Valuing a Small Business in the UK – What You Need to Know
Remember Snugglebundl? Don’t worry. You’re forgiven if you can’t.
Snugglebundl made a brief appearance on TV’s Dragons’ Den as the world’s first baby-lifting blanket.
The product initially made a good impression. Interior design entrepreneur Kelly Hoppen described David Solomons and Mike Edwards’ concept as a clever one.
But the pitch came to a dead end when the businessmen, whose product retailed at £39.99, valued their company at £500,000. Peter Jones suggested a ‘carrier bag for a baby’ wasn’t a business concept worth half a million pounds.
Ultimately, all five dragons weren’t convinced by the valuation. Jones believed the returns would never be strong enough and Duncan Bannatyne thought the firm could make a profit, but would never be valued at £500,000.
How to value a small business in the UK
Regular viewers of Dragons’ Den will be no strangers to these over-enthusiastic valuations. Determining the value of the small businesses that appear on the nerve-shredding BBC programme is tough with such fledgeling operations, and overvaluations are common.
So how do you value a small business for purchase in the UK?
It’s no small task. As well as the figure on the balance sheet and the tangible assets, such as machinery and vans, you’ve also got a whole host of intangibles. These might include things such as branding and strength of client relationships.
Why would you value your business?
There are several good reasons why you might want to value your business:
- You want to sell it
- You’re desperate to know how much you’ve managed to grow it
- You want to secure investment in your business
- Coming to a fair price for employees wishing to buy or sell shares of the company
- You want to expand and help secure funding
Whatever your motivation, knowing what your business is worth can help you with your next steps.
Your goal should be to establish a valuation that does justice to your firm — one that doesn’t sell you short. By the same token, the valuation shouldn’t overestimate the worth of the business. Finding the right balance might involve combining established valuation methods.
Business valuation – factors
Some aspects of a business are easy to value, but there are also intangible assets that are less easy to quantify. As well as stock and fixed assets such as buildings and machines, you could also consider:
- The reputation of the business
- The value of the clients
- Circumstances of sale
- Time in business
- Type of product
- Quality of employees
Since these are intangible factors, an accurate valuation might be difficult. But there are techniques you can apply to help you get there.
How to value a small business for sale
It’s common to value businesses by their price-to-earnings (P/E) ratio. This method is best used for established concerns with good profits.
Working out the ratio can be done using profits. High forecast growth can point to a higher P/E ratio, as can a track record of repeat business.
If your business has post-tax profits of one million pounds and has a P/E ratio of five, you would value it at £5,000,000.
Methods for getting the right P/E number vary. A technology start-up might attract a high P/E ratio, as this type of business is often high growth.
High-street bricks-and-mortar businesses, such as estate agents, might have a lower P/E ratio as they’re probably quite mature businesses.
If your company is ‘quoted’, shares are easier to trade, which makes it more appealing to investors. A small, unquoted company will typically have a much lower P/E ratio than a quoted business.
P/E ratios can differ vastly, but ratios suggested by business advisors tend to range between four and ten.
Cost of entry
P/E ratio too tricky? Cost of entry might be easier. Imagine your business didn’t exist. What would it cost you to set it up tomorrow?
There are a few things to remember. Like all those start-up costs, tangible assets and product design and development. Then you’ve got marketing costs, recruitment and training.
Next, consider how you could save money. If your business is based in London, how much money could you save by basing it in Glasgow? Could you also use cheaper materials? If so, deduct the appropriate figures from your total.
Thought of everything? Congratulations. That’s your valuation.
Another way to value a small business for purchase is through asset valuation. This method is often appropriate for strong, stable businesses with plenty of physical assets. Property and manufacturing businesses are good examples.
For an accurate asset valuation, you should establish the business’ Net Book Value. The NBV comprises the assets that are logged in the company’s accounts.
But don’t forget to factor in the economics that governs those assets. Tweak the figures according to the actual value of the assets. This might include old machinery that’s dropped in value or property that’s risen.
A business’ accounts tend to show the net book value of the business, which is assets minus liabilities. However, they might not take into account such things as inflation, appreciation or depreciation. Make sure all your asset values are up to date.
Asset valuation tends to result in the lowest value for a business. That’s because it doesn’t take goodwill into account. Accountants define this as the difference between market value (what someone is happy to pay for it) and its cold asset value, which is simply assets minus liabilities.
Discounted cash flow
If you’re up for a challenge, you can value your business according to discounted cash flow. It’s a complex option that depends on a little crystal-ball gazing. It’s a good fit for established businesses with predictable cash flows, such as energy companies.
To establish the value of a small business through discounted cash flow, you’ll need to come up with an estimate of what future cash flow might be worth today. Get to your figure by adding dividends forecast for the foreseeable future, then tack on a residual value for the end of the period.
Use a discounted rate to work out today’s value of each future cash flow. This takes into account risk and the money’s time value. In short, time value is based around today’s pound having more value than tomorrow’s, owing to its earning potential. The discount interest rate tends to vary between 15 and 25 percent.
Just to confuse you even further, you can express discounted cash flow in an equation:
CF = Cash Flow
r = discount rate
One of the problems with the DCF approach is selecting the cash flows to be discounted when we’re dealing with large or complex investments, or where investors can’t get access to future cash flows.
Valuing a company this way is chiefly based on cash flow that will be available to new owners. If DCF analysis is constructed around dividends received by minority shareholders for public stocks, that would normally show that the stock is bad value.
However, DCF is a good way of assessing projects or investments that the business or the investor can confidently forecast.
Rules of thumb
You can also value your business based on industry rules of thumb. If your sector is one that sees a lot of businesses bought and sold, there might be particular rules of thumb you can use as a guide. Profitability won’t be a factor.
For example, the retail sector has a number of rules of thumb used for valuations. These take into account numbers such as turnover, footfall, and outlets.
The rule-of-thumb method works well for buyers to put a value on a business according to how they intend to put their own stamp on a business and bring it up to an industry standard.
Value based on intangibles
You can even value a business based on intangible assets. This, surprisingly, is a good way of putting a number on a company, as your business is worth only what someone else is willing to pay for it.
If your business has great relationships with suppliers or clients, a buyer might place a high value on that. And if the buyer can’t supply their own management team, providing your own existing team could give them a huge leg-up.
Ultimately, when putting a value on your small business, you want to cut down on risk. Of course, every potential buyer could interpret risks differently, which will affect the value. As the business owner, the trick is to pre-empt and minimise the risks.
How to improve the value of a small business to buy
So how do you improve the value of your small business? Going through the process of valuing your firm can be useful. It can prompt you to identify areas that can be improved. You can achieve a favourable valuation by:
- Having a clear business plan that shows how you intend to reach short-term and long-term goals.
- Minimising risk: don’t put all your eggs in one customer basket, for example.
- Improving your processes: how do you store information? Do you have a good customer relations management (CRM) system? The more evidence you can present that the business is well run, the better placed you’ll be.
Business value calculator
If you want a rough idea of how to value a business for sale, you could try one of the many online calculators.
Ultimately, it’s up to you to decide what will work best for the type of business you run and the sector you occupy. One business’ meat is another one’s poison. Choose carefully which business-valuation method will work best for you.
Then buy that pool villa in the Maldives.
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