Whether you’re thinking of selling or seeking more capital to grow your business, a valuation will give you a clearer picture of your company’s financial health. And more leverage in those all-important negotiations.
But what factors affect the value of your business?
And how do you go about putting a price tag on the fruits of your hard work?
Why value your business?
The most obvious reason to value your business is that it helps you put a fair price on it.
This won’t necessarily be the figure you’ll ultimately get if you decide to sell.
That said, it can be a good starting point in negotiations with prospective buyers. And it can help hammer home the point that they’d be acquiring a profitable venture.
But valuing your business isn’t just useful if you’re thinking of selling.
If you’re looking to secure more funding, for example so you can create a new product or expand into new markets, a valuation can help persuade potential investors that your business is sustainable in the long term and, so, a safe bet.
A valuation will also pinpoint what’s working well for your business and what isn’t. This will allow you to take steps to strengthen your position, such as addressing inefficiencies, improving your processes, or diversifying to reduce your risk.
What affects a company’s valuation?
There are five main factors that impact how much your business might be worth:
- How profitable it is
- Your customer base
- Your people
- Your assets
- The industry you operate in
What is your profit margin (this is your sales minus expenses, expressed as a percentage)?
Do you have healthy cash flow, or could a few late payments get you in financial trouble?
And what are your revenue prospects like in the coming years?
Needless to say, the answers to these questions are hugely important. Ultimately, businesses are valuable because they consistently make money for their owners. So, the more profitable your business is, the longer it’s been profitable, and the more sustainable that profitability is, the higher the valuation is likely to be.
Your customer base
Do you have a broad, loyal customer base? Or is your income largely dependent on a handful of big accounts?
The broader your customer base is, the more valuable your business, because your risk is spread around.
By contrast, if a big chunk of your revenue comes from one or two customers only, it could spell trouble. Should one of those customers end their contracts, your revenue could take a serious hit and put you in financial difficulties.
Your churn rate — the rate at which you lose customers — also has an impact on your valuation, for two reasons:
- It costs five times more to acquire new customers than it does to retain old ones
- More importantly, if customers don’t tend to come back, it could mean something is seriously wrong. Perhaps your after-sales is letting you down. Or, worse, the quality of your product or service isn’t meeting expectations
It’s an often repeated mantra that the strength of a business lies in its people. And this couldn’t be more true. Where strong leadership and motivated employees drive businesses forward, weak leadership often leads to unhappy employees. Which results in poor quality work that will put customers off and harm your reputation.
Your own level of involvement will also have an impact on how much your business is worth.
Can the business thrive without you? Or is its success dependent on you, for example because of your specialist skills or industry contacts?
If you are the business, that’s risky for a prospective buyer or investor. What will happen if / when you’re no longer around?
Got trademarks, patents, or copyright? Or physical assets such as premises, land, or equipment?
These assets are valuable in and of themselves. And if the worst happens and your business is no longer viable, they can always be sold at a profit.
How are things going in your industry?
If demand for your products or services is increasing and there are opportunities for growth, this is will make your business more valuable. By contrast, a challenging environment could hurt your business’ prospects and its worth.
Challenges don’t necessarily mean less demand. It could be, for instance, that tighter regulation is making it harder or more expensive to do business. Case in point, UK exporters’ businesses have suffered because of the new requirements they need to meet when trading with the EU.
How to value your business
There are several methods you can use to value your business. And one isn’t necessarily better than another. It really depends on the nature of your business, its situation, and the reason why you want to value it.
Here’s a look at five popular business valuation methods and their pros and cons.
1. Market comparison
This entails looking at what similar businesses in your industry have recently sold for — for example by searching on a website like Businesses For Sale — and valuing your business at a similar level.
This is probably the simplest way to value your business. It also strengthens your position in negotiations by allowing you to argue that this is what businesses like yours are selling for.
The catch is that you have to make sure you compare like with like — not just in terms of industry, but also taking into account other factors such as the size, reputation, and even the age of the business.
2. The ‘entry cost’ method
This involves working out how much it would cost to:
- Start a business that is identical to yours
- Get it to the level where yours is today
In other words, you’ll need to ask yourself: ‘If I had to start my business from scratch today, how much money would I have to invest?‘
Begin by making a list of your startup costs. These could include hiring premises, equipment, utility bills, the cost of getting a website up and running, and solicitors’ and accountants’ fees.
Next, work out the cost of hiring and training employees, developing your products or services, and building a customer base to your current levels. And follow that with a list of all your business assets and how much they’re worth.
Lastly, consider where you could cut costs — for example by using technology or locating the business in an area where rents are cheaper — and deduct those savings. The figure you’re left with is how much your business is worth.
Entry cost valuation is reasonably straightforward and quick to do, but it also leaves room for speculation.
A prospective buyer could argue that they could make bigger savings than the ones you’ve made in your valuation.
Of course, you could counter that those savings might hinder rather than help. Case in point, while rents might be cheaper in Basingstoke, there might be less demand for your services than there is in London.
3. Price-to-earnings ratio
In this method, you multiply your profits after tax by the price-to-earnings ratio. So if your annual profits after tax are £100,000 and your price-to-earnings ratio is 2, your business would be worth £200,000.
Price-to-earnings ratios are worked out based on factors like the total value of your assets, the size and quality of your customer base, your people, the state of your industry, and even how easy it would be to re-sell.
So a company that’s listed on the stock exchange, for instance, might have a higher price-to-earnings ratio than a private company, because a buyer can simply put their shares back on the stock market.
- Owner-managed businesses have a ratio of 0 to 2.5
- Businesses with profits of up to £500,000 a year have a ratio of 2 to 7
- Businesses with profits of £500,000 a year or more have a ratio of 3 to 10
That said, there are no hard and fast rules, and ratios can vary quite widely.
4. Discounted cash flow
This method involves predicting your likely profit over the next 15 years based on your current earnings less a ‘discount’ — this could be anything between 15% and 25% — to account for unforeseen risks and inflation.
This method is considered one of the most accurate ways to value a business, but it’s extremely complicated.
It also assumes your income will remain fairly stable and that the market conditions in which you operate won’t change too much. This is a lot to ask, especially if your business is in a fast-moving industry like technology.
5. Asset valuation
Here, you tot up the value of your business assets and subtract loans and other debts.
This method is ideal if your business owns valuable tangible assets, even if things aren’t going that well.
If, for example, your business owns a prime piece of land worth £1 million, your debts wouldn’t matter as much. The price the land could fetch if a buyer or investor sold or developed it would still drive up the valuation.
By contrast, if your business doesn’t have many assets — for example because you’re a graphic designer who works from your bedroom on an old laptop, or you rent all your equipment — an asset valuation probably won’t work for you.
It’s also worth noting that it can be difficult to put a number on intangible assets like goodwill — this includes things like customer loyalty and reputation. So, this method may result in a lower valuation than you’d get using other methods.
A valuation is only a starting point
In business, you often hear that value is ‘what someone is willing to pay.’
But that’s not entirely true.
A more accurate way of putting it is that value is ‘what you can persuade someone to pay.’
With this in mind, valuing your business is a fine balance.
You can’t slap a price tag on every single ingredient that makes your business a success.
At the same time, don’t let your emotions cloud your judgement. You’ve worked very hard to get where you are. But you still have to come up with a figure that potential buyers or investors will consider realistic.
Not sure how to get started?
Or feel like tearing your hair out at the idea of valuing your business yourself?
Seek out an accountant or valuation specialist.
They’ll help you get the numbers to make sense.