What’s It Worth? How to Value a Business for Sale

If you are buying – or selling – a small business, you need to be able to put a value on that business in order to arrive at a fair price for the transaction. Whether a business is a limited company, start-up or even in liquidation, neither party can just name a price and expect it to be accepted. Also, past performance counts little; what matters is what that company is worth today.

That said, what a business is worth can mean different things to different people, depending on a range of factors. It’s also, especially for sellers, something that can be based more on emotion than logic. It’s not like selling a used car, where there’s a book value depending on the make, model, age and condition. As Jonathan Jay says, ‘The biggest challenge that a business buyer has is agreeing a valuation of the business with a seller.’

So, how do entrepreneurs go about arriving at a value for a business? That’s what this article is about.

What is a Business Valuation?

A business valuation looks at various aspects of a small business to arrive at a fair sale price. There’s a variety of business valuation methods that can be used and it can be useful to use more than one to help get a clear picture.

The kinds of things that are likely to be taken into account when calculating a business’s value include assets, tangible assets such as machinery and property, and intangible assets including intellectual property and copyrights; the customer base and debtor book; contracts with other parties, whether customers or suppliers; the staff and management team; and the financial performance of the business.

Financial records, including balance sheet, profit and loss, and cash flow, are examined to establish financial health. The valuation process will take into account depreciation, net profit, and the business’s track record of profit and growth.

One method of valuation is net book value (NBV), which is based on asset valuation. With this, you take the total value of the assets of the business and deduct the liabilities; the resulting figure is the net assets, or NBV.

That said, no matter how the numbers can be crunched using valuation methods and rules of thumb, all business are worth only what potential buyers are prepared to pay for them.

Business Valuation Tips

When it comes to company valuation, you need to focus on facts and logic as far as possible. As a prospective buyer, you might find that the current owner takes a more emotional view – and that’s understandable, they might have started the business from scratch a couple of decades or more ago and nurtured it ever since. It’s their baby. They don’t see it with the same clear eyes you do. And while it’s important to acknowledge their response, you need to get them back to facts and logic when it comes to setting the selling price.

Jonathan Jay has some great suggestions as to how you might handle this, among them that you can acknowledge how happy everyone is – staff, customers and suppliers – and agree it’s a great business, but then say, ‘But we’ve got some problems with the numbers.’ That way, you aren’t insulting the seller, you are agreeing they have a great business, there’s just an issue with the numbers. And as many small business owners don’t really understand their financials, focusing on facts and logic gets the point across.

1. Acknowledge Distress Early

The seller of a distressed business needs to admit it is distressed. That can take time for them to accept, but you need to get them to that stage early on in the process. Why? Because while due diligence will provide the proof of the assertion, you will outline the offer and terms long before that, in heads of terms, and you want heads to be as accurate as possible to prevent disagreements at a later stage.

2. Beware of Overvaluation

Business owners are prone to inflating the value of the business based on things that are, to be brutal, of no relevance to the current market value. Here, we’re talking about things like initial investment or long-term ownership. Those things have value to the life of the owner – they had the foresight to invest in a start-up and the ability to grow the business, and they maintained that business over possibly very many years – but they don’t add value now. Rather, the owner benefited from that over the years they ran the business and extracted profits generated. Now, the value is based on verifiable data.

Business brokers can also be guilty of overvaluing businesses and inflating the asking price, so be extra careful of dealing through a broker.

3. Focus on Current Performance

As well as looking back and seeing value to be added, business owners can have a tendency to look forward and see the same. In this instance they are anticipating potential future cash flow – but you can’t pay now for what might happen in the future. You need to tell them, ‘What matters is the present value of your business.’ Also, if that does happen in the future, it will be under your ownership and as a result of your hard work.

Business worth must be based on current performance. That said, we look at earn-out deal structures below, and that is a way to potentially bridge the gap between actual and anticipated.

4. Value What Exists Now

The value of a business to potential investors depends on its current operational state, and past achievements and speculative projections don’t affect that. What matters are things including business assets, liabilities, customer base, financial performance – things that are measurable and verifiable, and that can go into a business plan when approaching lenders, and help you negotiate a favourable interest rate.

5. Bridge Valuation Gaps with Earn-Outs

In effect, an earn-out strategy is flexible deferred consideration, and an earn-out structure can bridge valuation differences by tying payments to future business performance.

The consideration is what is paid for the business. The initial consideration is paid on day one; deferred consideration is paid later, in line with a pre-agreed schedule, generally over a period of years.

With flexible deferred consideration, however, we take things a step further: both the amount and timing of payments can change. Instead of it being a fixed amount every quarter or every year, it’s a flexible amount that changes depending on the performance of the business. If the owner is confident in their assertions of improved future profitability, they can be paid more when that bears fruit. If it doesn’t happen, you are no worse off. An earn-out strategy is a great way of de-risking an acquisition.

6. Set Clear Terms Early

Before you get as far as due diligence, you will need to agree heads of terms. While only four elements in heads are legally binding – jurisdiction, fees, confidentiality, and exclusivity –- it’s still important that heads is clearly set out.

Heads will include price, terms and special conditions, and while price and terms aren’t binding – they will be impacted by the outcome of due diligence – it can be useful to set out the mechanism by which payment will be made, for example, how much on completion and over what period any deferred will be paid.

Special conditions can cover issues such as personal guarantees, the property lease, what happens to family members employed in the business and more. This is where you set out the rules, if you like, so that potential future disputes can be headed off at the pass.

7. Financials Over Operations

To keep negotiations positive, focus on financial performance in discussions rather than operational challenges. Operational issues might be clear to you, but could be something the owner gets defensive or argumentative about. Look for things you can agree on – the staff all seem happy, for example – rather than, say, the staff need training in various areas. Then value and negotiate based on the financials, which are factual and verifiable.

8. Thorough Due Diligence

Comprehensive due diligence is essential so that you understand as clearly as possible what you are buying and can be confident it is valued accurately.

What you don’t want is to get a short way into ownership and be hit with a legal claim of some sort, or discover that as a result of the business changing hands, the most valuable contract has been rendered null and void – or indeed any other kind of adverse event. Yes, you can aim to mitigate issues by including warranties and indemnities in the sale and purchase agreement, and where appropriate, you should, However, you should also aim to get the most accurate possible picture of the business, leading to an accurate valuation.

9. Market Comparables Analysis

Comparing recent sales of similar businesses can help set realistic valuation benchmarks based on financial performance and market trends.

Comparable analysis arrives at a value for a small business based on the current market value of comparable companies. Valuation methods such as price-to-earnings ratio and EBITDA (earnings before interest, taxes, depreciation, and amortisation) are generally utilised.

Price-to-earnings ratio (p/e ratio)

The p/e ratio compares the price of company stock to the profit a buyer can expect to make from it, generally using figures realised over the previous twelve months.

EBITDA

EBITDA is the profitability of the company before items the owner has control over, such as interest on loans, are introduced.

EBITDA is a standardised method of valuation that creates a level playing field. It allows you to take two companies, look at the EBITDA of both, and start to create a sense of comparison.

That said, if the company used in the comparison is publically traded, then a further adjustment is needed. Because public companies tend to have a higher valuation than a private company, a discount rate of generally 30–50% is applied to arrive at a more accurate valuation.

10. Use Discounted Cash Flow (DCF)

The discounted cash flow method is used to estimate the value of an investment based on its expected future cash flows. It attempts to answer the questions: ‘How much money will this business generate in the future?’ and therefore: ‘What do we pay for it now?’

It’s quite complicated and not typically something you would do with a smaller business; however, you need to know about it, at least in case a seller’s accountant brings it up.

Conclusion

Buying a business for the right price based on things like asset value – physical assets and intangible assets – plus financial health and operational performance can be tricky to achieve. As well as the logic aspect of business valuation, there is generally an amount of emotion in there too. And as many business owners don’t have an exit strategy, they can be unsure of what to expect or clear on what is achievable.

Having someone with years of experience in business mergers and acquisitions on your side can be a huge advantage. Jonathan Jay has helped more than 3,000 people buy successful existing businesses and become acquisition entrepreneurs, and he has put together the most comprehensive FREE package of business buying resources available today. To get started on your acquisitions journey, download your FREE Business Buying Toolkit now.