Business valuation: how much is a business worth and how to find out
How much is a business worth? It’s a pretty common question, yet answering it isn’t that straightforward. The reason why it’s an increasingly popular topic is that our workforce is ageing fast and many entrepreneurs are Gen X or even Boomers on the brink of retirement. COVID-19 isn’t making things easier for them, by the way. Besides, many execs are going through a midlife crisis and/or are given the gold watch precisely because they are considered too old to rock and roll. Many of them are therefore tempted to take over existing businesses and leave their enterprise past behind them. Yet, understanding how much a business is worth is far from being simple. This is what I found out while attended an overcrowded meeting, a few years past, with a particularly sharp panel of specialists and an audience which knew the business well.
How much is a business worth and how to find out
How much is a business worth? A strategic and marketing (and then financial) exercise
To many, valuating a business seems like an easy task: work out your financial ratios and hey presto! You’ve got it all figured out. Not so, not so… The task of business valuation is a highly complex matter. Above all, it is an exercise that is essentially hinging on strategic flair.
On the one hand, business valuation is not as linked to finance as is ordinarily believed. Finance matters of course, but it’s not sufficient. On the other hand, business valuation is a difficult exercise although it’s not rocket science either.
Lastly, with many business types, including High-Tech start-ups (or Bio-Tech or other flavour-of-the-month subjects), this exercise may be somewhat irrational and shall be based on a pure marketMarket definition in B2B and B2C - The very notion of "market" is at the heart of any marketing approach. A market can be defined... rationale, similar to that of the stock exchange or the art market, where the value of a company is a bet on future gains. And like it or not, this bet is often based on market expectations rather than reason.
The strengths and weaknesses (SWOT) of a business is the starting point
Above all, business valuation is a matter of assessing the strengths and weaknesses of a company, which is part of strategic analysis. This is where it all starts. First of all, how the company is positioned on its market, is the market buoyant or bearish, and what are the company’s future prospects.
Much depends on how the buyer perceives that business’s intrinsic strengths and weaknesses, namely its employees and its ability to run the business in the absence of its founder. One of the tricks that the buyer may resort to is establishing close contacts with the managers of the targeted company, or even turn them into business partners in the takeover project.
These managers may also be prone to share secrets that the owner doesn’t want to reveal (the real value of stocks, how much of the machinery — in manufacturing — needs replacement or other points worthy of note).
Next, we can relate the company’s current situation (this is where the concept of detailed financial analysis and auditing comes into play) to its future prospects.
Don’t you think that the analysis stops with the balance sheet! This involves the quality and obsolescence of the machinery if you are considering buying a manufacturing business, but also and above all, real-estate assets, which can make up a huge barrier to entry. Last but not least, don’t forget about the cash flow. In this respect, things are neither black nor white, and be aware that too much cash flow may be an issue as well.
Numerous and complex methods of business valuation exist
It would then be wrong to believe that there is a silver-bullet method for company valuation. There are many such methodologies and what I have understood through this conference is that experts use them according to context. Each expert has a preferred method as well, depending on experience.
8 top tips to find out how much a business is worth
- Use business valuation multiples with caution: one of the commonest valuation methods consists in establishing a multiple (revenue, EBIT/EBITDA…) based on an industry average or a historical sector average. This is a quick and dirty approach that can save time in the screening of initial targets (too expensive, not profitable enough, etc. for example). This first-cut approach needs to be refined according to the SWOT analysis mentioned above and may prove to be too low or too high. It is by no means sufficient.
- A SWOT, as well as the strategic analysis, is the starting point: the audience was made of seasoned business leaders with extensive M&A experience who are able to precisely evaluate a business in a given industry. They asked very relevant questions about on-going orders, payroll ratios, skills and competencies… All this knowledge is out of reach for M&A or business rookies who should seek guidance from seasoned professionals (even if that means paying them fees) before delving into a business valuation project.
- Beware of undisclosed information (executive pay, rents, … ): the devil is in the details. Emphatic gross margin figures may hide a cost structure made in Hell. It is in the seller’s interest not to disclose all the information he or she has in order to sell at the highest price. The buyer then launches his investigation without all the necessary information and must try to uncover as much as possible about the business and the reality behind the figures.
- Real estate is a major obstacle and requires 3 to 5 years of preparation for its sale. It is therefore important not to believe that you can get rid of it so quickly;
- Cash flow is important but should not be too high.
- A struggling business is more of a target for a manufacturer, or for a second or third takeover. Even though there are counter-examples, in case this is your first go at acquiring a business, avoid flailing companies and focus on deals pertaining to flourishing ones. It is therefore recommended to focus on targeting healthy businesses, even though the price is higher. The amount of debt should also be taken into account.
- Conversely, beware of companies that are growing too fast or with too much potential because they are too expensive for individual buyersThe B2B purchasing process is the result of a long life cycle often linked to a contract as there are many people to convince.. It should be noted that takeovers by other businesses are generally valued at a far higher price, which explains why some sellers refuse contact with individual buyers.
- There are many “rational” and financial valuation methods with varying results (the same business could be valued anything between 6 and 9 million euros! depending on the valuation method). At the end of the process, one produces a mix of all those results with Goodwill as a cherry on the cake and the end result is a price range which will be used for negotiation. These calculations are generally left to the financial advisers (audit/finance/accounting) who support the buyer. It is in the buyer’s interest to remain hidden behind them in order to conduct a classic “good guy” (buyer)/ “bad guy” (advisor) negotiation.
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