Business owners thinking about selling their business often ask us, “What is my business worth?” For many owners, the answer is an unpleasant surprise, as the value is much lower than they think. Understanding what impacts value and building a strategic action plan to make the changes that increase that value can mean the difference between a successful outcome and a disappointing one. Moreover, since implementing these changes takes time and energy, it is important to get started months or even years before you plan to sell. Below is a formula that can help you determine the value of your business as well as a framework that shows how risks and strategic assets of the business affect its value.
Calculating the Value of a Business
In simple terms, the valuation formula for a business is the company’s profit times a multiple:
Valuation = Profit x Multiple (“V = P x M”)
In the formula above, “P” represents profit, the historic performance of the business, while “M”, the valuation multiple, represents its future earning potential. While business owners know how to impact profit — by increasing sales, improving margins or reducing costs — they have little, if any, training in how to improve “M”.
Every industry has an average valuation multiple — an industry benchmark — that’s used to compare one company against another. Businesses with higher multiples are considered the best performers while those with lower multiples are underperformers in the industry.
While growing ‘P’ is important, we recommend also focusing on ‘M’ because it will both increase future profit and result in dramatically higher valuations.
Above and Below the Line Value Framework
Here is a framework you can use to understand the factors that impact the valuation multiple of your business. We call this our “above-and-below-the-line” framework.
The horizontal line in the diagram represents the industry average multiple. This “line” is the starting point to determine your business’s valuation multiple. If a business looks exactly the same as its competitors, then both will get the same multiple. However, there is a reason that some businesses sell for multiples lower than the industry average and others sell for multiples that are higher than the average. Your company’s position along the vertical axis will determine your “M”: the valuation multiple of your business.
Items below the line are business risks that result in a discount from the industry average multiple and will drive the multiple down. Examples of business risks include excess costs, concentration of revenue, underperforming assets, hidden liabilities, management problems and external factors. Identifying and correcting items below the line minimizes any discount from the industry multiple norm. Likewise, items above the line are strategic assets that increase equity value by providing the platform for the future growth of the business. Examples of strategic assets include unique business culture and processes, transferable intellectual property, and brand.
These factors, in addition to impacting the value of the business, can also in some cases make the difference between getting a business sold and not getting it sold.
Let me provide an example. A small technology company with unique software was approached by a global technology company wanting to jump start its entry into a new market. During due diligence, the buyer discovered that the seller had used independent contractors to write its software without securing intellectual property rights from them. While using independent developers is standard practice in the industry, it is also standard practice to get the developer to assign the intellectual property rights. Without the assignments, the seller could not prove it owned the software. Rather than have a valuable strategic asset, the seller had significant business risk. The seller assured the buyer that it could obtain the requisite assignments of intellectual property and release of all claims, but it would take at least three months to get it done. The buyer did not have time to wait and moved on. The company was not sold and is now out of business. Had the seller identified and fixed this issue prior to starting the transaction, it might have closed the sale.
Owners should undertake a full assessment of the current status of their business before starting a sales process, because all these changes take time and energy. You must identify, prioritize and tackle the issues that you find and be ready for your transaction. If you are not prepared, it is extremely unlikely that you will reach your goal and have a successful transaction.
Marty Jaffe, a Partner with Assay Advisory, was most recently the CFO for an international consumer products company. Assay Advisory helps owners of privately held businesses increase their equity value before a sale. Call him at 415-906-6070, X240 or email: [email protected].