How much is a business worth?
There are three (3) dominant considerations that determine how much is a business worth.
At a glance: How much is a business worth is largely a consideration of:
- Profits in the business
- The business potential for future profits
- The perceived risks in the business
If you are a buyer, you may assign different weighting on the above considerations, and this will affect the price that you are willing to pay for the business. Business value is often expressed as a multiple of Earnings Before Interest and Taxes (EBIT). EBIT is simply the net income excluding the interest expenses paid on debt and taxes payable.
1. Profits in the business
Profits in the business is probably the most well understood, and carries significant weight with most buyers. To prove the profits, business owners should keep meticulous financial records and up-to-date financials that may include the Profit & Loss Statements, Business Activity Statements, bank statements, merchant facility statements, supplier invoices, accounting records and balance sheets.
Business benchmarks help you work out how one business compare to other businesses in the same industry. Buyers should compare the business' financial metrics against industry financial benchmarks, such as the ATO Small Business Benchmarks. Business benchmarks can help to cross-check alleged profits in the business, and identify business issues.
Profits derived from residual income is more likely to inflate the value of the business compared to profits derived from one-time transactions. This is because residual income is seen as lower risk and more consistent. Residual income can come from subscription revenue, rental books or commission trail books and they can take years to build.
Even big businesses are introducing some form of paid subscription program to create residual income. Some notable examples are Club Jetstar, Amazon Prime, and Costco's annual membership.
Business owners should begin with the end-in-mind when they buy or start a business, and have a business plan to create residual income in the business.
2. The business potential for future profits
To identify future potentials, buyers often compare past financials to analyse financial metrics. These metrics indicate trends, which in turn identify future potential or future problems. Two of the most important metrics are those around working capital and cash conversion cycle.
Although buyers are unlikely to uplift the offer price significantly for unrealised potential, negative trends in the business on the other hand can severely depress the value of a business. Business owners should work with a specialist to analyse their business financials for the most recent three (3) years, identify any negative trends, and take positive steps to turn these trends around in the coming 12 to 24 months.
Often these negative trends are only picked up by a commercial lending specialist when a potential purchaser applies for a loan to buy the business, or the business owner applies for a business term loan or line of credit. The commercial lending specialist is typically required to analyse the business financial metrics as part of the application process to the lender.
3. The perceived risks in the business
The higher the perceived risks in the business, the lower the EBIT multiple on the value of the business. Real or perceived risks in the business can result in severe discounting on the EBIT multiple.
Risks can come in any form. They could be, but not limited to:
- Profits in the business
- The business potential for future profits
- The perceived risks in the business
- Compliance and accounting risks
- Financial mismanagement and high levels of unpaid invoices
- Key persons and employee risks
- Potential or existing lawsuits
- Risk around market conditions and competitors
- Legislative and government policy risks
- Technology risks
- Supplier chain issues
- FX (currency) fluctuation risks
- Disputes between business partners or key persons
- Coupling personal and business finances
In doing proper due diligence, buyers should have a check list to identify risks in the business. Business owners looking to sell their businesses should perform a reverse due-diligence and de-risk the business as much as possible. Unresolved risks in a business can destroy much of the value in the business, and/or even result in no buyer interest.
Types of buyers
Different types of buyers assign different weighting to the three (3) dominant considerations in pricing a business. In the market, there are broadly two (2) types of buyers:
Cash buyers and Strategy buyers.
Cash buyers places a higher value on profits, while strategy buyers assign a higher value on realising business strategy (and potential) from buying the business. Cash buyers and strategy buyers may offer significantly different prices for the same business.
As a business owner, you should strive to know WHO you are selling to, if you wish to calibrate your business for the best possible price. As a buyer, you should understand WHO the competing buyers are on the market so as to avoid over-paying for the business.
The information on this website is provided for general information only and does not take into account your personal situation. You should consider whether the information is appropriate to your needs, and where appropriate, seek professional advice from financial, legal and taxation advisers. Although every effort has been made to verify the accuracy of the information, we disclaim all liability (except for any liability which by law cannot be excluded), for any error, inaccuracy, or omission from the information or any loss or damage suffered by any person directly or indirectly through relying on this information.