The challenge of continually building and demonstrating the value in your private business is one many business leaders face. In comparison to listed public companies, whose value is on display for all to see each day in the company’s share price, it’s not uncommon for a privately-owned business to go about the day-to-day operations with little or no regard to the value of the business, let alone what could be done to improve that value. One reason for this is that there is no immediate perceived need to know what the value is.
Even where a business’s owners are open-minded about the possibility of selling to a third party, they are typically under-prepared when an offer comes along. Business owners can only expect to derive the best price from a sale if prospective buyers can clearly see the business has enjoyed an established pattern of performance and consistent management structure prior to any due diligence process commencing. Therefore, in order for a business to be sale-ready, owners must address performance and management issues well in advance, ideally three years or more, of any sale offer.
Privately owned businesses commonly struggle with a number of issues that can have a negative effect on their sale value, for example:
- Lack of succession planning for directors and CEO
- Lack of independent Board members
- Inexperienced family members of owners inappropriately employed in senior positions
- Systems and procedures not properly documented
- Lack of robust financial reporting
- Inadequate business governance.
Another relevant aspect is that directors of privately owned businesses have a legal duty to act responsibly and protect the company’s assets, which includes a duty to ensure the value of a business does not dissipate due to a director’s actions or inaction. At the very least, directors are charged with the obligation to ensure shareholder value is not damaged, and is preserved and enhanced as much as possible.
How does a business arrive at a value?
While there are many different valuation methodologies available, for profitable businesses with a reasonable record of accomplishment, the capitalisation of maintainable earnings is one of the most commonly used methods.
The capitalisation of maintainable earnings is a three-step process involving:
- Calculation of a dollar amount of Future Maintainable Earnings (FME), which is normally an average of current and anticipated net profits, adjusted for abnormal and non-recurring items
- Identifying an appropriate capitalisation rate, i.e. a multiplier
- Multiply the abovementioned factors to obtain the dollar value of the business.
It is worth noting that calculation of FME is rarely straightforward and can involve a certain degree of subjectiveness on the valuer’s behalf. Furthermore, often the selection of an appropriate multiplier can prove even more problematic, common deficiencies tend to emerge, which can suppress the multiplier and therefore, suppress value. The multiplier arrived at will have an inverse relationship to the perceived risk of investing in the business, that is, the higher the risk, the lower the multiplier and vice versa.
Therefore, the key controllable factor in the valuation process is Future Maintainable Earnings. Business owners should be doing all they can to maximise FME as this will have a positive impact from the perspective of maximising the valuation of the business, but also to improve dividend flows and the level of profit to reinvest in the business.
The aim of a business owner should also be to identify as clearly as possible those factors that can be improved, so as to reduce the risk to a potential investor. Factors that influence the multiplier fall into one of four broad categories:
1. Products and distribution:
- Does the business have time-tested products?
- Is the business reliant on one or two major customers or suppliers?
- Do contractual arrangements exist with key customers and suppliers?
- Is the business operating at full capacity or does a ‘blue sky’ element exist?
- Is there a pipeline of future products or services?
- Is there a product development/research and development process underway?
- Is there identifiable Intellectual Property that is saleable and therefore of some value?
- Is there an effective Board of Directors?
- Is there a succession plan for key management positions?
- Are key management job descriptions properly documented?
3. Market position:
- How much of the market does the business control and what is the scope to increase that position?
- Can the business attribute a separate (saleable) value to any existing brands?
- How susceptible is the business to factors beyond its control, such as exchange rate movements?
- Is there a threat of offshore competition?
- Are there merger or takeover opportunities?
- Does the management information system produce relevant, accurate and timely reports?
- Are the financial statements audited?
- Are all relevant systems properly documented and regularly reviewed and updated?
- Is there a properly documented strategic plan?
- Is there a properly documented business recovery plan?
At a minimum, directors of privately owned businesses should conduct an informal/internal valuation exercise at various stages of the business’s growth, or engage the assistance of a business valuation specialist if required. Understanding the key factors that have the greatest potential impact on the valuation multiplier will help guide the focus of management and shareholders, and enable strategic decisions to be made. Periodically revisiting this valuation is integral, if not by way of a full re-calculation, then at least by assessment of whether improvements of the relevant key factors have been achieved.
The process of examining the key factors would focus attention on those weaknesses the business should be addressing in any case, and the directors would be able to sleep more soundly at night, having gone further down the path to satisfying their legal and moral obligations to the company’s shareholders.
To find out more about determining the best valuation method for your business and how to execute and revisit it, contact your local BDODrive Adviser.