As part of our work with clients on income & share ownership planning (ISOP), one of the main questions that the business owner asks is: how much is my business worth?
The simple (and unhelpful) answer is: what someone is prepared to pay for it.
If you are selling your business to a third party in a trade sale, it is fairly easy to find that number, but you would be wise to get a good idea of the value well before then.
Of course, if you are passing ownership of the business to your team, then you need to agree something that is seen to be fair by both sides, especially if other family members are involved, and an accurate valuation may be even more important.
How are businesses valued?
The classic formula for valuing a business is:
Business value = Profits x PE ratio
‘Profits’ is the real profit after tax, ignoring exceptional items and after paying a fair salary to the business owners.
The PE (price/earnings) ratio is much more subjective. Typically, this is between 3 and 7 for most small private businesses, depending on such factors as dependency on the business owner, repeatability of income, and future prospects.
Add to this the value of any assets on the balance sheet that are not needed to trade, such as investments or excess cash.
Your accounts show £300k profits before tax and dividends. You pay yourself a minimal salary and take most of your money out as dividends. It would cost about £100k to buy in someone to do your job, so the real profit is £200k. After tax this would be £160k.
With a PE ratio of 5, the business would be worth £160k x 5 = £800k.
You have £500k cash in a bond that is not needed by the business for day-to-day trade, so you would add this to the value, giving a total of £1.3 million.
Other ways of valuing a business are net assets plus goodwill, discounted cash flow of future profits. Some industries, such as the insurance and many professional sectors, use multiples of turnover as the norm.
Other factors to bear in mind
Agreeing the value is only part of the story. You also need to agree:
- Payment terms: when will you actually get the money?
- Assuming it is on deferred terms, are these subject to future performance or profitability?
- In what form will you be paid: e.g. cash, loan notes or shares?
- What indemnities and warranties will the buyer make you sign?
One of the main advantages of ISOP succession planning as opposed to a third-party sale, is that these issues tend to be much less important because the vendor is likely to retain a degree of control over the business after handing over day-to-day management.
As part of the Financial Review reports that we at K&H produce, we prepare a basic business valuation using PE principles. Please post a comment with your thoughts or give me a call if you’d like to know more about business valuations.