How to value a business
Here we guide you through how to value a business to ensure that the price you get is as high as possible.
How to value a business is an art as well as a science.
The first thing is that in a successful sale, a compelling story is just as important as healthy numbers.
Many entrepreneurs dream about the day they’ll sell their business, but few are comfortable discussing valuation with a potential buyer.
It isn’t every day that a business owner gets to sell their company, and it’s easy to get caught up in the excitement of it all.
But according to experts – people involved in both buying and selling companies – it is crucial to have a realistic valuation as a starting talking point. No one likes an unrealistic negotiator at the other end of the table.
But it’s hard – and it’s become a science led by people like Aswath Damodaran who have spent their lifetimes researching valuation.
Now, there is one tiny issue. Valuing a business isn’t an exact Science, but a combination of estimation and bias on the part of both buyer and seller.
“That moment when you meet with the private equity guy for the firsttime… and you say: ‘I want 20 times multiple’ and they say ‘how about four?’ Suddenly Barbados goes out of the window, you think they are ripping you off. The PE guys think you’re deluded,” explains Richard Bland, chief executive of Pomanda.
“A calculation of how much your business is worth using our tool allows you a sensible starting point,” he adds.
But the starting point can take many forms depending on the biases and assumptions built in the calculation.
Take the case of Brompton Bikes, the hipster bike shop that has every other banker using them, to examine how you can arrive at two different valuations using Pomanda’s tool.
If we regard Brompton as a mature business, meaning that both growth and margins will remain stable in the foreseeable future, we arrive at a discounted cash valuation (the measurement used to determine the appeal of a business as an investment) of merely £16m.
However, a second valuation that assumes the recent rise in capital expenditure to £2.5m is being used to develop the new and trendy electric model that will ultimately lead to a boost in sales and margins. With this assumption, we arrive at a sexier price point around the £70m mark.
“The difference between the two valuations is knowledge and bias around the assumptions,” explains Scott MacDonald, co-founder and director of strategy at Pomanda. “Brompton management will lean towards the latter, but a pessimistic buyer will push towards the former.”
A basic valuation is a valid conversation starter, but what are the biases or discounts that business owners must take into account? To begin with, business owners need to be aware of all the emotions they bring to the negotiations, says Simon Myers, an entrepreneur who sold his £6m digital consultancy in 2013 to a US marketing firm.
“Entrepreneurs have a very emotional relationship with their business and I think these can often get in the way of a realistic valuation of what a business is worth,” he says reflecting on his experience.
In his view, this is when an initial valuation becomes even more important. a business should be both about the science of the numbers, but also about the story built around why a business is worth however much. Investors are humans – they want the story of the business, and how this underpins the owner’s valuation. But it has to be a believable story.
“Entrepreneurs tend to either over inflate what their business is worth or even, in my experience, they might think that it isn’t worth nearly as much as it actually is,” he says. Myers adds that valuing a business is about tangible measurements on how a company performs.
But he also says that it is about things beyond the control of a seller and that may discount the value of the business. “Investors may decide, for instance, that a prototype for an electric car is more valuable than a prototype for a petrol vehicle. You may get higher multiples depending on the places your business operates or whether the company is in a sexy sector,” Myers says.
Buyers’ and sellers’ expectations on top of an emotionally charged process can present a daunting prospect for both sides, according to people who have lived through the process. It is, therefore, crucial to look at both the intrinsic value of a business through a DCF valuation, but also to analyse how the business compares to rivals in its sector, cautions Pomanda’s MacDonald.
Other elements to consider when valuing your business, including earnings before costs, or EBITDA, and how much the business turns over.
These measurements on their own are important but they are also relevant when it comes to understanding the intentions behind the acquirer, adds Myers.
“You need to understand the buyer,” he says. “If they want to buy you for your turnover, then all of the sudden those figures become much more important.”
Beyond all this, it is important to avoid the ‘man in the pub syndrome,’ explains George Pennock, managing director at Four Seasons, a family investment office with decade’s experience in valuing businesses.
“If you don’t have a valuation starting place, you start with what I call ‘the man in the pub syndrome’, which is you get [with] these business owners with no valuation experience talking to friends telling them are worth a certain amount,” Pennock says. “And they believe it.”
In his view, this is unhelpful because entrepreneurs will have unrealistic expectations which will then weaken their bargaining position against a potential buyer. If an investor sits wide-eyed with surprise at the first valuation estimate that an owner comes up, then that can be very damaging.
Trust and respect between both parties is so important to the success of a deal – but you have to start somewhere. With Pomanda’s valuation tool, entrepreneurs can play around the numbers and explore their different options for the time when the question comes: so how much are you worth? We hope you now have the tools on how to value your business.