There comes a time in the life of many a small businesses when the owner wants out.  There can be a variety of reasons; retirement, the call of a new opportunity or simply boredom.  This is the point where the owner calls in his accountant and asks that dreaded question “How much is my business worth?”

The accountant, more often than not, will have to explain that there isn’t a quick an easy answer.  That there are so many conflicting valuation methods, each of which gives a different result.  Of course, none of these will satisfy the frustrated owner who will quote the story of his nephew who made a fortune selling his six-month-old dot-com.

So why is it so hard to value a business?

Let’s start by looking at some of the usual methods used by accountants:

Net Asset Value:  This simply takes an open market or replacement valuation of what assets the business owns, less any liabilities.  Basically, it represents what could you get for the factory, or the shop, or those old vans outside.  Not very exciting but easy enough to work out.  Even then, it can be misleading.  A potential purchaser may look at your inventory and conclude that you’ve got too much of the wrong stuff, for example.

Discounted Cash Flow:  This is a lovely one for the spreadsheet jockeys.  Take the future ongoing cash flows that the business will generate and discount them to a net present value.  It is a “return on investment” calculation.

Dividend Basis: I’ll skip this as it is irrelevant to an SME – and almost irrelevant elsewhere as it ignores the value of undistributed profits retained in the business.

Price/Earnings multiple:  This is the fun one and the most popular.  Take the profit of the company, adjust for any one-off issues, and multiply by a PE (price to earnings) ratio.

Now, PE ratios can vary enormously.  Smaller businesses often have PE ratios of around 3 to 5.  Larger businesses can have PE ratios of maybe 12.  Ratios also vary by sector and by country.  There are huge teams of people in The City calculating and analysing these ratios in order to figure out how to value a business – and they have been arguing about it for years.

So, the most popular method of valuing a business is to take the profit and multiply it by a huge poorly defined fiddle factor.  Why is that?

The reason lies in the fact that valuation methods start with accounting measures based on an internalised, introvert perspective.  The classic accounting mistake of knowing the price of everything but the value of nothing leads to the need for a huge self-defined multiplier.

As a business owner you need to be looking outwards.  If you can understand why PE ratios vary then you can start to manage them as part of your business strategy long before you want to sell up.  You can also use the reasons behind PE ratios to seek out potential buyers.  Businesses are bought for very different reasons to why they are sold, so let’s look at some example motivations that may push up the PE ratio:

Buying Talent:  You’ve got a great team – and great connections with outside suppliers – but, because your business doesn’t have enough funding, they are not achieving what they could.

Buying lack of Talent:  You may have potentially a great business but you’re doing a bad job of running it.  Someone may think they can do a much better job than you.

Supplier security:  Your business may be a key part of the route-to-market for one of your suppliers.  They may buy you in order to secure that chain.

Customer security:  As above but the buyer is the other side of you in the chain.

The above four are not major influencers.  Talent can be obtained elsewhere, supply chains can be rebuilt and, if you were really that bad, you would probably have gone bust anyway.  Let’s look at four more:

Complementary product:  Another company may be envious of your undersold product.  They may be able to push your product through their existing distribution network and customer base.  You may be selling 10k units a year in the UK but the market in the USA may be for 100k units.

Complementary channel.  Another company may be envious of your underutilised distribution network, customer base and relationships.  They may be able to push their existing products through this route to market.  Your special relationships may be bringing in £50 net profit for each of your customers.  However, another company may be able to use this channel and make £500 per customer.

Intellectual property:  Do you have IP that can be applied to other products and markets?  This could be your most valuable asset.

Growth potential of your marketplace: Take two markets.  The first is expected to grow at 10% per annum for five years.  The second will shrink by 10%.  The 5-year NPV of the first market is 40% higher than the second.  The PE ratio of businesses in those different markets will vary by the same proportion.

This second group of four are the real gems.  They indicate that you have a scalable business.

The first and third are interrelated – you will have to have protected any IP in your product for someone to prefer buying you rather than just copying you.  The second and fourth are also interrelated as they are the key drivers behind ultra-high PE ratios on dot-com and social media businesses.  Your sleepy little business may be just what someone is looking for.

For completeness, I’ll cover a couple more:

Rival – buying market share.  Although, in effect it is a special case of the complementary scenarios.

Rival – preventing a third party.  A rival may buy you simply to prevent a third party from carrying out the four strategies listed above.

So, the lesson for you entrepreneurs is that there is a methodology for maximising your potential PE ratio:  Focus strategically on building a strong customer network, protect your IP, and operate in a growth market.  Do that well and you can create massive value that can be unlocked when you sell.

Any bad news?

Well, yes there is.  There are factors that can reduce a PE ratio which you need to watch out for.  Of them all, the biggest factor that can depress the PE ratio of your business is you.

Yes, you read that right.  Potentially, you are the biggest handicap to getting a good price for your business.  To diagnose if you are part of the problem or the solution just think about these questions:

  • Are you entwined with the business?
  • Are you the brains behind it?
  • Can nobody else make a decision without your input or approval?
  • Would the place just collapse if you didn’t turn up?

If you answer “yes” to these questions then your business may be worthless without you.  This is why, as you grow your business, you need to put in place the right people to whom, and structures through which, you can delegate so that you can detach yourself when the time comes.  In the words of Theo Paphitis being interviewed for EnCountry:

“You could be the best salesman in the world.  You could be the most creative person.  If you can’t scale you business then it just becomes a cottage industry.  You’ve got to be able to scale.  To scale you need to find the right people to work with, to be able to give responsibility, delegate, and when do that then you really do have a business that is scalable.”

Scalable and sellable, Theo.