Ask most business owners what they think their business is worth and the answer is usually “no idea”. In fact, they have always wondered about value even if there was never any inkling to sell. Most generally have an idea but sometimes widely wrong.

We had several post-recession cases in the late 90’s where previously successful businesses were doing it hard. The grind and pressure of reduced sales, minimal profits, higher debt and tough conditions had worn the owners down. They had had enough. Time to sell.

They too would ask, “what’s my business worth”. Sadly, the cold hard facts of the matter are that a struggling business is never an attractive proposition, especially in a down market. Minimal profit meant minimal value. Tough conditions meant no market. Desperation meant fire sale. For smart investors, this is always the time to look for bargains as part of an acquisition strategy.

Often these owners would say “in our industry, there is a rule of thumb that businesses are sold for X times sales”. By coincidence, this can occur with specific market conditions, but the most common technique used by financial people is a future earnings multiplied by risk basis.

Future earnings. Sounds easy enough. Just look at the earnings before interest and tax (EBIT). Do you use last year’s figures? Average of three years? This year’s half actual, half budget? Next year? Most likely it will depend on the trends. Significant favorable or unfavorable movement looks more into the future, although buyers can hold back part of the sale price where generous results are likely but yet to be achieved.

And EBIT may not necessarily reflect the future earnings of the business. Most commonly, the owner’s drawings are not an accurate reflection of what is shown in the accounts as owner salary. A new owner will need to replace the work currently undertaken by the existing owner. There needs to be an adjustment to the accounts to reflect this higher or lower cost.

Similarly, there may be other peculiarities in the accounts to take into account. They could be other owner related expenses; high capital spends that were written off for tax purposes or perhaps one-off expenses or revenue items. A valuer will adjust for such items to produce what they call “normalised EBIT”. This is a good indicator of future earnings.

This normalised EBIT is multiplied by a risk factor. Most private businesses we see have a multiple of between 2 and 4, with the very best businesses valued at 5 times EBIT. This number reflects the number of years a new owner will take to recover their investment. The higher the risk, the lower the multiple.

There are many factors that help determine this risk number but probably the most common barrier to a high multiple is what is called “owner dependence”. Where a business is unable to continue to perform without the owner’s continual and on-going presence, it is said to be owner dependent. Typically, the owner works huge hours, controls all of the key relationships with suppliers and customers, they have no written plans and all strategies are on the fly, they lack proper structure, job descriptions and delegation processes, and the business problems grow when the owner goes on holidays, which invariably they never take.

A new owner could see this type of business decline rapidly after the owner exits with the loss of their investment. Hence, the low multiple. In extreme cases, a multiple of just 1 is possible.

So, the business value can be calculated as future earnings times risk. However, the structure (company, partnership, trust) may also include excess assets (buildings) or liabilities (overdraft, hire purchase, other debts). A normal level of working capital is also required to be included in this business value such that the new owner pays for the business and does not have to spend any more to fund the cash cycle.

It is easy to understand the reaction of the clients we met in the 90’s. Frankly, when they understood their business’s value they were dismayed. That value had completely collapsed. They just wanted out.

Having broken the bad news, we would show them the path out. We put in place a Strategic Plan that focused on building value in the business. Key to this was: reducing owner dependence, understanding competitive advantage, building a cost/volume/pricing strategy, managing overheads, right sizing and fixing business structures.

These businesses went from (say) making an EBIT of $200,000 and a multiple of 2 (hence value of $400,000 for the business) to say $800,000 with a significantly improved multiple of 3.5. Value now $2,800,000. This was a common outcome and took around three or four years.

The irony was that in most cases these owners no longer wanted to sell. “This is what I always wanted … the business is easy to run, I can go on holidays and I am making more than I ever did … why would I sell?”

One final comment. A valuation is an opinion. Can be on the back of a napkin or independently obtained through a specialist valuer. What ultimately counts is the number written on the cheque of a buyer. To maximize this number requires a strategic approach to the sale of the business.