To begin to understand a methodology for calculating a sale value for high growth potential business, we need to start by examining the manner in which buyers see value in a potential acquisition.
I am continually amazed at how little entrepreneurs know about building buyer value in the business as part of a process of selling their business. They seem to have little appreciation for why businesses are acquired and what the buyer looks for in an acquisition. Not that I should be that surprised having spent many years now educating business owners on how to best prepare their businesses for sale and how to generate a premium on sale. But the thing which constantly amazes me is the fact that their professional advisors and business
brokers know little better.
There seems to be a disconnect between the way in which conventional business valuation is determined and the manner in which the buyer will extract value from the acquisition. Part of the answer lies in the fact that the question ‘what is the value of my business?’ neglects to ask ‘for what purpose?’ If the purpose of the question is to raise a bank loan, inform investors as to how the business is tracking or to see if the entrepreneur can bring in some external investors, then it is appropriate to determine the value of the business as a ‘going concern’.
However, if I wanted to know what a willing buyer would pay for my business, I should expect a different approach, use different assumptions and will almost certainly arrive at a different valuation.
If I am to value the business as a going concern, I will make a number of implicit assumptions about the manner in which the business is managed.
Basically, I am going to assume that the business will continue with the same management, product/market strategy and access to networks and resources.
If the external environment relating to the economy and competitors is similar to the near past, I can expect the business to continue tracking along a path similar to the most recent performance. The best evidence I have to
future performance is recent history. Calculating a valuation for the business is then a simple extrapolation of past performance. Perhaps this is the reason why valuations built on multiples of current earnings (the EBIT multiple formula) are so common.
Even in this simple application, few business owners understand the basis of a conventional earning multiple valuation or why a specific multiple should be used in a particular situation. In a recent conference, I asked a number of experienced entrepreneurs to tell me the valuation norm in their industry. The answers ranged from 1.5 to 8 times EBIT. They were surprised at the variation within their group. When asked why the multiples varied so much, they were unable to explain why. When asked how they could improve their multiple, only one or two mentioned profit growth. There was clearly a lack of understanding about valuation methodology and about the factors which influence the valuation. More specifically, they were relatively ignorant about what they
could do to substantially influence their own valuation.
However, let us change the objective. What if I want to know what value I would achieve on sale. If that is the purpose of undertaking the exercise, then why would you make the same assumptions in determining future revenue and profit?
Almost without exception, the entrepreneur leaves the business at the time of sale. Often several of the senior management leave at the same time, taking the opportunity to cash out and do something new. There is also no reason to assume that the new owner will manage the business in the same manner or not make changes in the product/market interface. You should also expect that any smart buyer will only purchase a business where they think they can bring something new to the table which will give them a premium for their knowledge, networks, resources or energy.
If that is the case, the basis for valuation on sale has to take into account
what the buyer is likely to do to the business. If, for example, we know that the right buyer can significantly improve the growth rate, market penetration and/ or profitability of the business, we should anticipate a higher value on sale than that which would be calculated for the business as a going concern.
Essentially we are being misled by our conventional approaches to valuation.
It is worth taking a little time out to consider what valuation implies about any business. The valuation basically determines what an investor would pay for the future stream of net earnings of the business. Fundamentally, it is all about investment theory.
My business is worth something (the investment) because it gives me back a series of future cash (income) payments. I can value any investment simply by applying a conventional Net Present Value (NPV) formula to the stream of future cash flows. The NPV formula also asks me to state what rate of return I require from my investment. Using this interest rate, I discount the future income values back to the present. The NPV will calculate what I need to invest to generate that stream of income using the applied discount rate. Higher interest rates applied to the same stream of future income flows will give a lower NPV.
Applied to business valuation, this tells us that businesses with higher risk profiles or higher uncertain future income values require a higher interest rate to reflect the additional risk faced by the investor. A business discounted at a 30% risk rate will be worth much less than a business discounted at 15%.
The valuation of a business is simply an application of this NPV theory. The future income streams are determined by applying a number of assumptions to the business projections. The risk rate or discount rate applied reflects the level of risk in the business or the level of uncertainty in the income projections. The
resulting NPV is the valuation of the business.
Clearly, if you change the assumptions about the future, you will change the valuation. Valuation of a business as a ‘going concern’ can be expected to be different from a valuation of a business for sale if we apply a different set
of assumptions about what might happen to the business in the hands of the buyer.
Once we make the leap to an investment theory approach, we should focus entirely on the future to determine our valuation. The only contribution our prior history makes is to provide us with some evidence to validate some of our assumptions about the future. With this in mind, let us focus on creating value for the buyer and, from this, determine an exit valuation.
Fundamental to the sale process is an understanding of the value which the buyer will extract from the business. The purchase price (value of their investment) is derived from their estimate of the future stream of income
discounted by their estimate of the risk rate or their required rate of return.
When you think about this a little more, you can see that a business which makes the effort to provide the buyer with a different, more positive, more profitable future for the acquisition, should get a higher price than simply a multiple of past earnings. This can lead to two possibilities: the buyer can extract more from the existing business than the seller or the buyer can utilise the assets and capabilities within a much larger business thus exploiting the underlying assets and capabilities much more than the seller could.
Given these possibilities, why is it that advisors and brokers force business owners to use past profits to value a business – normally using an industry EBIT valuation model which is more guess than science? The buyer does not invest in past income streams, they only invest in future ones. Our efforts in preparing a
business for sale must concentrate on how we communicate the future income
streams and risks to the prospective buyer.
If you want to extract the highest sale price for the business you should be seeking out a buyer who can exploit the business better than you can. The process of sale preparation should be to reduce risk in the business to the buyer and to create future potential for the business way beyond the current owner’s capacity and capability. By finding multiple potential buyers who can generate greater value in the business in the future than that which could be generated by the current owner, the seller can readily achieve a premium on the sale.
If you are a business owner, you need to break away from the past and concentrate your preparation on what the future of the business might look like in the hands of a much more capable and better resourced buyer. Find those buyers who can best exploit the potential in the business. By setting them up in a competitive bid, you will be able to extract the best price for your business.
In this book I am going to examine in great detail the nature of business potential which allows us to create a different future for the business and assist us to attract the premium buyer. I will be looking at different models of business growth and how this impacts on the type of sale preparation you should follow.
I will be explaining how to find the best buyers and what you need to do to bring them into a competitive negotiation. Using this process, you can be assured you will generate the best sale price possible and almost certainly one at a significant premium over a conventional valuation.
Tom McKaskill is a successful global serial entrepreneur, educator and author who is a world acknowledged authority on exit strategies and the former Richard Pratt Professor of Entrepreneurship, Australian Graduate School of Entrepreneurship, Swinburne University of Technology, Melbourne, Australia. A series of free eBooks for entrepreneurs and angel and VC investors can be found at his sitehere.
Smart Company is the leading online publication in Australia for free news, information and resources catering to Australia’s entrepreneurs, small and medium business owners and business managers.
