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Business valuations – what you need to know to plan your exit

Business valuations – what you need to know to plan your exit

Quite a few years ago as a graduate within a large strategy practice, we approached strategic decision making using the Value Based Planning approach ie. which decision amongst a series of scenario’s would give greatest shareholder value ?

Whilst SME’s don’t have the budget to hire a large strategy consulting team they do have the ability to work with a SME strategic advisor who will assist in understanding which decisions will contribute to an increased business valuation.

Understanding the drivers that feed into a business valuation is key to a larger payout on exit, whether this be part of a M&A deal or business succession where entrepreneurs buy a business, build and sell it at an increased value.

The standard approach for SME’s (ie. micro businesses with 0-4 employees up to medium sized say 200 employees) is to use a multiple of earnings or “capitalisation of future maintainable earnings”.   Note, there are many different valuation methodologies commonly used in valuation of SME’s including discounted cashflow, net asset backing, or industry rule of thumb however this is not a blog about the selection of appropriate valuation methodologies.

Most SME valuations use the capitalisation of FME which is :

Enterprise value = (maintainable earnings x capitalisation rate) + net surplus assets

Maintainable earnings is your starting point and is not net profit.    To determine the true earnings of your business, you will need to ‘regularise’ and ‘normalise’ the earnings.    Sounds more complex than it is but you would look at your net profit and add back items such as ‘personal’ spending, abnormal costs such as bad debts, or material contracts that will no longer recur to name a few.

The capitalisation rate is the key component (note the capitalisation rate and earnings multiple refer to the same factor ie. capitalisation rate of 25% is equivalent to an earnings multiple of 4).   This rate is designed to be a measure of risk.   It assesses the riskiness of maintainable earnings – both current and future risks.   This assessment needs to be reduced to a % rate that reflects a reasonable rate of comparative return for an investment in the business.  What rate of return would an investor require to invest in your business ?

The difficulty lies in the fact that most SME’s are not public companies and access to comparative information is limited however a valuer commonly use publicly traded information as a ‘guide’ and discount’s or weight’s the SME business for differences based on the following criteria :

1.     Size, scale and access to markets15 – 30%
2.     Quality of Infrastructure & Management10 – 15%
3.     Lower dependency on key person15 – 25%
4.     Access to Capital15 – 20%
5.     Liquidity of investment25 – 30%

(ref. A practical Guide to Business Valuations for SME’s, Greg Hayes)

What does this tell you as a business owner ?

If you are wanting to craft an exit from your business at a greater valuation you should focus on key aspects of your business that :

a) increase normalised net profit and

b) reduce the risk weightings

For example :

1.     Repeatable and documented systems and processes that reduce key person dependency and increase efficiency.

2.     Up to date technology and systems stack to support the key business decisions with relevant & frequent staff training.

3.     An organisational structure that reduces the dependency on one person with clearly defined job descriptions, targets and KPI’s that support your business culture and strategy.

4.     A strong finance function that produces accurate and timely financial reports with up-to-date statutory reporting and governance.   At due diligence you will be asked to verify all your historic financial and future financial information including pipeline.

5.     Monthly, or at least quarterly, Board Meetings with Directors to discuss the key strategic, financial and operational aspects of your business.  This also demonstrates appropriate Governance oversight.

6.     Increase turnover of your business either organically or inorganically via strategic acquisitions.

7.     Focus on the quality of your earnings, the more predictable & consistent the greater the multiple ie. long term contracts, quality of customers, repeat business and customer churn.

If you plan your exit well in advance by focusing on the factors that drive a higher business valuation, you will give yourself the best opportunity to achieve a greater return on your investment – and don’t all business owners want that.

Reach out to one of our strategic advisors if you would like to have a chat about what your business plan for exit should include.