Valuing a Business For Sale

How to value a business for sale - There are many ways to value a business and to derive an asking price.

We suggest that four methods cover most options:

• The capitalised value model
• The net profit model
• The appraised value model
• The multiplication model

The Capitalised Value Model

The Capitalised Value model is based on the potential for the business to earn a profit. Capitalised Value is defined as the amount of money that you would need to invest in an interest bearing account in order to earn an income equal to the profit potential of the business.

To calculate the Capitalised Value, divide the projected annual profit by a specified capitalisation rate:

Capitalised Value = Projected Annual Profit
                                     Capitalisation Rate

The calculation depends on two variables - the projected annual profit for up to 5 years and the capitalisation rate.

An estimate for Projected Annual Profit can be obtained from past year's financial statements. Generally, it is net profit less your salary/wages and it is a projection. Some commentators use EBIT (earnings before interest and taxes) others use EBITD (earnings before interest, taxes and depreciation).

Capitalisation rate reflects the return on a buyer's investment and is related to the amount of risk with the business. If the business were as safe as a Bank deposit, you might use current interest rates (5-10%) as the Capitalisation Rate. However, few if any, businesses are free of risk.  The more risk, the higher the Capitalisation Rate. Rates usually range from 20 to 50%. 

Use the Capitalised Value to set the sale price of your business. It presumes that the Projected Annual Profits can be attained and that the Capitalisation Rate accurately reflects the risk and thus the return on investment.

The Net Profit Model

Valuation methods that try and predict how much money your business will make each year for the next three to five years invariably involves a lot of assumptions and uncertainty.

An easier way is to look at how much money the business made in the last year and simply multiply this value by a number.

The Net Profit Model suits businesses that have a trading history over a number of years. It is easy to justify and easy for the purchaser's solicitor to follow.
From the past financial year, extract these figures:

          Value of Sales
Deduct Expenses (before depreciation, interest, tax, personal drawings)
Equals Net Profit

For a weak business, set the business value (asking price) equal to the Net Profit. 
For a strong business, multiply the Net Profit by 3 to obtain the business value (asking price).

The rule for using rule-of-thumb formulas for pricing a business is - don't use them. The problem with rule-of thumb formulas is that they address few of the factors that impact a business's value. They rely on a "one size fits all" approach when, in fact, no two businesses are identical.

If you originally purchased the business, ask yourself how your present asking price differs with the original purchase price. Does it reflect all that you have put into the business since purchase date?

The Appraised Value Model

For any business, the Business Value = Assets  + Stock +Goodwill but the
Asking Price = Assets + Goodwill with Stock being sold as a separate item (although in "walk-in walk-out" businesses, stock is included in the asking price).

Assets and stock relate to tangible items that can be sighted and valued with relative ease. Goodwill is more difficult to value but is equally important when valuing your business. However, it has no value unless it can be proven and also transferred to the purchaser.

The sale price of most small businesses is based on the value of assets being transferred plus the value of goodwill. Asset and stock values can be obtained from the lists that you will have prepared. Then set a value on each of the items that make up the Goodwill component and total them to get a sale price for the business. This approach has the advantage that, should the purchaser query the Goodwill value, you can defend the value that you have set on each item that is being transferred.

Exclusivity

• Trade name
• Unique location
• Unique methods and processes
• Exclusive product range

• Exclusive distribution network
• Internet Domain Name and Web page
• 0800 telephone number.

Suppliers

• Names, addresses, and contact persons of all suppliers
• Special contracts, discounts and other promotions obtained from suppliers.

Customers

• Existing sales contracts
• Customer lists and databases
• Telemarketing lists and databases.

Marketing and Promotion

• Unique Signage
• Advertisements, Brochures, Mailings, Leaflets that can be shown to work
• Radio and television advertisements that can be shown to have worked.

The Multiplication Model

Goodwill can involve intangibles that are not reflected in Net Profit. Net Profit from a financial statement may be unreasonably low in businesses that have been trading for only a short time or for businesses that have extraordinary circumstances (perhaps expenditure made but not yet recovered in sales, or businesses that work from home).

The Multiplication model attempts to set a value on intangibles. These intangibles usually reflect values assigned by the seller and cannot be easily discussed with the purchaser. For example, what value do you place on working from home, what should you be paid relative to what the business is actually paying, just how risky is the business that you are going to sell?

Net Profit (from financial statement)                   $____________
Plus wages actually paid
Plus interest and depreciation
Plus the value of working from home
Plus other unusual expenses
that have decreased net profit                 $_____________

subtotal A      $_____________
Less an accurate wage for your efforts                        
Less unusual income that has inflated
net profit                                                $_____________

subtotal B     $_____________

Adjusted Net Profit (Subtotal A-Subtotal B)         $____________ 

Multiplication factor

When valuing a business that is based on working from a domestic home, consider the value you place on cost savings from not having to purchase business clothes, transport to/from work, benefits of having a home office, repairs and maintenance, and housekeeper/child care.

Use the Multiplication method to cross check values obtained by the Net Profit and Appraised Value Methods. Think carefully before disclosing your work sheet calculations to the buyer.

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