- You need to fully understand your business's growth
The most common of the above reasons are for investment and sales purposes, which is what we will focus on during this article, although this guide to valuing your business can be used for any of the reasons listed (or any other intention you have for valuing your company).
Having a value placed on your business means you can say to an investor, stakeholder, buyer or banker that it is worth X amount and, therefore, if you want Y percentage of it, you'll have to fork out Z. For investors and buyers, this is very important. Cash is king in the business world. Evidence of value is vital to gaining the attention and interest from those with the financial capital you seek. If you can't demonstrate to an investor how much your business is worth, how can they know how much money is reasonable to invest?
Whatever your reasoning, you need to make sure that your valuation is done properly. Improper valuation of your business can lead to financial issues later down the line, upset or unimpressed investors/buyers and a general knock to your reputation as a business owner.
Below are some steps to obtaining a proper valuation of your business.
Step 1: Avoid the biggest mistake you can make
We understand you (probably) aren't qualified chartered accountants and that you are unlikely to be a financial wizard, which means you may have made the common mistake of associating asset value with business value. In fact, these two entities are completely separate.
Here's the common misconception: Suppose your business has an office block worth $500,000, supplies and products worth $100,000, financial backing of $200,000 and a fleet of trucks worth $85,000. In total, you've got $885,000 in capital assets. If you were to sell everything now, that is the cash value you'd receive from selling, so that is what your business is worth.
While all of this information may be correct, it isn't what we mean by business valuation. It's not what your business is worth; it is how much cash is tied up in your business. A buyer isn't interested in how much money they can make if they sell your office block; they are interested in how much money they can pull in through the products and services produced there.
Forget about capital assets when valuing your business.
Step 2: Work out what truly makes your company valuable
If the value of your business isn't measured in capital assets, then what is it measured in? The answer is simple: profits.
A valuation of your company is all about the money you are making and the money you are likely to make in the future. A buyer wants to know what sort of money they can expect to be making if they take over your company.
To work out profitability, you need to be aware of your gross income and all outgoing payments, including payroll – yes, even your own salary. We aren't talking every cent you earn from the business, just your base operating wage. Net profit is what we are aiming for here. The complete and accurate figure.
But that isn't all we need. A business is not valued based on its income for a single year. We also need to consider two more aspects important to valuing your company:
Multiples. Multiples are essentially longevity meters. You don't expect your company to go out of business in a year if it is worth selling, so how long is it likely to keep going for and earning investors/new owners money? In the small business world, multiples usually range from two to 10. This number depends entirely on the risk factor involved and the size of the business. Larger corporations, with solid foundations and longevity estimated in the decades/centuries, are likely to achieve much higher multipliers, but for your common variety small and medium enterprise or startup, a multiple between two and 10 is the accepted norm. What this means is you multiply your net profits by whichever multiple is reasonable for your company.
- Profitability adjustments. A company is unlikely to carry on generating the exact same amount of money year after year. Eventually, profits will either fall or drop. When valuing your business, you must determine what sort of growth or profit loss you can expect over your applied multiples. To do this, you’ll need to look at historic financial data (if you have it), your market's expected growth and your competitors' progress.
Step 3: Performing the business valuation calculations
Uh-oh. It’s the bit everyone dreads: the actual mathematics required to calculate the value of your small business.
Let’s start simple. Take your small business's gross profit, shave off all expenses and establish your net income. Let's say our example business brought in $750,000 with $500,000 in expenses – equipment, travel, supplies and salaries – we are left with $250,000.
Now, let's look at multiples.
As mentioned before, the riskier or smaller the business, the lower the multiple you can expect to achieve. To work out your unique multiple, you need to accept that you'll be working with a bit of guesswork and subjectivity. Unfortunately, there is no set way of finding a designated multiple. Instead, there are a few basic rules of thumb to follow:
- Research your industry. What multiples have other businesses like yours sold for?
- How healthy is your business's financial history? Is it stable enough to request a higher multiple?
- What situation will the business be left in once you depart (if you are selling)?
- Do you have any contracted income guaranteed over the coming years?
- How expansive is your customer base and how strong are your supplier relationships?
Looking at your variables, you must make a decision based on what you think your multiple should be. As a basic guide, a business run by a single worker will be unlikely to sell for a multiple above three, businesses with revenue below $500,000 will often max out at five and only those larger companies earning $500,000 plus in net profits can expect to reach the fabled double digit multiple.
With our example, we've got an annual net profit of $250,000, although we have $500,000 in expenses, which implies a reasonable amount of staff. Let’s assume, then, that we fall into the second bracket for this example, leaving us with a multiple between two and five.
Playing the middle ground, we'll go with four, taking us to a current value of $1 million.
Now we have to bump up the value of the business based on potential growth. It sounds intimidating; however, finding this information is fairly simple, though it takes time and energy to ensure accuracy. As mentioned earlier, you'll need:
- Your own historic growth (or your competitors' if you don’t have any)
- Your market's growth
Your historic growth is your most powerful foundation. It is pure, cold, hard evidence that your business has a track record of growth. Look at your profits and track how they've changed. Let's keep things simple for our example. Over the past five years, our pretend company has increased profitability by around eight to 12 percent; so we value our business with additional growth of 10 percent per year over across the x4 multiple selected.
But this isn't the end of it.
Your market significantly affects your profitability in future years to come. If you are in a relatively established and stable market, you'll probably be better off using historic figures, as there is likely to be little movement. However, if you're in a new market, such as mobile app development, which is set to grow by 270 percent over the next three years, you've got an opportunity to increase your numbers considerably.
To determine your potential market growth rate, read this guide. In essence, the idea is to compare how your current growth rate compares to the market you are in. Let's say your market grew by 15 percent last year and you grew by 14 percent. You now have reasonable evidence that suggests to investors and buyers that they can expect to see similar levels of growth as those predicted by industry experts.
While you can evaluate market growth yourself and its potential impact on your company, now is a good time to ask financial experts for assistance or other business owners in your network for a second opinion.
Finally, we add our growth projections to our $1 million example. We aren't in the app development industry; we’re in the accounting industry, so we're going to use historic data to calculate our growth, because accountancy isn't likely to see more growth as a whole than we will ourselves.
So, add 10 percent per year to our net profits. Remember to multiple incrementally, instead of adding 10 percent to your current figure, to ensure accurate numbers.
- Year 1: $250,000
- Year 2: $275,000
- Year 3: $302,500
- Year 4: $332,750
That leaves us with a total company valuation of $1,160,250. Now that is what our company is worth to investors and buyers, right?
Step 4: 'Listening' to your market valuation
It is important to note that your valuation is a guide price. By using best practices and proper techniques, you've created a valuation which you can present to investors and buyers, providing them with a reasonable and respectable answer to the question of "What is your business worth?" However, that does not mean your business is actually worth the value you've put on it.
In the end, your business is worth exactly what the market says it is worth.
For example, we've valued our business at $1.1 million. We meet with investors/buyers and time and time again, while we state the figure of $1.1 million, we cannot secure more than $1 million, as while they agree with our valuation to a point, they cannot accept the full figure.
This $1 million figure is now our business value.
If you cannot secure the money you need for the value you have placed on your business, it is not an acceptable value, rather one that has helped buyers and investors reach their own. The market dictates your business's overall value. If your business isn't worth $1.1 million to investors, then the business just isn't worth $1.1 million.
The final step of establishing your business's value is to accept the will of the market and compromise on your figures. If you need investment to survive or you can't wait to sell, then you cannot afford to be stubborn with your numbers.