How much is your private business worth? (Karl Schranz November 2007)

Even if you are not looking to sell part or all of your business, how many times did you wonder to yourself how much your business is really worth? What is the maximum price you are willing to pay when negotiating the purchase of a business? Unlike public listed firms, whose prices are constantly available at the click of a button, a private firm’s value is dependant on various factors that are not easily quantifiable. A business is worth only as much as a buyer is ready to pay for it. For this reason, I will be looking at the value of a business from the perspective of a buyer.
The first step is to look at the assets and revenue streams of the firm. A buyer is not looking to buy real estate or machinery, he is looking to buy into a source of profits. The value of a business boils down to current and expected free cashflows. Free cashflows are the firm’s earnings before interest, tax, depreciation, amortization and other income or expenditure that would distort the real value of earning. This figure is then increased by a multiple. The choice of this multiple is dependant on various factors, both market and firm specific. There are various other methodologies for valuing businesses, but this is the most commonly used and is suitable for all types of businesses that are not running on a constant negative free cashflow stream. There is no universally agreed multiple for a particular sector or firm, and multiples vary widely between and within particular sectors depending on a number of factors, but principally the certainty and size of the future cash flows of the business are the main drivers in deriving this factor. The multiple applied to a business will depend on a combination of factors, some of which are detailed below.

Quality of earnings:
Sustainability of earnings: A potential buyer needs to look at whether the firm he is acquiring is already at the apex of its business cycle, or whether earnings will continue to grow. He would also need to look out for oneoff events that may have distorted previous earnings. These non-recurring events should be eliminated in the analysis.

Dependency of the business on the current owner/manager: A business that evolves around the capabilities of the current owner/manager is less attractive for a potential buyer, as once the buyout is complete, earnings will inevitably dip.

Customer base: A firm that derives a large chunk of its earnings from a few large customers is less attractive to potential buyers as the loss of one of these clients will lower current earnings significantly. On the other hand, a large and varied client base ensures that earnings will not be notably impacted by the loss of a client. Also, the potential growth of customers’ industries plays an important role in identifying potential earnings growth from current customers, thus making the current customer base more attractive to potential buyers.
Quality of assets
A potential buyer should ensure the assets the firm owns are in good condition, and not dated. Even though assets that soon need replacement should be heavily depreciated in the books, he should also look into the costs of replacing these assets. The likelihood of changes in technology should be looked into, thus evaluating the risk of these assets becoming obsolete. There is also potential for the assets to be undervalued increasing the attractiveness of the potential deal.

Quality of intangibles
Competitive advantage: A well-established business, which has a prized name, patent, or location, would be more valuable than a younger business without any of these intangibles.

Barriers to entry: The time it would take to set-up a similar business as well as the expenses and risks involved in bringing the business to the current stage of development would impact the value of the firm. If it takes a significant amount of time, money and risk to build an identical business, this would add value to the current business, and a buyer would be ready to pay more for this business than for one which is pretty straight forward to set-up.

Potential for further growth: A buyer will pay more for good growth prospects than for a low or zero growth business. This is because from a high growth business buyers will be able to recoup the initial investment much faster than a no growth business.
Working capital: A firm with minimum needs for working capital would require less capital to be tied up, implying a higher value for the buyer. High sustainable cashflows would ensure less reliance on debt to run the day-to-day operations of the firm, as well as curtailing bad debts. Businesses with a history of good cash, debtor and creditor management attract higher multiples than those with a poor track record.

Synergies: A poor current structure could actually increase the worth of a business. Buyers look for easy wins. If a buyer identifies areas where he can make large efficiency saving, he will be ready to pay more for the business. Also, when buying a business to form part of a group, one could benefit from lower overall overheads or increased marketability of his current product range. This would be achieved by the merging of certain business functions, or the newly acquired business would compliment the current marketing and sales structure of the firm.

Selling or buying a business is a big decision in an individual’s life, so one must ensure this step is approached in a methodological manner, ensuring all relevant factors are considered in deriving the correct value. Knowing how much your business is worth is also fundamental in planning further growth of the business, enabling you to have a more specific idea of capital that can be raised through loans or issue of equity, to finance these growth plans.

This article is for information basis only and should not be used as advice. Seeking professional advice is highly recommended.

Karl Schranz A.C.C.A; M.A Financial Services (University of Malta); M.Sc Quantitative Finance and Risk Management (Universita Bocconi), Mila.n He has since taken on the role of Consultant with Victor Schranz & Associates CPA, offering Corporate Valuations, Feasibility Studies as well as Corporate Risk Management.