Sometimes when I get into the topic of establishing a business's value, I think I am entering a world where opinion counts for more than fact. Certainly, from what I have seen over the years, the process seems to involve as much guesswork as cold figures.
Most business owners will be familiar with sales of businesses in their own sector and will know what the typical valuation formula is. Generally this is some multiple of profit – normally referred to as EBIT (earnings before interest and taxes) – but in some sectors it will be a multiple of revenue or a value per client or per member. Few will, however, understand why a specific multiples apply in their sector.
When I have asked for clarification of the specific multiple that is being applied, I usually get the arguments that it is “typical” in the sector, that it reflects industry volatility and risk, or that it includes adjustment for industry growth.
The truth is that most business owners, business brokers and business advisers don’t know why a specific multiple applies. They just know what norm has been established over many years and many sales.
When you ask “How can I get a higher multiple?” the answer will be “grow faster!” How much faster? – well, more!! Not very useful, and certainly not very scientific.
Excluding liquidation or break-up value, there are only two fundamentally different models for establishing a value for an operating business. The first is based on the future stream of free cash flow generated by the business; the other is the strategic value of the business to a large corporation.
Most conventional businesses, such as retail, wholesale, transport, property, and services businesses, achieve value by producing profits (EBIT) for the new owner. It is the size, duration, growth and likelihood of that profit stream that creates the value.
By the way, it is only ever future income streams that create value, never past ones. You don’t put money into a savings account to get the interest rate the bank paid last year. The only relevant rate is the one they are going to pay. Thus, it is only projected future profits that are relevant. While past profits may give you some indication of the likelihood of future profits, you can dramatically improve your valuation by creating a different future.
Conventional valuation theory can be applied to business valuations. This is based on net present value (NPV) of a future stream of income relating to the initial investment. Once we know the income streams and the discount (risk rate) to apply to them, we can calculate the value of the investment (or the business in this case).
It then follows that conventional valuation using EBIT multiples should be able to be expressed in a NPV formula. Thus 2 x EBIT is a 50% discount rate, 4 x EBIT is 25% and 6 x EBIT is 15%. A business valuation can therefore be improved by reducing the applied discount rate and improving the visibility and probability of future income streams.
You reduce risk by improving recurring revenue, account penetration, customer and employee churn, and by implementing better systems and processes internally to set and monitor performance.
Visibility of future income streams is improved with long-term contracts, greater recurring revenue and deeper account penetration as well as establishing good competitive advantage around patents, brands, trademarks and deep expertise.
This should gradually improve the EBIT multiple. Further increases in valuation will come from increasing sustainable profitability and building income (EBIT) growth in the business.
This process is fairly conventional. Now comes the clever part!
To gain a premium on the sale, you can build growth potential into the business that the buyer can exploit. Can you identify how a much better-funded, more-skilled, more-able buyer could grow your business and can you provide the framework or template for that growth?
Where you can set out a path for higher growth and profits, and clearly demonstrate how that can be achieved, it is possible to gain some of that increased profit in your valuation. But you will need to find the right buyers, and you will need to put the business into a competitive bid in order to extract that premium.
A business that has underlying assets and/or capabilities that a large corporation can exploit is a very different proposition. These are businesses based on patents, brands, copyright, trademarks and deep expertise. The valuation in this case is not based on what your business can generate in future profits, but how much profit the buyer can generate by exploiting your underlying assets and capabilities.
Imagine a very large corporation that has a customer base 100 times the size of yours that would be highly receptive to your product or service. The large corporation may be able to quickly sell your product or service into an existing customer base, reaping 10 times your revenue, or greater, in the first year of the acquisition.
Therefore, what would your business be worth to a large corporation that had a ready market for your product or service? The value of your business is based on what they can do with your business, not what you can do with it. In fact, your own revenue, profits, customers and numbers of staff may be quite irrelevant in putting a value on your business. It is now all about them, not you.
Working out a valuation based on strategic value is very difficult but not impossible. What you have to do is estimate the revenue and profits that the acquirer will generate from your business. Thus, if they have a customer base 100 times yours, then it might be fair to say that the value is 100 times your conventional valuation.
Will you get that for your business? Probably not, but you will gain some portion of that value if you set the deal up correctly with the right potential buyers and ensure you have a competitive bid running when you come to sell. With strategic selling the task is to work out what you have or do that could be of interest to a large corporation, identify the potential buyers, set up a relationship to educate them on your potential and then manage the final competitive bid. Generally strategic buyers are prepared to pay many times the conventional value of a business.
If you compare these two models, what you will see is that the value of your business is solely in the eyes of the buyer, and especially in the manner in which the buyer can exploit its potential.
What this should be telling you is that the identification of potential buyers is one of the most critical aspects of gaining the best price for your business. The best buyers are the ones that have the experience, willingness, capacity and capability to best exploit the potential in your business. Your task then is to create that potential, and then find the right buyers.