As soon as you start thinking about selling your business, a whirl of questions will immediately come to mind: how find a seller, is it the right time for you to sell; is it the best time to go to market, and, of course, how to set a price. Working out a valuation is also necessary for the purposes of raising capital, being involved in a merger or takeover or for succession planning. So how does the process work and what would examples of valuations look like using different methods?
Valuers, who are usually specialised accountants, use earnings-based, market-based and asset-based approaches to create a valuation. That figure will be influenced by intangible or external factors such as the quality of the company’s leadership, its finances, how it compares with rivals and the overall health of the sector.
Earnings-based valuations are the norm for privately owned companies as buyers will be interested above all in profitability. Please see companion article Valuing a Business: Market and Asset-Based Approaches, to find out more about market-based and asset-based approaches.
This uses methodologies such as Ebitda ratio, price/earnings ratio and discounted cashflow. These methods tend to suit buyers who are focused on the company’s future profits.
Either the past year or the past three years of accounts are used. Ebitda (earnings before interest, tax, depreciation and amortisation) are used to create an agreed profits figure. Adjustments are made to the agreed profits figure to make it more representative of future years’ figures, and factors such as goodwill and interest on loans will be taken into account. This figure is divided by the turnover, to generate the Ebitda ratio, which is expressed as a percentage. The higher the number, the more profitable the company is.
The Ebitda ratio is a measure of profit per pound of turnover. The Ebitda ratio will affect what multiplier is used. A company with a 45% Ebitda ratio will be able to demand a higher multiplier, eg, x4 rather than x3.5, than one with a 30% Ebitda ratio because it is more profitable. Generally, a smaller company will try to have the same Ebitda multiplier as a larger company.
The example here shows how using Ebitda to create a valuation works in practice.
This requires an accountant or valuer to work out adjusted annual profits by making adjustments to actual profits that will reflect things like depreciation, amortisation and interest on loans, and then multiplying the agreed profit figure using a range of factors to get a valuation.
A three-year period (see table below) is commonly used to calculate annual average profits. This profit figure is then subjected to industry-specific statistics and discounts to create the multiplier. This is to some degree subjective and the agreed multiplier will often only come about after negotiation.
For specific industries, indices are used in the creation of the multiplier but often for small businesses they don’t exist or are not relevant as the indices are intended for use with large companies.
More than one multiplier can be applied to transactions, which might be a generic small business ratio rather than one based on the target company’s financial data or sector.
In the example below the valuer is using four different ratios to build the multiplying factor and also using a discount to reduce their effect.
This is good for businesses that sell time to long-term clients, such as a firm of solicitors or accountants. A recurring sales figure is agreed, which is multiplied by a rate to produce a valuation.
Often the sales figure will be reduced from the actual one, for example, if the buyer does not want some of the clients. Payments are likely to be made in tranches, say, three of one-third each, one at sale, one at the end of year one and the third at the end of year two. A clawback clause can be used to cut the later payments to allow for things like clients dropping down their fee or leaving.
Some buyers will want only the client list and essentially are only buying the goodwill of the company.
This is a sophisticated, algebraic technique that will generally require professional advice to ensure it is sufficiently accurate. It is best suited to stable, established businesses with predictable cash flows.
Its aim is to work out how much projected cash flow is worth now. A discount interest rate expressed as a percentage is applied to the future cash flow – the discount is to account for unforeseen expenses, changes in profit margin or revenue falls and the time value of money*. Other types of discount rate can be based on the cost of someone financing a purchase of the business, or what other return might be available on the capital.
Much depends on the accuracy of the input data: modelling cash flow in five years’ time will inevitably involve a degree of guesswork or, even worse, wishful thinking. But, when done right, DCF is a reliable way for buyers to work out if they should proceed with a potential takeover.
* Time value of money – a pound is worth more now than at a given point in the future because of the investment return it can generate between those two time points and because inflation will erode its value.
The valuation is arrived at by dividing expected annual earnings by a capitalisation rate, which is calculated by the valuer. The latter is the rate of return expected by investors. This is best for well-established companies where there is a degree of confidence about future earnings.
For this method to be reliable, a thorough understanding of the business is necessary as well as an accurate assessment of future earnings. It is more appropriate to larger businesses and is equally useful as a way of determining return on investment.
Clearly, there is a lot to think through and research before selling your company. Particular challenges are finding a buyer, managing negotiations and setting an achievable price that does not undervalue the business. This is where expert advice from outside the company can be invaluable.
The accountants at Finsbury Robinson can give you all the help and insights that you need, so, if you are thinking about exiting your business, or just want to draw up a plan ahead of time, please give our friendly team a call on 020 8858 4303 or email us at info@finsburyrobinson.co.uk.
