For many business owners, their business is a major component of their overall personal wealth and in many cases will form a significant part of their retirement funds.

One of the biggest challenges facing business owners is understanding the value of their business, and the business drivers, to ensure that they always have their business “ready for sale”.

A purchaser will only pay what the business is worth to them. Recognising the basics of business valuation will ensure owners’ expectations are realistic, and help avoid disappointment and unnecessary stress during a sale process.

The main factors affecting the value of a business include the certainty of future profits/cash flow and risk. Valuers normally try to assess future profitability or “maintainable earnings” and then apply a capitalisation rate to calculate value.

Capitalisation rate

A capitalisation rate is effectively the rate of return an investor is likely to demand to invest in a business within a certain industry and based on the profit and risks of the business.

The capitalisation rate reflects the degree of certainty of the business’s sustainable profitability or, in other words, the degree of risk that the expected future profit may not be realised.

This is usually reflected as a multiple of the net expected future annual sustainable earnings.

Valuation methods established as “industry norms” or “rules of thumb” are considered an indication of value only, and in my view the application of this methodology is flawed in many cases.

Strategic value

A business is likely to be more valuable to a competitor than if it is sold to a party who will become another participant in the industry. This is known as strategic value.

Competitors may be able to extract obvious savings in areas such as rent and personnel, as well as economies of scale, which means that the profitability of the business for sale is significantly more as the competitor does not have to duplicate costs.

Plan to maximise value

The key to unlocking the full value of a business is planning, and this means investing time and effort in preparing the business for sale.

Profitability and business risk

Profitability matched by dependable cash flow, is an important element to consider when determining a business’s value. However, not all businesses with the same profitability will have the same valuation.

The different is risk, particularly if businesses are more dependent than others on the business owner to achieve profitability.

This is a very important issue when trying to sell a business.

In addition, a business that has many customers versus a business that relies on a small number of key customers is likely to be considered less of a risk, as the loss of one key customer can have a big impact on the profitability of a business.

A business with a key supplier also has considerable risk as the business carries the risk of the supplier’s business including pricing, service, and delivery.

Cash flow

If the business has a regular and dependable positive cash flow, the business’s value is likely to be enhanced. For all businesses cash flow is a paramount importance.  It is therefore an aspect of the business that all business owners should strive to improve in order to increase the value of their business.

Financial records

It is important that business maintain reliable accounting records and can produce current financial accounts.

When planning for a sale, the business records should correlate with what would be required in a due diligence process to be conducted by any potential purchaser.

Business structure

Reviewing the business structure is important because the correct structure may directly increases the “after-tax” value of the business.