There are some questions that are best answered by yet another question. “What is the value of this business?” is one such question which begs the question: “Who wants to know?” as a response.
A seller of the business, who may have spent many years and tears building it, will try to emphasise the most positive aspects. If s/he cannot find much to be positive about in the last set of financial statements, s/he will find it in the future prospects of the business and build it into his/her price.
The buyer, on the other hand, is almost always skeptical about what is under the hood of the business, more wary about the future of the industry in which s/he is about to place a sizeable bet, and, if nothing else, keen on a bargain. His/her valuation will inevitably be lower than that of the seller.
I have of late been spending a lot of energy doing careful valuations of businesses that Business Partners has considered investing or better still actually made the investment. If there were a single, universal formula to measure the true market value of a business, the job would be much easier.
But there are many methods to value a business. While each has its own logic and emphasis, the variety of methods does nothing to make the haggling around buying, selling or investing in a business any easier even though they inevitably form the basis of such negotiations.
In some industries, there are established norms on how to value a business. For example, the generally accepted method in the retail sector—the value of a shop—is based on a multiple of its annual turnover plus its stock. Norms such as these help to lubricate deal making, but not many industries have them.
Net asset value, the sum of the market value of each of the business’ assets, was a method commonly used in the past, but has largely fallen out of use because it does not take into account the potential of the assets to generate an income as a fully functioning business.
In contrast, the price earnings (P/E) ratio method often used today, uses the ability of a business to generate a profit as the starting point of the valuation. The P/E ratio indicates how many years it will take to pay off the selling price of the business with the profits generated by it. A P/E ratio of five, for example, means the selling price can be paid off in five years.
The details of any method can become quite complicated in the cut and thrust of a sales negotiation.
What if the business has just come through a bad year, while the previous two years had shown excellent profit, for example? The parties have to agree on how to weight each year to determine the profit potential of an “average” year.
The situation becomes so much more difficult if the information available is not complete or is suspect, a situation that Business Partners International (www.businesspartners.mw) routinely encounters with owner-managed small businesses. Frequently, the record-keeping is neglected or, just as often, income is under-declared and personal purchases disguised as business expenses to pay less tax.
However, this eventually catches up with the business owner. They enjoy a slight tax benefit for a while, but the honeymoon ends when it comes to selling their business or getting investment as it becomes almost impossible to convince a skeptical buyer or investor that the profits were actually much higher. If you could lie to the tax collector, why not to someone who wants to buy or invest in your business?
Further factors complicate the buying and selling of owner-managed businesses.
For instance, small business owners often resist conditional clauses that don’t influence the price, but provides some level of assurance to the buyer. One very sensible arrangement is to insist that the previous owner remains on in the business for a few months to help with the handover, but many small business owners “just want to shake hands and get out of there”.
It is a good idea for both the buyer and the seller to seek the professional services of an accountant and lawyer to guide them through the difficult terrain in search of a fair compromise.
Sellers should strive to present their price as much as possible on real facts and figures, the basis of which is a complete and verifiable set of books. Buyers are right to be wary, not only about the financial statement presented to them, but also about the fact that the track record is no guarantee for future performance of a business.
Occasionally, the price paid for a business can be quite off-kilter with any valuation done on paper because of some strategic consideration. The buyer may wish to decrease the competition in the market, for example, or may see some hidden upside in joining the business with his own. Such strategic moves are best left to only the most experienced of entrepreneurs—those who have learned both the science and the art of valuing a business.
Fosters Kalaile is Malawi Country Manager for Business Partners International, a specialist risk finance company for formal small and medium enterprises (SMEs)