The science and art of valuing a business
The question “What is the value of this business?” is one of those best answered by another question: “Who wants to know?”
A seller of the business, who may have spent many years and tears building it, will try to emphasize the most positive aspects, says Gerrie van Biljon, executive director of Business Partners. If he cannot find much to be positive about in the last set of financial statements, he will find it in the future prospects of the business and build it into his price.
The buyer, on the other hand, is almost always skeptical about what is under the hood of the business, more wary about the future of the industry on which he is about to place a sizeable bet, and, if nothing else, keen on a bargain. His valuation will inevitably be lower than that of the seller.
As the leading small-business financier in South Africa, Business Partners spends a lot of energy doing careful valuations of businesses. If there were a single, universal formula to measure the true market value of a business, the job would be much easier. But there are many methods to value a business, says van Biljon. While each has its own logic and emphasis, the variety of methods does nothing to make the haggling around buying and selling a business any easier even though they inevitably form the basis of such negotiations.
In some industries, there are established norms on how to value a business. Van Biljon mentions the generally accepted method in the retail sector as an example – the value of a shop is based on a multiple of its annual turnover plus its stock. Norms such as these help to lubricate deal making, but not many industries have them, says van Biljon.
Net Asset Value, the sum of the market value of each of the business’s assets, was a method commonly used in the past, but has largely fallen out of use because it does not take into account the potential of the assets to generate an income as a fully functioning business.
In contrast, the Price Earnings method (p/e) which is most often used today, uses the ability of a business to generate a profit as the starting point of the valuation. The p/e ratio indicates how many years it will take to pay off the selling price of the business with the profits generated by it. A p/e of five, for example, means the selling price can be paid off in five years.
The details of any method can become quite complicated in the cut and thrust of a sales negotiation. What if the business has just come through a bad year, while the previous two years had shown excellent profit, for example? The parties have to agree on how to weight each year to determine the profit potential of an “average” year.
The situation becomes so much more difficult if the information available is not complete or is suspect, a situation that Business Partners routinely encounters with owner-managed small businesses. Frequently the record-keeping is neglected or, just as often, income is under-declared and personal purchases disguised as business expenses in order to pay less tax.
Eventually it catches up with the business owner, says van Biljon. They enjoy a slight tax benefit for a while, but when it comes to selling their business it is almost impossible to convince a skeptical buyer that the profits were actually much higher. If you could lie to the tax man, why not to someone who wants to buy your business?
Further factors complicate the buying and selling of owner-managed businesses. Van Biljon says small business owners often resist conditional clauses that don’t influence the price, but provides some level of assurance to the buyer. One very sensible arrangement is to insist that the previous owner remains on in the business for a few months to help with the handover, but van Biljon finds that many small business owners “just want to shake hands and get out of there”.
It is a good idea for both the buyer and the seller to seek the professional services of an accountant and lawyer to help guide them through the difficult terrain in search of a fair compromise, says van Biljon, who cautions that business brokers are not the impartial arbiters they often claim to be. Rather, any well-qualified professional accountant should be able to give good advice on how to value the business.
Sellers should strive to present their price as much as possible on real facts and figures, the basis of which is a complete and verifiable set of books, says van Biljon. Buyers are right to be wary, not only about the financial statement presented to them, but also about the fact that track record is no guarantee for future performance of a business.
Occasionally, the price paid for a business can be quite off-kilter with any valuation done on paper because of some strategic consideration. The buyer may wish to decrease the competition in the market, for example, or may see some hidden upside in joining the business with his own. Van Biljon strongly recommends such strategic moves to only the most experienced of entrepreneurs – those who have learned both the science and the art of valuing a business.