You Can’t Rely on a Business Broker to Give you a Reliable Valuation
Any business owner who has spoken with a business broker or a business transfer agent will likely have been offered a free appraisal for their business. This is usually a fixed number or quoted as a multiple of turnover.
We’ve covered business valuations by brokers and how they can be misleading elsewhere on this site.
A few brokers, very few, do have the in-house expertise to conduct valuations, but they generally won’t do it for the smaller sub £1m businesses as it takes considerable time to analyse the books and other variables to come up with even a rough guide to the “range” of offers the business might get when it goes to market.
Bottom Line: Yes, you can get free valuations from brokers, but the large majority of such valuations are pie-in-the-sky figures and can’t be relied upon.
The valuation multiples (P/E ratios) of large firms in the industry don’t apply to yours
People often quote multiples achieved by large, publicly traded businesses in their sector and fool themselves into believing their own business is worth a similar multiple. In fact, business brokers often quote these public examples as justification for the unrealistic valuations they routinely hand out.
Here’s why there’s no connection between the multiples those companies sell for and the multiples you’re likely to attract.
Large firms have a moat around them – a moat that prevents competitors growing to their size. MacDonalds’ moat is the sheer strength of their brand. For internet backbone providers the moat is the mountain of capital required to build a network of cross-Atlantic fibre optic cables; this acts as a “barrier to entry”. For some online firms – from eBay to Facebook – the huge market share they control (partly as a result of their first mover advantage) is a significant moat for a competitor to take on.
A moat presents two competitive advantages. First, it allows the company to make oversized profits in their sector. Second, it reduces the risk profile.
The importance of that second factor cannot be overstated. Risk is a big influence on valuations. Not risk as perceived by the seller, but risk as viewed (and quantified) by the buyer. The greater the risk the buyer sees in a company continuing to grow and increase profits, the lower the multiple he’ll be willing to pay.
Let’s move our gaze right down the food chain to firms that are only a bit larger than yours. If there is a competitor ideally matched to your business in every respect except that they boast double your turnover and double your profit, they’ll still command a higher multiple than your business would. Their size itself adds to their appeal. Bigger is better in M&A. For some trade buyers acquiring your business wouldn’t make an appreciable difference to their profits and balance sheet. But if they bought this competitor of yours it would “move the dial” so to speak.
Buyers Don’t Make Offers Based on the Valuation Done by a Business Agent
No buyer who has a modicum of sense would rely on a valuation conducted by a business broker who’s engaged by you, the seller, and being paid by you.
Buyers will collect detailed information about the business and form their own opinion on value, usually with the help of professional advisors.
They don’t like dealing with unrealistic sellers. If there’s a large disparity between your asking price, based on your broker’s valuation, and their own assessment of what you’re worth … they may simply walk away and not bother engaging.
Bottom line: An inflated valuation put together by an over-enthusiastic (or unethical) broker could lose you valuable buyers.
Don’t Kid Yourself on Profits, Your business is Probably Not Making as Much as You Think
Small business owners usually underpay themselves because there’s a tax advantage to taking only a small salary and taking a larger amount in dividends.
While that’s a cushy little tax advantage we UK-based small business owners have, we shouldn’t fool ourselves into thinking that the profit we declared was all “real” profit.
Let’s say you’ve been working 60 hour weeks, paid yourself £10K a year and declared £25K in profit. A buyer would recalculate your profit. He’d work out how much that 60 hours of labour was worth – how much he’d need to pay someone with your talents to do that job.
If he can get that covered at £12 an hour (including national insurance contributions etc for any employee/s he takes on). ..it’ll cost him £12 x 60 = £720 a week. Or nearly £40,000 a year.
Your “profitable” business, far from being profitable, is actually losing money!
Most buyers would walk away on this realisation.
Some business vendors try to argue that the buyer could do the job himself and save the cost of an employee. That’s a somewhat naive argument as it assumes investors are looking to pay good money to buy themselves a job. If your business is going to pay him just a salary for his time, he’s getting no return no the capital he invested and no compensation for the risk he’s taking with buying a business!
Bottom line: Make an honest assessment of what it would cost someone to replace you … and deduct that from your profit before declaring your profit to a buyer. Don’t do that and you’ll end up looking more than a bit silly (and, possibly, a bit shady).
The “My Business has Great Potential” Myth
Buyers are not going to pay more for the potential of your business.
In my 35 years of business I have never come across a single seller who didn’t claim his business had “great potential”.
Buyers are sick to death of hearing the word potential.
As far as a buyer is concerned if the business has so much potential you’d be exploiting that potential yourself and growing the business, not making excuses about why you can’t.
So even if there really is potential in your business, you can bet your last penny that the buyer is trying hard to filter out everything you’re saying about potential.
There’s another way of looking at this: Every single business has potential. The domain Google.com once had potential. It was sitting there waiting for someone to buy it for $5. Nobody did. Till Brin and Page bought it and built a search engine on it.
Should Brin and Page benefit from the fruit of their efforts? For the potential they exploited and monetised? If yes, then surely any potential in your business is not to your credit. The buyer will need to invest time, money and skill to convert that potential into pounds. All credit should then, as with the Brin and Page example, go to the buyer. Why would he pay you, in advance, for the improvements his efforts are going to generate?
There are ways to play potential to your enormous advantage as I advise my clients, but do not expect to claim potential, in your discussions with buyers or documents you submit to them, and expect your buyer’s offer to be influenced by it.
Don’t Think of Valuation as a Single Figure
It’s very rare to get an all cash offer for your business. Offers are usually a package of part cash, part promise to pay in the future, part lots of other things. And it’s a balancing act. Make a concession in the amount of cash you want upfront and you could extract a higher price in exchange for that concession.
We cover deal structures in this post.
Bottom line: The value of your business is not in a number but in a deal.
But it’s not just about deal structure. Just choosing to sell the business’s assets rather than the business’s shares can add as much as 100% to the price (as we explain here).
Yes, there are ways to obtain a price in the market that’s far in excess of any paper valuation
In fact, we’ve got a whole ebook on the subject, and subscribers to our email newsletter get it for free. Download your copy here.