Starting a business is no walk in the park. Nor is turning that fledgling two-person home garage operation into a thriving commercial entity. This is perhaps why, when business owners come to calculate the value of what they’ve worked so hard to build, they’re often surprised by how little it’s actually worth.
“More often than not, when you tell someone what their business is worth, they assumed it was going to be worth more,” says David Patterson, director of Succession For Business Group.
It’s important to be familiar with the value of your business for a number of reasons. The calculation of a business’s value involves looking beyond the day-to-day operations and earnings that so often fixate business owners. Without a clear and up-to-date picture of how the broader aspects of the business are performing, it’s difficult to get a comprehensive idea of how successful the business is. Further to that, if you don’t know how much your business is worth, you’re going to run into trouble when it comes time to sell it.
“If the first time you’re getting a business valued is when you’re about to sell it, it doesn’t give you an opportunity to realize what you want to get,” says Patterson. “You’ve left it too late.”
Rachel White, a chief financial officer at Azure Group, claims there are two main approaches involved in evaluating a business: internal and external. Externally, the business’s maintainable earnings and perpetual revenue streams need to be calculated to give an idea of its ongoing viability within its industry.
The internal factors that help to determine the value of a business are more difficult to gauge, and often have a greater impact on the final value figure. Systems efficiencies, the quality of the customer base, and the strength of relationships with suppliers and staff all bear upon how much a business is worth.
One of the simplest and most direct ways of gauging a business’s value is to examine its past profitability. If it’s easy to trace the financial success of a business through previous years, then it’s much easier to project its future profitability, which is effectively where the value of any business lies.
“The longer the thing has been operating successfully, the more confidently you can predict that it’s going to be profitable into the future,” says Graham Long, chair of the valuer’s chapter of the Australian Institute of Business Brokers (AIBB). “It’s not guaranteed, but, obviously, if something’s been around for 20 years, you can be much more confident in its earning capability than something that’s been around for 20 months.”
When evaluating a small business, it’s important to be able to demonstrate its success by showing where the revenue is coming from.
“Traditionally, people valuing businesses would look at, say, three years of financials and apply a multiple that they consider appropriate. Any further back than that is too far back,” says Succession for Business’s Patterson.
Although those three years may be a reasonable basis with which to formulate estimates about the next three, it’s important to note that some years would be more relevant to the current value of the business than others. Patterson recommends that the emphasis be placed more heavily on the performance of the business in the year leading up to its valuation, rather than on the two years prior to that.
“You can’t take one year in isolation, because there might be one-off situations that occurred in that year,” he says. “Three years tends to give you a good overview of how the business is going.”
Another method of figuring out a business’s worth is to apply a multiple to its earnings over a set period.
“To measure value using a multiple, you take your earnings before interest and taxes and times that by a certain number – that gives you an estimate on value,” says Azure Group’s White.
The ‘multiple’ she refers to is the number by which the earnings are multiplied. It can be determined by an array of factors, but is largely contextual, varying from industry to industry, and between different business types and sizes. Small businesses tend to attract multiples at the lower end of their respective industry’s scale because they typically present a higher degree of risk for the owner.
In the IT industry, for example, White explains that the value of a business is often calculated by applying a multiple to projected future earnings, in order to account for the intellectual property being developed.
“The thing with small business is they tend to be at the lower end of the range,” she says. “If the industry will average a four-times multiple, the multiple ranges for that industry will be anywhere from two to six. The small businesses will be at the ‘two’ end. It’s a reality check for a lot of small business owners. They tend to hear the average for the industry, and they tend to get a bit of a surprise when they’re at the lower end of the range.”
The value of a business lies in working predicting the future profits of the business, and establishing how much can be charged for the current rights and the profits. If a contract with a third party, such as a landlord, gives them a direct influence on your business’s future revenues, it will almost certainly lessen your business’s value. Accordingly, one of the most fundamental and easily overlooked factors in determining a business’s value lies in the details of its lease, and the associated legal obligations and restrictions.
“The lease is critical because it controls your tenure, it controls the cost that you’ve got to pay for your lease. It controls your opening hours. It can control your assignment conditions, refit conditions, relocation conditions – a whole bunch of conditions in the lease can destroy the value of the business.” says the AIBB’s Long.
Effectively, a lease gives the business permission to occupy the premises from which it operates.
“It controls the terms and conditions under which you can occupy those premises,” says Long. “Any variation on the lease or any impact on the lease is a direct impact on your business.”
If the business operates out of a shopfront, it’s important to consider the characteristics of the potential customers in the area it’s targeting.
“If you think of a river system between mountains, the watershed is the collection of all the rain that runs into a river,” explains Long. “If you take that across to the business world, your watershed is your primary market area. There, you’re looking at the demographics in terms of age, earnings, housing, transport, travel, all those things are your watershed. The demographics of your watershed are important in relation to your customers, how you market, and what products those customers may be looking for.”
For example, if the business is targeting an aging demographic with declining levels of disposable income, that will result in a lower overall value.
“Whereas, if you’re going to an area that’s growing at 3-5% a year, then your watershed’s growing, and your future earning prospects are going up as well,” says Long.
Many businesses are built around the skills and personality of the owner – assets that are difficult to factor into the value of the business when it comes to succession.
“A lot of times, the profit streams are really dependent on the individuals that own the business. Just look at electrical contracting businesses, or builders, or small manufacturing businesses,” says Greg Heaney, director of ITAS Consulting. “Typically, The owner is the driving force. All of the marketing is normally resting with him and his network, and so it’s often very difficult to commute that value into a new owner.”
Conversely, if the business can easily be operated without the owner, it’s much more valuable to prospective buyers.
“A business that is non-reliant on the owner is going to be worth more down the track than one where the owner walks away and there’s nothing left,” says Succession for Business’s Patterson. “There’s no value in a business like that.”
Azure Group’s White notes the issue is commonly referred to as ‘keyman risk’ or ‘single person dependency’.
“Unless you start the process of extracting yourself from that fairly early on, you can reduce the value of your business very, very quickly, from the viewpoint that when you sell it, you’re not in it anymore,” she says.
Counter-intuitive though it may seem, trying to do as much as you can in a small business can actually count against its overall value in the long run. This way it’s wise to develop systems that allow the business to run without you after the start-up period.
“Make sure systems are in place, so that someone can come in and virtually take over and that there’s a process for every aspect of the business,” says Patterson.
Short of systematizing yourself out of the business altogether, White explains that there are a number of strategies that can be used to counter the impact of the owner’s value in the business.
“You can remain as an advisor for the business, or if it’s a management buyout with your staff, you can have an earn-in clause,” she says. “That means you can have a transition period where your business can stand under its own name, and it’s not dependent on you as an individual anymore.”