Business Valuation SME – selling a business series

Business valuation for SME can be reasonably straightforward for the well prepared, we will cover the basics here, in short the price will be based on future profits and cash flow so these are the most important considerations. For SME an earnings multiplier is often used – so the value is based on some measure of profit multiplied by a multiple which will be based on quality of earnings and expectation of future growth. Here at CFO Counsel we aim to improve both the earnings and the multiple in order for the seller to obtain the mot value for their business.

 

Price is what you pay. Value is what you get.
– Warren Buffet

Thinking of selling your business or looking for a business valuation ? For a free consultation and discussion around what to think about contact us now. 

A business is worth what a buyer will pay for it. And in the end what a buyer wants to pay and what you want to sell for are generally quite different. The difference between pricing a pair of shoes and an SME is that the pair of shoes normally has many comparables and options so a buyer can quickly gauge the price, whereas an SME will not generally have very similar competitors with recent public prices. When selling a business, particularly an SME, a large level of asymmetry of information is expected between buyers and sellers – buyers normally have experience in buying other companies, sellers may only sell a  company once, therefore buyers have an edge in the process, but sellers have experience in the business and, if done well, can guide the sale process to get a higher valuation and therefore get a better price.

So it’s important to get a valuation prepared to set a marker for where you expect your value to be, but it is just as important that you are aware of the basis of the valuation and how you can take steps to increase it before you seek a buyer in order that you do not leave millions on the table.

CFO Counsel specialises in building value in SMEs with exit business  valuations in the region of US$2m to US$80m. We are not a broker, we work for the seller to improve the valuation and to get the best price and terms of sale. We provide services from the first thoughts of sale to the final exit and receipt of cash, including building value, valuations, sourcing buyers, negotiations, assistance with due diligence through to dealing with lawyers and advisors, contracts, the sale and post completion flourishes. We can provide services throughout the sale process or piece by piece as required. Contact us for a free consultation around your needs. 

This series of articles deals with ongoing businesses, and not start ups where different valuation metrics are often used.

Basis for Valuation

A business valuation should be simply the future cash flows of a business. The past may be used as a guide but it is future performance that is being purchased, and therefore anything that affects future business and cash flows will have a direct affect on the valuation. Take the recent Facebook stock meltdown, the earnings numbers were pretty much as expected however the FB executives reduced their forecast margins and growth and the stock tanked 20% (USD 120 billion !) in one day  – that is with actual results as expected, actual balance sheet as expected, but just a change in future expectations.

There are many factors which could affect the future cash flows of a business, and none of these are certain. Factors that could change include the company, the clients, the products or services, management, staff retention, the industry, the economy, inflation, political, legislative or environmental changes. Generally therefore a valuation is based on a forecast of future cashflows  (itself subject to reliability issues), together with a risk multiplier. None of these matters are certain, and therefore there are different assumptions used and different expectations by each party to a deal. That is why there is never a clear valuation of a business and why everything is subject to negotiation.

Valuation methods

There are various business valuation methods and sometimes, for example with start-ups, a number of different methods and metrics are used in order to get a reasonable idea of a valuation. All methods are trying to find the same thing – what is the current value of future cashflows. For SME there are two major methods :

• Discounted Cash Flow (‘DCF’) is the most rigorous valuation method but it is not that easy for an SME as it needs good forecasts and is not that easy to understand for a layman. It requires forecasts of cash flow for minimum the next 3 to 5 years with an assumption then taken of a growth rate for the rest of the life of the business. These cash flows are then discounted for each period by a discount rate (to be negotiated) and the cash flows are added together to form the valuation. The discount rate should be based on expectations of a long term interest rate plus a risk factor (technically this is based on a weighted average cost of capital between equity and debt) and could be between, say, 5% to 25%.
• Price Earnings Multiple (‘Multiple’). This model is used to support / check a DCF model but often in SME’s it is used s the sole basis for valuation. It’s simple to use and often uses only historic data. It works on the basis to take your earnings for year and apply a multiple to those earnings. So, for example, if the average of your last 3 years profit is $100, and the Multiple is 10 then the valuation is $1000. Simples. Of course, it’s not that simple as there are questions around :
  • earnings – what are they ? Is it net profit, earnings before tax (EBIT), earnings before tax, depreciation and amortization (EBTIDA), or a form of adjusted earnings which is often used for private and family companies where are controlling shareholder may share some private and company assets and expenses.
  • multiple – what is the multiple ? A crucial part of the valuation, is it 5, 10, 20 times earnings ? The multiple will depend on a larger number of factors, the main one being growth (past and expected) and related issues such as the size and growth of the market, the business market share (if you have leading market share the multiple will be higher as it protects earnings and reduces risk). any USP (unique selling points). and Intellectual Property (IP) which will protect your earnings going forward – basically anything which supports your growth and reduces risks of the forecasted cashflow will lead to a higher multiple. In practice we look for comparable sales multiples, public listed multiples (discounted down to allow for size and risk) and then use a range. As always, in selling, it’s all negotiable and there is no magic number so we look to support and increase the multiple by understanding the business and the buyer.

The DCF method will be needed for start ups where there are no consistent earnings, for companies where there are heavy capital needs such as property or heavy manufacturing or where there are very inconsistent earnings, but for most SMEs an earnings multiple basis is good enough.

The general principle for any variable is to go back to basics, and understand that the valuation is based on expected future cashflows. So anything that affects future cashflows needs to  be taken into consideration. For example any buyer will not be taking over personal expenses of a seller so those costs should be taken out.

Requirements

Financial Statements for minimum past 3 years.

Management accounts for a similar period, reconciled to the audited financial statements where different. Ideally the management accounts will be split into any significant geography, division, product or service that supports a significant part of the business as it is possible different parts of the business will attract a different multiple.

Forecasts for a minimum 3 years in the same format as the management accounts. These need to be supported by assumptions (eg why has a certain product revenue increased revenue by x and the other y), preferably written and clear. This helps to support the forecast and reduce risk (thus increasing value).

Organisation chart, both legal and management/people

Brief detail of the major products, services, geographies, a narrative around the change in the business in the past and plans for the future, brief descriptions of any IP, significant market share etc as well as any particular barriers to entry to the market which stop competitors entering.

 

Ok, so that’s all well and good but what is the multiple, what is the discount rate, and what exactly are your earnings ? What really is adjusted EBITDA ? Before or after tax, before or after depreciation, and  what about my assets, when do I get paid for those ?

We will look further at  these and other variables, adjustments, problems and what is your value in the next articles in this ‘Selling a Business’ series. Meanwhile if you are thinking of selling your business or looking for business valuations,  for a free consultation and a rough idea of what you are worth contact us. We’ll be right over.

Other Articles in this ‘Selling a Business’ series :

Selling a family business

Client sells majority stake in US$50m fundraising

How to sell a Business

Plan ahead if selling your business

Small business valuations

how CFO Counsel can help you to sell your business