Knowing the true market value of your business is useful for many reasons, not least for raising investment. Whatever the reason is for putting a price on your company, it’s vital to understand the main factors that will affect its market value, and the steps you need to take to achieve an accurate valuation.
Why value a business?
Typically, a business valuation has two purposes: to help the company raise investment, or to help the company to be sold.
Knowing your valuation can also give you a stronger hand in negotiations, says Andy Smith, finance director at Abbeygate Accounting. “Having an idea of your value means you can go into negotiations better informed, and aware that whatever your size, you have value to potential partners,” he says.
This is the case for Innovation Agri-Tech, a company that has developed technology with the potential to help farmers drastically reduce their water usage. Because the technology is new to the market, it’s hard to find easy price comparisons, says CEO and co-founder Jaz Singh.
Agri-Tech worked with professional valuers with experience in valuing other fledgling technologies and patented inventions, meaning they could advise on how such products should be priced for licensing in a way that reflects their potential value, even without any competing products on the market.
“This helps us to understand what we should charge companies that want to license our technology,” says Singh.
Whoever is valuing your business will want to have full access to your accounts, so it’s important to have all your numbers in order, and complete forecasts, says Smith. “If you are using a software package then make sure everything is linked in, and all the relevant information is up to date, complete and accurate. Your financial and management accounts must be available before you start the valuation,” he says.
What affects the value of a business?
The main variables that will affect business valuations are:
Profits
The most important factor in determining a company’s valuation is its profit. Anyone who wants to buy or invest in your business wants to know how much money it makes. Your valuation will be higher if profits are increasing for multiple years, but will be lower if they are decreasing or erratic. It’s also important to remember that any valuation will be based on net profit rather than gross profit or operating profit.
Forecasts
Investors don’t just want to know how much money you’re making now. They also want to see forecasts and evidence-based rationale for your projected revenues and profits. Your valuation will be affected by profit forecasts over the next 12 months (at least) and will reflect any changes that might limit or cause an upswing in revenues and profits.
People
Who are the key people in your business, and how likely are they to stick around? A high staff turnover or a sign of recruitment problems could reduce your valuation. A founder that is required for the business to function is another red flag, explains Smith. “Do the relationships and contracts sit with the business or with the business owner?" he says. "As a founder, you want to get to a place where you aren’t indispensable.”
Assets
In many cases, a bigger company will buy a small business to acquire its specific assets. Your business valuation will be higher if you own buildings or machinery, for example, but will also be helped by intellectual property, especially if that is protected by patents or agreements such as non-compete agreements and trademarks.
Liabilities
Valuations will be lower if your business has higher than expected liabilities. “Lots of companies have taken on debt in recent years, whether through bounce-back loans or other funding," says Smith. The more debt a company has taken on, the more this will affect the value.”
How to value a business
Depending on the nature of your assets and the purpose of the valuation, your existing accounting firm might be able to carry it out, or you might need to hire a specialist.
Although Innovation Agri-Tech has technology with growth potential, the company needed a valuation before it had a product ready for sale, explains Singh. “We interviewed several agencies before finding one that had the right experience and expertise in pre-revenue valuations," he says. "The valuer had experience in patents and technology, which was really helpful in creating the best possible valuation.”
There are several simple ways to value a business for sale or investment:
Book value
This method looks only at the company’s assets and liabilities. Assets might include property, equipment, and intellectual property, while liabilities include payments to suppliers, debt repayments and staff costs.
Valuation = business assets – business liabilities
If your assets total £500,000 and your liabilities are £100,000, then your business valuation is £400,000. This formula is very simple, but fails to account for intangible assets and doesn’t reflect things like profitability or growth.
Discounted cash flow value
This valuation method is based on future business performance, by estimating a company’s projected cash flow in future, and then expressing that as net present value (NPV). It is used to calculate the value an investor should be willing to pay for an investment, given a required rate of return on that investment.
The discounted cash flow formula is complicated [1], but with the right data, it is possible to come up with an acceptable estimate of the following year’s cash flow. Each additional year becomes more difficult to estimate with an acceptable degree of accuracy.
Revenue/ earnings multiple
A more common - and simpler - method of valuing small and medium businesses uses a multiple of revenue or earnings. This calculation involves taking a company’s earnings after all business expenses are paid and using an industry multiplier to generate a value.
Different industries have different multipliers, and each business within that industry may have higher or lower multipliers depending on factors such as growth opportunity. For example, a technology firm will commonly be valued at 3-5x earnings, but a firm in a particularly high-growth sector or one that has proprietary technology could see a valuation of 7x earnings. Meanwhile, accounting firms, which are likely to grow much more slowly, are commonly valued at 1.6-2x earnings. Your accountant or a specialist valuer will be able to advise on the most appropriate multiplier for your business.
This means an accounting firm earning £400,000 a year could expect to be valued at £800,000 but a technology firm with the same earnings might be valued at between £2 million and £2.8 million.
Other considerations when valuing a business
A formula can rarely capture the full value of your business. In some cases, a business might receive a higher-than-expected valuation because the purchaser is prepared to pay a premium for specific knowledge, equipment or simply to remove a competitor.
An accountant will consider what could go wrong in your business that could reduce its value to a potential investor or new owner. What happens if the business owner leaves? What happens if regulation changes, and you need to adjust products? What happens if the company can’t afford its debt repayments? An accurate valuation will consider the likelihood of a specific event and what the potential ‘hit’ to the business could be, and make a judgement as to how that affects the valuation.
“I would suggest sitting down with your valuation team and talking through how you address those risks,” says Smith. "Before you set a valuation, what can you do to reduce risk? Can you pay down debt, can you invest in certifications of compliance, or improve policies within the business?
"Once those changes are made, the result will be a better valuation.”
Sources:
[1] Corporate Finance Institute, Discounted Cash Flow Formula
