The science and art of valuing a small business

Accurately evaluating how much a business is worth is the most challenging part of the buying and selling process for both the current small business owner and prospective business buyer, as the question: “What is the value of this business?” is one of those best answered by another question: “Who wants to know?”.

This is according to Gerrie van Biljon, executive director of Business Partners, who explains that that there will always be two opinions when evaluating a business – that of the seller of the business, and that of the buyer. “A seller of the business, who may have spent many years, and put much blood, sweat and tears into building it, will try to emphasise the most positive aspects. If he cannot find much to be positive about in the last set of financial statements, he will find it in the future prospects of the business and build it into his price.

“The buyer, on the other hand, is almost always sceptical about what is under the hood of the business, more wary about the future of the industry on which he is about to place a sizeable bet, and, if nothing else, keen on a bargain. His valuation will inevitably be lower than that of the seller.”

Van Biljon says that there are many methods to value a business and that in some industries, there are established processes that are followed.

“For example, in the retail sector, the value of a shop is based on a multiple of its annual turnover plus its stock. Norms such as these help to lubricate deal making, but not many industries have established practices in place.

“Net asset value, the sum of the market value of each of the business’s assets, was a method commonly used in the past. This however has largely fallen by the wayside because it does not take the potential of the assets to generate an income as a fully functioning business into account. In contrast, the price/earnings method (p/e) which is most often used today, uses the ability of a business to generate a profit as the starting point of the valuation. The p/e ratio indicates how many years it will take to pay off the selling price of the business with the profits generated by it. A p/e of five, for example, means the selling price can be paid off in five years.”

Van Biljon adds that the details of any evaluation method can become quite complicated during the sale negotiation process. “There are many aspects to consider, such as whether the business has just emerged from a less profitable year, yet showed excellent profit the previous two years. The parties involved then have to agree on how to weight each year to determine the profit potential of an ‘average’ year.”

He adds that the situation becomes even more difficult if the information available is not complete or is questionable, a situation often encountered with owner-managed small businesses.

“Often the record-keeping is neglected or, just as often, income is under-declared and personal purchases disguised as business expenses in order to pay less tax. While the business owner may enjoy a slight tax benefit for a while, when it comes to selling a business, it is almost impossible to convince a sceptical buyer that the profits were actually much higher.”

Further factors, such as such conditional clauses, can also complicate the buying and selling of owner-managed businesses, says van Biljon. “Small business owners often resist conditional clauses that don’t influence the price, but these can provide some level of assurance to the buyer which can be a selling point. One very sensible arrangement is to insist that the previous owner remains on in the business for a few months to help with the handover. However in our experience, we find that many small business owners prefer to shake hands and walk away from the deal with no further dealings between the seller and buyer.”

It is advisable for both the buyer and the seller to seek the professional services of an accountant and lawyer to help guide them through the difficult terrain in search of a fair compromise. “Any well-qualified professional accountant should be able to provide good advice on how to value the business.

“Sellers should strive to present their price on real facts and figures as much as possible, the basis of which is a complete and verifiable set of books. Buyers are right to be wary, not only about the financial statements presented to them, but also about the fact that track record is no guarantee for future performance of a business.”

Van Biljon adds that occasionally the price paid for a business can be off-balance with any valuation done on paper because of some strategic consideration, such as to minimise the competition in the market. He however strongly recommends such strategic moves to only the most experienced of entrepreneurs – those who have learned both the science and the art of valuing a business.