In my work as a business broker, valuer and adviser, it's probably no surprise that most conversations with small business owners are based around a single question. What is my business worth? 

It's just not straight forward like the housing market. For legitimate reasons assessed value (for example in a business sale) can be light years apart, where as in the housing market it might be single digit percentage differences. The financial implications for business owners can be dramatic. Understanding that any business valuation is part science, part art is where you need to start if you want to realise the highest possible value when selling. 

So let me break this all down and provide an overview of how we generally derive a business' valuation.

Let’s start with something that is relatively scientific.

Typical small businesses are valued in a range of between one (1X) and five (5X) times annual profits (adjusted).

The formula is Multiple (1X to 5X) multiplied by Annual Profits

Small businesses are higher risk (i.e. very owner centric) and ill-liquid (i.e. hard to sell quickly), that’s why as a group the value range is 1x to 5X.

This contrasts with other investments that have much higher Multiples;

1. Shares on the Australian Stock Exchange.
   As at 18^th October 2024, the ASX had an estimated P/E Ratio of 21.47. A well known individual stock is the National Australia Bank Limited (NAB) and that had a 16.8.P/E ratio. This equates to investors valuing the business at 16.8X the annual dividend (call them annual profits). I understand it’s simplistic, but the takeaway is that because NAB isn’t owner-centric and can be sold quickly, investors value them more highly. In really broad terms they might pay 16.8X for NAB shares versus between 1X and 5X for your small business.
2. Cash in Bank.
   Let’s stick with NAB. At writing, their 90 day Term Deposit interest rate was 3.15% (call the interest Annual Profits). Again, simplistically, investors will invest $100 for $3.15 pa (an equivalent Multiple of 100/3.15 or 31.75X

Buy NAB shares and the value goes up and down daily, but overall are pretty stable and you can sell today. Over time it can grow in value if the bank is well managed. So, there is some upside.

Buy a NAB Term Deposit and you have, call it, 100% certainty of getting your money back plus interest but no more. So, there’s no upside.

For small business owners and advisers faced with a major decision based on the value of the business 1X to 5X is a huge range.

A business making $200K annual profit (adjusted) could then be worth anywhere between $200K to $1M.

The bad news? With the stroke of a pen you could sell your business for 2X instead of 3.5X and miss out on $300K! This would be pretty significant in terms of the wealth of a typical Australian family.

The good news? The value potential of small businesses can be increased significantly, e.g buy a business at 1.5X, improve it and sell it 3X. Now that’s a good investment! Could you do that with your NAB shares?

So, the opportunity is there to increase personal wealth via a small business.

 

If increasing your personal wealth is what you’re aspiring to achieve, here are some key pieces of essential information every owner should have in their back pocket as cornerstones of growing the value of their small business investment. They take some effort (investment of time) but don’t need to be especially complicated;

 

1. What value could you (if you had to) sell at tomorrow? If not tomorrow at least in say a couple of months. (LIQUID INVESTMENT VALUE)

 

2. What are the three most controllable important influences on
   • Your bottom line Annual Profit?
   • The Mutliple a potential buyer (investor) would pay and why? (POTENTIAL INVESTMENT VALUE)

 

3. Can you find credible information on sales of similar businesses through your own personal, business or industry networks?

 

If your aspiration is to maximise value, not to mention the ease and speed of your sale, then here a few tips based on my experience;

 

1. The value of your business, to you, will be different (often dramatically) to a potential buyer. Starting with a ‘sticker price’ 25% above your target sale value and negotiating down should not be considered your only or best strategy. When you use a headline price, you potentially lose a buyer (a strategic buyer) offering more than you want that would have been fair value for them.

 

2. Dollars after tax in your bank account can be very different to a headline offer made on your business. Don’t get too excited about an offer until you work it through with your adviser and understand your ‘dollars in bank’.

 

3. The formula for calculating value is straightforward – per above = Multiple (1X to 5X) multiplied by Annual Profits. But the same can’t be said for the inputs as there’s a lot of ‘Art’ involved in these calculations;
    
   • Annual Profits
     It’s convention to use an historical average of the last 3 or 4 years. I don’t disagree with this when the business is incredibly stable, however for many businesses that isn’t the case. Significant changes can happen quickly and, so, the last 6 months (on an annualised basis) might actually be more relevant.
   • Annual Profits
     Nearly all small business financials need adjusting (addbacks) to reflect what the business made net of personal items, discretionary items, one-off items, and so on. Your taxable income mostly isn’t the same as the Annual Profits you need to estimate business value.
   • Multiple (by way of example)
     Take 2 retail businesses making Annual Profits of $100K. One has a 5 year lease and the other a 10 year lease. Buyers will pay a higher Multiple for the second business because they have more 5 more years of earning $100K. But is the Multiple 1X higher or 2X higher? Ask 10 different small business owners and you’ll get 10 different answers.

 

4. Businesses that don’t make profits can still have value to buyers.

 

5. ‘On paper’ there are many different ways to value a small business. These methodologies are built on industry jargon. This complexity is great for the advisers who want the whole process to remain mysterious and makes it baffling for owners and buyers.
   
   If you’re stuck on understanding, as examples, the difference between Enterprise Value and Equity Value or the impact of working capital changes on the valuation, get your adviser to translate for you. You want to know how much money will be in your bank account after tax if and when the business were to be sold.

 

As a selling owner, be aware that potential buyers can also find it all too confusing. Their ‘bottom line’ is how much money they will make every month and how long they will take to pay back the purchase price.

The lesson is simple. Don’t let jargon get in the way of you understanding the current or future value of your small business investment. And if you need any advise or a chat, don't hesitate to contact me.