The dark art of valuation
Valuing a business, and the process behind it, can be complex and has often been described as being part art, part science and part perception. It’s also heavily influenced by three factors, only one of which you can control, namely: the wider economy, the state of your market and the shape that your business is in.
However, take away the veil of mystery that surrounds the valuation process and in reality there are things you can do well in advance of any prospective sale or exit event to ensure that you get the best possible valuation.
There are multiple ways to value a business and often a couple of methods will be used to give a range of values. Underlying the various methods are the competing factors of the potential profit a purchaser might be able to enjoy, as set against any potential risk. Factors relevant to this will include past profitability and asset value, goodwill and intellectual property.
In brief, the most common valuation methods you’ll come across are:
- Asset valuation: Appropriate if your business has significant tangible assets. For example, a property business.
- Price earnings ratio: Used to value a business that is making sustainable profits. Using this method, you value the business by multiplying its profits by an appropriate P/E ratio. For example, using a P/E ratio of 5 for a business with post-tax profits of £100,000 gives a valuation of £500,000. What amounts to an appropriate P/E ratio varies vastly and will also depend on whether the business is quoted or not. Profit will usually be calculated based on historic and possibly forward projections for earnings, measured before depreciation, interest and tax, but adjusted for average directors’ drawings.
- Cash flow valuation: Based on past and projected cash flow. This is appropriate for businesses which have invested heavily and are forecasting steady cash flow over many years.
- Entry cost: Values a business by reference to the cost of starting up a similar business from scratch.
Influencing factors that you can control
There is no one factor that guarantees you a premium valuation. But there are things within your control that will work against you if not in place and can in some cases enhance a valuation. Many of these factors require early and forward planning and preparation, including the involvement of your legal team.
Customer, supplier and key personnel contracts
Ensure your supplier and customer contracts are up to date and enforceable. You or your legal team need to check that you have decent contracts in place and watch out for any provisions such as change of control clauses which could reduce the value of a company and lead to complications and risk for a buyer.
Similarly, you need to make sure that your key staff and director service contracts protect you against resignation or poaching. Well put together share incentive schemes can be effective in ensuring key personnel stay with the company and are therefore attractive to potential buyers.
Employment and HR policies and processes
As part of the due diligence process a company’s HR and employment practices are going to come under close scrutiny. Therefore it will be an advantage to have in place compliant, up-to date, and easily accessible contracts, handbooks and policies. A well put together shareholders agreements between all owners will also help a sale and give the buyer comfort that completion can occur without any undue hurdles.
Intellectual Property is often central to a sale. Where possible, any relevant IP should be properly registered, while all IP should be well protected and documented in all contracts the company is a party to.
Preparing for due diligence
The due diligence process is going to require a thorough examination of almost every, if not every, aspect of your business. Thorough preparation should ensure it runs smoothly. As part of this preparation, ensure you have an up to date register of members, all flings at Companies House have been made correctly, there is an up-to-date register of fixed assets and schedules of HP, lease and rental agreements. If appropriate have a record of contingent liabilities and make sure you can demonstrate good processes in place that minimise the potential or risk of any legal, HR or quality issues / complaints.
You should already have in place a strong business plan. The earlier you plan your exit strategy, the earlier your financial team can collate information in a manner that supports your exit strategy objectives and demonstrates a strong and well evidenced financial history. That includes not just up to date financial forecasts but also tracking of historical performance against budget, projections of future working capital needs, up-to-date annual financial statements and a full set of management accounts with appropriate analysis. Proof of strong historical financial performance and projections nearly always attracts higher valuations.
Other key factors to achieving a premium valuation
There are other factors which can help achieve a premium valuation. They may be harder to control or influence but early planning which takes these factors into account can be effective:
- Size and market. Larger businesses usually attract higher valuations as do technology focused businesses and those in a growing market.
- Customer demographic also counts. A business with a broad client base or a secure contracted client base will generally generate a higher valuation than those businesses that depend on a few key clients or need to continually generate new business. It is often key business relationships that provide the most value to a business.
- A strong and effective sales and marketing strategy and process and a strong, positive brand can also be influential.
- A competent, well engaged team with a proven track record. Whether at management level, in terms of technical skill or at workforce level, personnel are frequently an influencing factor when it comes to value. Are they skilled and well trained, loyal, effective and dynamic? If the business relies heavily on one particular employee, because for example that employee is responsible for the majority of one aspect of the business, that can pose a risk which may effect value.
- If a business owner is still involved day-to-day with the business and the business will be affected by their departure then this will impact negatively on the valuation a buyer may agree.
- Systemisation of the business. If there are no systems in place that a new owner can easily follow this could potentially render the businesses unsaleable.
It will always be true that there are factors that you can’t control when selling your business: the economy, the competition and potential purchasers for a start. But what you can do, right from the outset, is have a clear set of objectives, a strategy for achieving them and a business that is perfectly in order so that you can exit for a maximum valuation.
Please do get in touch for a no cost and no obligation initial consultation in respect of how we can help you. In particular, we have many years of experience as solicitors advising both buyers and sellers of companies. We are also happy to recommend business sales agents and valuation consultants appropriate to your circumstances.