Understanding the value of your business should be important to every business owner and company director. However, many do not understand or appreciate this number.
Unfortunately, many business owners and directors over-estimate the value of their business. What few of them understand is how easily the value of their business can be increased and what they can do to multiply it over the long term.
There are five ways to calculate the value of your business:
- Earnings Multiples- this is the most common and most misunderstood way of valuing your business. Many owners and directors think that their business is worth a multiple of their annual turnover when it is actually based on a multiple of their post-tax profits. We look at this in more detail below.
- Industry valuations- In some industries industry-wide rules of thumb are used to value a company rather than its profit. For example, the number of customers for a mobile phone company or the number and worth of repeat clients at an accountancy practice.
- Asset valuation- This valuation is made by calculating the net realisable value of all assets. This method is used for established companies with a high level of tangible assets, such as property companies. In this case, you simply add up the value of the assets and subtract the liabilities.
- Discounted cashflow or earnings capacity- this usually used by businesses with significant potential but few assets, e.g. an online business. It is a complex calculation which predicts the company’s cash flow over the next 5 or 10 years and applies a discount rate for interest and inflation.
- Entry cost- this is the predicted cost of setting up a similar business to the one sold. This includes the cost of buying similar assets, developing products and services, recruiting and training employees and building a similar customer base.
In understanding the value of your business, you must be aware that whatever method is used, there are several factors that will reduce your valuation figure. One of the biggest, yet easiest to fix, is your legal documentation. For example, having up-to-date and beneficial Terms and Conditions, a sound credit control policy and a debt collection process in place.
At Else Solicitors, we have a saying “Run your business like you are going to sell it tomorrow.”. We think this is sounds advice as nobody knows what is going to happen one day to the next. So, it is always worth being prepared for;
- The worst- if you stepped under the proverbial bus, you would want your family to get the best possible value from your business. If it happened to one of your partners, you would want to know that your business could keep running profitably or that you would get the most money if you had to sell up.
- The best- someone could make you an irresistible offer tomorrow and you would want to be able to maximise your profits.
In this short article in our commercial series, we will cover:
- Understanding the Value of Your Business
- What Increases the Value of Your Business
- What Destroys the Value of Your Business
- How to Increase the Value of Your Business in the Long Term
- Why Else
Understanding the Value of Your Business
Understanding the value of your business is important. This is critical if you want to:
- Sell your business or buy one
- Buy or sell shares
- Identify poor performing divisions in a business
- Motivate your management through measuring their performance and offering shares
The most frequently used business valuation method is earnings multiples. Many business owners and directors incorrectly think this is based on annual turnover. It is based on a multiple of your post-tax profits.
Advisors will refer to a price/earnings ratio (P/E). This is simply the amount they multiply your post tax profits by to calculate the value of your business. For example, if your business is making a post-tax profit of £100,000 and a P/E ratio of 4 is applied then your business would be valued at £100,000 x 4= £400,000.
There is no standard P/E ratio figure that can be used to value every business.
It depends on several factors:
- Companies within certain industries such high tech and IT will have a much higher P/E ratio than traditional businesses;
- Businesses where profits are growing rapidly will command a higher multiple, than firms where profit growth is low;
- A small or medium sized business will have a much lower P/E than a FTSE-100 company in the same industry. There is more stability in a large corporate than a smaller company.
As a very general guide, P/E values vary from 1 (for small companies with low profit growth and reliant on key employees) to 10 or more for a large, high growth business.
What can give a guide to your P/E is the cost of setting up a similar business using the entry cost valuation approach. This involves examining the cost to the business of:
- Raising the needed finance to buy fixed assets and have working capital to cover stock in trade and cash funds
- Developing the products and services
- Recruitment and training
- Building up a customer base and reputation
You should also factor in cost savings like streamlining the firm, using more up to date technology so requiring less staff, having a cheaper location etc.
There are many things that affect your P/E value. You will want to maximise this while the buyer will try to minimise it.
What Increases the Value of Your Business
In understanding the value of your business, you must also learn what can help to increase its value. Buyers generally want to either take over the business as a going concern and run it exactly as it is or move the work it does and its clients into their own business, for example an accountant buys out a sole practitioner and takes over their clients. The buyer may keep the name (and goodwill) of your business if it is advantageous to do so.
Key factors that increase the value of your business include:
- Clients locked into on-going legally binding contracts- The more on-going and regular customers you have, the more your business is worth. It is important that you have good terms and conditions in place so the buyer can simply carry on looking after your customer base.
- Repeat business and client retention rates– this is not as secure as locked-in customers but these clients do have value. For example, businesses tend to stay with the same accountant, so these recurring fees add to the value of your practice.
- Goodwill- Goodwill adds considerable value to your business and this can extend to your suppliers as well as customers.
- All legal documentation up-to-date- this is very important. You need everything up to date and correct including your company memorandum and articles, shareholder agreement, director’s service agreements employee contracts, HR policy, Intellectual Property etc. If you have all of this in place then your business will be worth considerably more.
- Profitable distribution deals– Distribution deals can add considerably to the value of your business provided they are profitable and have been correctly drafted.
What Destroys the Value of Your Business
There are numerous things that destroy the value of your business:
- Key employees- If your business is dependent on a handful of key employees, such as managers, sales people, fee earners (in any industry) etc. then it is important that they have golden handcuffs and long notice periods. Your contracts must cover what happens if they leave including keeping private any confidential information and adhering to restrictive covenants that stop them poaching your customers.
- Excessive old and bad debt- Many businesses have some old and some bad debt. However, in cases where this is excessive, it will have a negative impact on the value of your business. No-one wants late or non-paying clients. This can be dealt with by improving your terms and conditions, credit control policy and debt collection process.
- Need to constantly hunt for customers- This is the case where you make a sale and that customer is not locked in to an on-going contract and may or may not come back to buy again. A branding company is a good example of this. They do the branding for a business but then this might not be revised for many years and even then, there is no guarantee that the client will use them again. This type of business constantly must constantly find new customers. This can be offset by a strong brand and position in the marketplace.
- Poor legal protection- poor or no employee handbooks, no IP protection, poor key employee contracts, poor terms and conditions etc. can all have a negative impact on the value of your business.
How to Increase the Value of Your Business in the Long Term
There are numerous ways to increase the long-term value of your business. This includes:
- Building your brand– a strong brand can greatly add value to your business, especially if it is widely spread among your target market
- Winning more long term clients and customers– Long term and repeat clients or customers add value to your business.
- Improving the efficiency of your business– this could be through workflow changes and/ or using new technology. Efficiencies will increase your post-tax profit and hence the value of your business.
- Negotiating distribution deals– these can greatly increase the value of your business.
Else Solicitors has considerable experience in helping companies negotiate and agree profitable distribution deals.
How we can help
Else is a modern, dynamic and forward thinking legal practice who offer the expertise you expect from a large, traditional law firm.
You will discover that we are different to other legal firms. We will help you sort out your commercial legal documentation and then look at other ways that we can add value to your company. This could include introducing you to new customers or suppliers in our extensive network or offering you some new insight into your market or your business.
If you would like expert commercial legal support, whether this is increasing and understanding the value of your business or if you are looking to buy or sell one, then we urge you to contact Adam Gilbert, Head of Corporate and Commercial and Partner at Else Solicitors on 01283 526 229 or at firstname.lastname@example.org.