Valuing your business – when, why and best practices

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Why get a valuation for your business?

There are many reasons to value your business, and they fall broadly into four categories which we have outlined below. The reason for valuing your business affects the approach you will choose for valuing the business as well as how often you would do it, and whether you might get external help.

Selling your business

If you have plans to sell your business, you will want to know the economic worth of your business so that you can get a price you are happy with. Different buyers will have different approaches to valuing a business and may value certain things more or less than you do. 

Valuing your business in order to sell it creates a starting point for any negotiation. And once you understand the key drivers of your business’ value, you can make a better-informed decision on what to work on to maximise its perceived value or help pick the right timing for a sale.

Raising finance – getting loans and equity investment

Knowing the value of your business is important for investors or banks considering lending money to your business or buying your company’s equity. It is a lot easier to attract investment if you can provide clarity on the financials of your business, in particular, what it is worth.

For UK tax purposes

There are many scenarios where you need to be able to provide a valuation of the business and its shares to satisfy HMRC tax rules, most commonly capital gains tax and Stamp Duty which applies when shares in a business are bought and sold.

The approach for valuing shares for tax purposes is notably different to the other purposes listed and will normally be a lower valuation because intangible value, such as goodwill or brand value, is usually not considered. 

HMRC will not normally pre-review a valuation ahead of a share transaction, so it is important to have a reliable valuation to reduce the risk of facing unexpected tax consequences. The exception to this rule is for employee share schemes, where you can apply for a valuation approval to get some certainty on the tax treatment for the scheme.

As a measure of business performance

It can be useful to know how your business’ value is changing over time as a measure of your company’s financial health. Some owners will link their management teams’ goals or bonuses to the value of the business, both as a measure of success and as a motivator.

It is crucial to decision making as the value of your business impacts how much capital you can access and how, which may drive decisions around expanding into new markets, services lines or geographies. It also informs you on when might be a good time to start approaching brokers and potential buyers if exiting your business is a route you want to explore.

What affects business valuation?

Fundamentally, the value of a business is the total worth of its net assets plus the perceived value of its future earnings.

First, we will break down the concept of net assets, the total value of what the company owns and owes, into tangible and intangible assets and liabilities, which is what you would see on your company balance sheet.

Next, we will look at the value of future earnings. There are many different approaches to estimating the worth of future earnings, and this is why valuation approaches vary based on factors like industry or the size of the business.

Tangible assets and liabilities

Tangible assets include physical assets such as equipment, buildings and inventory a business owns, and non-physical assets like cash held at banks, loans owed to the business, and investments. Examples of tangible liabilities could be a loan owed, accounts payable or taxes payable.

Intangible assets and liabilities

Intangible assets are usually non-physical assets which are best described as a type of intellectual property. They can often be far more valuable than the tangible assets of a business and include:

  • Patents
  • Copyrights
  • Trademarks
  • Franchises
  • Goodwill

Estimating the value of intangible assets is often a lot more complicated and subjective in nature. Of the list of common intangible assets listed above, goodwill is usually the hardest to value but is often a really important aspect of a valuation, especially if you are thinking about selling your business.

What is Goodwill?

Goodwill is a premium paid by the buyer of a company over and above the fair value of the company’s net assets and liabilities.

Why would a buyer pay above fair value?

There can be many reasons, such as a strong synergy for the buyer in obtaining the company’s patents, customer base, or technology; a benefit in removing a competitor; or simply the buyer sees extra value in the company’s management team, processes, connections, know-how, etc.

How can you maximise goodwill?

This is really a question of how can you maximise the price you can achieve when your business. And the answer is to make your business as attractive as possible for potential buyers. This means two things in practice:

  1. Identifying where there is goodwill and making them super clear to any buyer
  2. Ensuring that this goodwill is tied to the business and not you personally

If you are serious about selling your business, you will benefit from having a strategy in place to extract you from the business. In other words, ensure that goodwill is dependent on the business rather than you personally.

  • Sales – are leads generated from personal contacts or based on the brand and pricing strategy?
  • Marketing – does it focus on you or the brand and products?
  • Partners and referrals – are the relationships personal or commercial and formalised?
  • Processes – is there key-man risk, or are processes documented and scalable without your involvement?
  • Management – could the business make decisions without you?
  • Contracts and agreements – are they personal spoken agreements or formalised with the business?

The earlier you are able to start placing the business as the central driver of success for your company’s various functions, the better. You will benefit from higher perceived goodwill and a greater number of potential buyers, both of which contribute to a higher potential sale price.

Business valuation techniques

There are a few approaches to how to value a company, and we will go into detail here about how each one works and when it might be appropriate to use. Often, a business valuation draws on multiple approaches to arrive at a reasonable valuation.

Price to earnings ratio

Take the annual profit of your business and multiple it by a suitable price to earnings (P/E) ratio. To find an appropriate P/E ratio, you will look at comparable companies in your industry and make adjustments based on factors like your business’ size, growth rate, variability of earnings, etc.

This method is most appropriate for businesses with an established track record of sustainable and consistent profits.

Entry cost

Sum up the costs to set up a similar business to the one being valued from scratch. Factor in everything that would go into getting to where the business is today, so include all start-up costs, tangible assets, how much it would take to develop your customer base, and recruit and train staff.

This method is most appropriate for early-stage businesses with replicable business models.

Asset-based valuation

Work out the total value of all of the assets and liabilities of the business. You will need to make realistic adjustments for assets, such as lowering the value of old stock or equipment (in other words, factoring in depreciation) as well as changes in the value of investments or property the company owns.

This method is most appropriate for established businesses with a high asset base, like property companies or manufacturers.

Discounted cash flow

Model the future dividends your company would be able to pay based on its cash flow and discount the value of those dividends to give an equivalent value of the dividend today. You discount the value of future dividends to factor in the cost of having the money tied up in the company compared to other investment opportunities. Commonly, for small businesses, you would forecast dividends 10 to 15 years ahead and use a discount rate of 10% - 25% depending on the riskiness of the business.

This method is appropriate for businesses with predictable cash flows, commonly utility companies. In ecommerce, this could be subscription or technology companies with stable and reliable business models which are reasonably insulated from competition or other disruptions.

Turnover ratios and industry rule of thumb

For some industries, there are generally accepted approaches and rules of thumb that apply to valuations, such as simply taking the annual turnover and multiplying it by the appropriate ratio for that sector.

For example, for accountancies, valuations are commonly based on taking annual revenue and multiplying it by a factor of two or three. Often turnover can be a more useful reference point than profit in sectors where cost bases are more predictable. A profit-based approach would likely undervalue a business with a relatively high cost base if buyers can be confident that the cost base could easily be brought in line with industry norms.

This method is appropriate for businesses that are similar to other businesses in their sector and where that sector has a well-defined rule of thumb.

When should I get help and who can I go to?

This comes back to what the reason is for valuing your business.

Selling your business can be a life-changing event, so we would recommend seeking the help of your accountant and speaking brokers. We keep a close eye on active brokers and aggregators in the market and can help you identify a trustworthy and competent broker or an aggregator or buyer who could be a good fit.

For any share transactions including new share issuances, other than transfers between spouses, a taxable event occurs for which you would need to have a valuation for the business. The size of the transaction and complexity of your business will dictate whether it is worth seeking expert help or attempting to DIY a valuation.

If offering shares to employees as part of a share incentive scheme, we would highly recommend taking advice from an expert as there are tax consequences for employees and employers that can be optimised if the right steps are taken in advance of issuing shares. We can help you in setting this up, as well as recommend trusted providers we know provide a consistent service.

If any of these apply to you, get in touch with us and see how we can help.

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