Looking at your business through a buyer’s eyes can reveal not only what it may be worth, but where value is being created, where it is at risk and what you can strengthen before a sale becomes urgent.
For many owners, the value of their business represents years of hard work, investment and risk. But the amount an owner believes the business is worth and the value a buyer places on it can be very different.
In my experience, this is often where the two perspectives begin to diverge. An owner naturally sees the history of the business and the effort involved in creating it. A buyer is principally concerned with what will transfer to them, what the business is likely to earn in future and what risks they will assume in earning it.
That is why two businesses with similar revenue and profit can have quite different values.
What determines the value of a business?
There is no single formula. The purpose of the valuation matters, and every business has its own characteristics, prospects and risks. Financial performance is important, but a buyer is also likely to consider:
- How sustainable and predictable the earnings are
- Whether the business is growing, stable or declining
- Customer and supplier concentration
- Dependency on the owner or other key people
- Management capability and documented systems
- How much working capital and future investment are required
- Whether key arrangements are secure and transferable
- The quality of the financial records
- Future opportunities and risks.
These questions are useful even when a sale is not imminent. They help identify what is creating value and what may be holding it back.
Profit is important, but it is not the whole story
Consider two businesses generating similar earnings. One has recurring revenue, a diverse customer base, an experienced management team and established systems. The other relies heavily on its owner, receives a large share of revenue from one customer and has few documented processes. Their current profits may look similar, but the ability to sustain and transfer those profits may be quite different.
Even the profit in the financial statements may not be the figure a buyer relies upon. Owner-managed businesses can include shareholder remuneration, related-party charges, discretionary expenditure or unusual items. Equally, the accounts may not include a full commercial cost for work performed by an owner or family member.
The aim is not simply to add expenses back or make the result appear better. It is to arrive at a balanced view of the sustainable economic return available to an incoming owner.
Turnover growth does not always mean value growth
I sometimes see businesses growing strongly while earning less from each dollar of sales or requiring significantly more capital to support that growth. Rising turnover can disguise falling margins, an unfavourable change in product mix, or more cash tied up in inventory and receivables.
Two businesses may therefore report the same profit, but one may require substantially more equipment, stock, debtors or owner funding to generate it. A buyer will usually consider both the earnings and the capital required to produce them.
How dependent is the business on you?
For an owner-managed business, this is one of the most useful questions to ask. If you stepped away for an extended period, who would maintain the major customer relationships, make pricing decisions, negotiate with suppliers and deal with the unexpected?
Owner dependency does not necessarily mean the business has no saleable value. Many small businesses rely on a working owner and still change hands. The dependency may, however, affect the price, the transaction terms and the period for which the outgoing owner is expected to assist with transition.
Reducing that dependency is not about making the owner unimportant. It is about making the relationships, knowledge, systems and processes of the business more transferable.
Are key relationships secure and transferable?
A major customer can be enormously valuable, but it can also create risk. A buyer will want to know how much revenue comes from the largest customers, whether it is recurring or contracted, who owns each relationship and whether it is likely to survive a change in ownership.
The same applies to leases, licences, distribution rights, supplier arrangements and related-party relationships. A longstanding informal arrangement may have worked well historically, but a buyer may distinguish between commercial goodwill and a right that is documented, secure and capable of transfer.
Do the financial records tell the story clearly?
One recurring issue in owner-managed businesses is that the owner can explain every fluctuation, but the explanation is not recorded anywhere. That may be manageable while the owner is closely involved, but it becomes a problem during due diligence if the information cannot independently support the story being told.
Clear financial and management information should help explain revenue and margin trends, customer and product performance, recurring and unusual items, owner and related-party transactions, inventory and debtor ageing, working-capital needs, debt commitments and current trading.
Good information also makes the business easier to manage today. If management cannot readily see where cash is tied up, why margins are changing or which activities generate the strongest returns, the issue is not limited to a future sale. It may also be affecting decisions now.
Be careful with headline valuation multiples
It can be tempting to apply a multiple heard from another transaction. But a multiple cannot be considered in isolation. A low multiple applied to broadly defined proprietor earnings may produce a different result from a higher multiple applied after allowing for a market salary, necessary capital expenditure and working-capital requirements.
Owner dependency and other risks may support a lower multiple, but they do not automatically mean there is no goodwill. Before comparing transactions, it is important to understand the earnings definition, the risks reflected in the multiple and which assets, liabilities and funding are included.
Can you increase the value of your business?
There is no single initiative that guarantees a higher valuation. Depending on the circumstances, practical steps may include diversifying the customer base, strengthening management, documenting processes, improving reporting, addressing underperforming products or services, increasing recurring revenue and resolving risks before they become transaction issues.
These improvements do not matter only when preparing to sell. A business with stronger management, better information, clearer processes and less concentration risk may also be easier to operate, finance and grow.
When should you have your business valued?
A valuation is not only relevant immediately before a sale. It may be required for ownership changes, shareholder transactions, acquisitions, restructuring, succession planning, disputes or other significant decisions. The appropriate approach depends on the purpose and surrounding circumstances.
There is an important distinction between an informal indication and an independent valuation prepared for a defined purpose. If a significant financial or ownership decision depends on the number, professional valuation advice can help ensure the relevant information, risks and assumptions have been properly considered.
Start by looking at the business through someone else’s eyes
Even if you have no intention of selling soon, ask yourself:
- How sustainable are our earnings?
- What makes customers choose us?
- Could the business operate effectively without me?
- Which relationships and revenue streams are genuinely transferable?
- How much capital is required to produce our earnings?
- Could we clearly explain our normalised earnings to an outsider?
- What risks would a buyer notice first?
The answers may tell you something more useful than today’s valuation. In many cases, the most valuable outcome of a valuation discussion is not the number itself, but a clearer understanding of what drives it and which aspects of the business can realistically be strengthened.
That gives an owner something a valuation figure alone cannot: the opportunity to act before a sale, ownership change or unexpected event makes those issues urgent.
How Moore Markhams can help
Moore Markhams can help business owners understand the factors affecting business value and provide independent valuation advice where a formal assessment is required. Contact your local Moore Markhams adviser to discuss your circumstances.
