How do you value a small business ?

thechampion

Hi

I was wondering is there a "rule of thumb " for valuing a small business. I've been told it is 3 times the profit. Has anybody any experience with this please?

Thanks

R3al

It will depend on assets + a multiple on profits based on the historical data that is available, so a business that has been trading a long time and can show a series of years with good profit would have a higher multiple than a new business which has done well in its 1st year or 2

The Apprentice

3 times the profit might be a terribad valuation for a business..

For example Amazon turned over approximately last year 4 billion in a particular qtr but had only a 100 odd million in profits .. Because obviously downturn affected, heavily investing in r+d also could be other factors like investing in infastructure for the future..

I have heard the multiple is from 1-6 concerning a few major factors such as assets, debt, profit margins, length of years with profits. I have read lots and lots of different scenarios but cannot really give you a definative answer and neither can 2 of my accountant buddies.. they differ for some reason ?

Hopefully someone will give us a 100% bulletproof answer lol :P

EamonOSullivan

There are way too many factors to even hazard a wild quess at a multiple to use.

Can you give any indication of the sector the business is in, what the profits were in the last 3 years, what the owners drawings were i.e. Directors Salary, or Profits ( the latter for a Sole Trader)?

DubTony

The retail grocery sector (convenience stores etc.) had a rule of thumb a few years ago, but I'd say that's changed significantly in the last few years. Value was based on turnover. For a leasehold business the value was about 14 times weekly turnover and for a freehold it was between 25 and 30. These figures are based on the seller clearing all debts and leasing before/when the deal is finalised.

Obviously profitability was a factor, but a decent store was getting these kinds of values. Having said that, I am aware of a leasehold business with a low rent to turnover ratio (it was less than 3%) sold for 20 times weekly turnover in 2006. It wasn't massively profitable (about 3% net) but the cheap rent in a decent location proved very attractive.

smeharg

Dubtony illustrates a very good point about how the method of calculation can depend on the industry. Obviously, a multiple of turnover is suitable to retail where volume is critical.

Contrast that with loss making social media startups where it seems you pick a number and add a 5 or 6 zeros :P

TheCostumeShop.ie: Ronan

Selling very small businesses is a totally different game to selling big businesses. Value really comes down to what someone is will to pay for it, a small business could have zero profits but the owner could be benefiting from a company car and have his/ her kids on the books while in college etc. So EBITDA type calculations make little sense. Proper professional due diligence is often so expensive that it makes purchasing a businesses that is small very difficult.

I dont think you can use rules of thumb in these circumstances. Basically you have to bring the business to market to see it's market value or look at what a similar business has been sold for recently.

BenEadir

Hee's the only rule of thumb I subscribe to:-

"Rules of Thumb are Dumb"

Why?

1. They are backward looking
2. They are rarely based on hard facts and don't reflect either the current cost of capital or the company specific risk of the business in question.

e.g. Business 'A' had €2m in sales and €150,000 in net profit for the last 12 months. Business 'B' also had €2m in sales and €150,000 in net profit for the last 12 months. They are both offering the same products and services so a rule of thumb would tell us they are valued equally. Right? Wrong!

Business 'A' has had declining sales and profits for the last 3 years and is located in an area where a huge local employer (e.g. Dell in Limerick) has just upped sticks for greener fields in Asia. Business 'B' has been growing sales and profits 25% a year for the last 3 years and is based in an industrial estate which is seeing a lot of growth. I know which one I'd value the highest.

Micro businesses (those businesses with less than 10 staff, less than €2m in annual sales and/or less than €2m balance sheet value) are extremly difficult to sell for a whole host of reasons, three of which are:-

1. They are too easy to replicate. Why buy when you can fairly easily set up an identical business?
2. Sellers have an inflated view of what their business is worth and won't sell for what the market is prepared to pay.
3. The transaction costs for acquiring a business worth €250,000 can be relatively high in relation to the overall value of the transaction e.g. the transaction costs to acquire a €5m valuation business won't be much higher than acquiring a €1m valuation business. You have to do the same due diligence, the same legals etc etc.

The bottom line when it comes to micro and small business valuation is the business is worth the higher of the disposal value of it's net assets or the present value of it's future cashflows. Establishing the maintainable future cashflows and applying an appropriate discount rate, which reflects the systemic and company specific risks, to those cashflows in order to calculate a fair market value can be difficult but is, in my opinion, the only correct way to objectively value a specific business.

There are no shortcuts. A rule of thumb might be convienient and easy to use but they can be very misleading and I would never make either a sell or buy decision based on a rule of thumb.

“A Rule of Thumb is an easy to remember guide that falls somewhere between a mathematical formula and a shot in the dark” From Tom Parkers book – Rules of Thumb

Ben

DubTony

Interesting points BenThere. Whatever about what Tom Parker says, each sector has its own rough or guideline valuations. These are starting points, and simply give an indicator to a prospective purchaser of a small business of what kind of price point he can expect. Obviously only a mug would buy any business based on a rough valuation.
My example of the c-store selling for 20 times weekly turnover is a good one. The buyers accountant did due diligence and agreed that the business was well worth the valuation. This was based on the fact that the owners took 100k a year from the business while at the same time employing a full time manager, and also that the business constantly ran a surplus in its accounts, while never owing more than 2 weeks turnover, borrowings and leasing aside (give or take a few grand).

Your analysis is fine for bigger businesses, but nobody around here is selling Facebook or General Motors. As Ronan said a small business is worth what somebody is willing to pay for it, after taking into consideration what the current owner is getting from it. In my experience most small businesses nett very little as most owners will get as much as they can from it leaving little "profit".

As for being backward looking; well it stands to reason that small business valuations are generally based on what has happened in the past. They are, by their nature, subject to local conditions and local economies (obviously those trading online are different), but predicting what may happen in the future from a small bricks and mortar business can be a pretty hit or miss exercise. (I have proof - Boy, do I have proof )

As far as due diligence goes, most will look at 3 to 5 years accounts to identify any patterns or possible problems, calculate if a loan can be repaid on any necessary borrowings and decide from there. Anyway, rule of thumb is good for an understanding of the approximate value, but obviously each will have different characteristics and dynamics that will increase or decrease the valuation.