Richard Heasman, partner and head of forensic accounting at accountancy firm Kreston Reeves LLP, explains why you might value your business and how to go about it.
Why would a small-business owner want to value their business?
Richard Heasman (RH): “Aside from selling a business? They might want to introduce a share option scheme for staff, transfer shares under existing shareholder agreements or sell shares to a third party. Possibly to calculate their capital gains tax and inheritance tax liabilities, or they might be getting divorced. There could be a shareholder or partnership dispute or loss arising from an insurance claim or compulsory purchase order. There are many reasons.”
How important is accuracy when valuing a business?
RH: “It’s essential when considering whether an offer to buy or sell a business is reasonable.
Many simple valuations are based on the business’s historical financial results. However, likely future results are equally, if not more important. But predicting them accurately is challenging. Valuing a business too high or too low can have serious consequences. Undervaluation can mean the owner loses money when selling a business, while overvaluation can scare off potential buyers or investors or create a higher tax liability.”
What methods are commonly used to value a small business?
RH: “There are some trade-specific ways, but the most common methodologies include ‘earnings basis’, with value based on a multiple of the business’s past, current and projected profits, while accounting for any surplus assets and debt.
A ‘cost approach’ is often used in asset intensive or low profit-making companies, when value’s based on individual assets the business could realise and its liabilities.
‘Discounted cash flow’ is another method that’s typically used to value start-ups and rapidly growing businesses. This relies on assessing likely future cash flows of the business and estimates present value of those cash flows based on risk profile.”
Is valuing tangible assets easier than valuing intangible assets?
RH: “Yes. Tangible assets are normally valued with reference to their original cost or similar assets sold or for sale, whereas often there are no ready comparators for intangible assets. Valuing some intangible assets is relatively straight forward, for example, a licence that generates a steady income. Others can be extremely complex, for example, software developed in-house.”
What factors affect the value of a small business?
RH: “Each business must be judged on its own merits, because it’s unique and there are very many factors that can affect its value. More important than the age of the business, is where it is in its lifecycle – infancy, growth, maturity or decline. Reliance upon key customers or suppliers can affect value, because it increases risk. Staff is another factor, and whether the business can still function without its present owner if the business is sold. The reason or circumstances for a valuation can impact value, as can size of the business and its sector. However, fundamental to virtually all valuations is future profitability and the business’s assets and liabilities.”
What common mistakes are made when small businesses are valued?
RH: “Sometimes historic results are used to value a business, when they don’t represent the future. Other times the wrong multiple is used or a business’s surplus assets or debt are ignored or underestimated when using the earnings methodology. Some valuations are based on aspirational rather than realistic financial forecasts. Many mistakes are possible, which is why I recommend that small business owners work with an experienced professional.”
What other key valuation tips do you offer to a small business owner?
RH: “If you do get a professional to help you, give them clear, concise, credible and complete information, with a full assessment of the business’s strengths and weaknesses. Don’t forget about your brand, it’s an asset, and internally developed intangibles, patents, long-term customer contracts, etc. If you’re looking to sell your business, make sure your financial systems are sound, as this can add value.”
Ultimately, is a business really only worth what someone will pay for it?
RH: “If you’re selling, yes. The demand might simply not be there. In addition, potential purchasers have different reasons for wanting to buy businesses, which can affect how much they’re willing to pay, despite your valuation.”