Maximising the Value of Your Business
It should be the focus of all business owners to maximise the value of their business so upon sale, the highest possible price is achieved.
When it comes time to sell a business or commence to sell down to key employees, business owners realise that they need to achieve a certain price in order to meet their exit goals and fund the next stage of their life.
In some cases, the sale of the business represents the business owners’ retirement fund or at least a significant portion of it. However, there is often a reality check when business owners realise that their business is worth less than they had anticipated.
You therefore need to prepare now for a future sale. You need to work on increasing the value of your business before going to the market to sell.
A quote from Steven Covey’s book, Seven Habits of Highly Effective People, ‘Begin with the end in mind.’
The valuation methodology for businesses varies according to the industry and size, however as a general guide, typically:
RoT – simplifies valuation process whereby value is linked to a measurable factor eg. turnover, gross profits or earnings
CFME – business earnings before interest and tax are normalised and multiplied by the earnings multiple
DCF – forecasted future cash flows are discounted back to present day dollars
In the small to medium business sector the most common valuation method is CFME. Therefore it is in the interest of the business owner to achieve the highest possible earnings multiplier.
Confusion reigns over the terminology of the CFME methodology. Capitalisation Rates, Cap Rates, Earnings Multipliers all refer to the same factor.
The Earnings Multiple is the inverse of the Cap rate. For instance a Cap Rate of 25% is equivalent to an Earnings Multiple of 4 and a Cap Rate of 50% is equivalent to an Earnings Multiple of 2.
The business valuation is determined by multiplying the business’ earnings before interest and tax (EBIT) by the appropriate Earnings Multiple.
Some business owners assume that their businesses are worth 3 times EBIT. This is a misconception. Businesses in this sector can achieve Multiples of anywhere between 1 and 5.
In order to maximise the sale price, one needs to maximise the Earnings Multiplier.
The Earnings Multiplier is designed to measure business risk - the riskier the business, the lower the Earnings Multiplier.
Consider the following scenario: Bob and Jane have $1M to invest.
If they invested the funds in Government Bonds they may achieve a 2% return. Low risk therefore low return. If on the other hand they invested $1M in an electrical business they may want to receive a 40% return. Higher risk therefore higher return.
In the first investment scenario (bonds) the Cap Rate is 2% and the Earnings Multiplier 50 times and the second investment scenario (electrical business) the Cap Rate is 40% and the Earnings Multiplier is 2.5 times.
With the 40% return on $1M you generate $400K or in other words it takes you 2.5 years for you to recoup your investment (ignoring interest, tax and principal repayments).
So the crunch is the ability for you as a business owner to lessen the business risk and or perceived business risk that a potential buyer will assume is inherent in the business acquisition which will allow you to sell your business using a higher Earnings Multiplier.
Here are several strategies to make your business more appealing and more valuable to buyers:
1. Less reliance on the owner – consider the key roles and key employees. Ensure that the roles undertaken by the owners have been transitioned across to the employees. Cultivate a high quality workforce and work environment. Build long term incentives for key employees that vest over time to motivate key employees to remain with the business post sale
2. Establish recurring revenue streams – securing long terms contracts or revenue of a recurring nature gives buyers comfort that they will have a consistent revenue flow from the outset
3. Increase profitability – businesses with increasing profit will attract a higher price. Create efficiencies before sale
4. Quality and mix of clients – diversify so that your business is not reliant on one product, service or a limited number of clients
5. Differentiate your service and product – businesses with difference can command a premium. Promote your intellectual property and patents which give you an advantage over your competitors
6. Create seamless business systems and procedures – so that buyers will be convinced that business will continue successfully when the current owner has exited
No matter the stage of your business cycle, you need to consider your exit.
Begin with the end in mind. In doing so you will differentiate your business from your competitors, develop a quality workforce and create efficient business systems.
Commence the implementation now and not just before you intend to sell your business.
HW One provides advice on business sale and succession planning processes
For more information contact either Brendan Podevin or Cameron Wilson on 07 3360 9600 or visit hwone.com.au
© HW One May 2015