The most asked question, and the most obvious one when it comes time to sell a business (or buy one for that matter) is: “What is the value?”
In my opinion asking this on the eve of a sale is way too late, but we'll ignore that for now. More and more people are making regular checks into the value of their businesses, and tweaking the actual business in good time to realise a value which is in line with their requirements, rather than ending up with the proceeds of a sale which are inadequate, at a time which is too late to make a difference.
So how does one value a business? Let's start answering that by considering what we would do in other markets – property, cars, commodities and even groceries:
For residential properties we might look at advertisements for other properties in the area. This gives us an idea only of asking prices, which are traditionally higher than the eventual selling price, but at least it gives us a ball park figure to play with. We might, if we have the resources, take a look at official deeds office records – banks and estate agents have access to this resource. Of course you could trawl through show houses for a looksee and compare what you have to what is being offered in the open market. Or you go to auctions of similar properties, for what that's worth.
For commercial properties, similar opportunities exist, except that show houses type viewings are more difficult and more likely to inconvenience a bunch of estate agents and owners as you bliksem your way through their lives, eventually resulting in you becoming quite unpopular. Of far more use is to have your commercial property properly valued by a registered property valuer. Spend a bit of money, and have something reliable to work with.
Similarly for vacant land. I am by no means an expert on property valuations, but it does strike me that vacant land in a particular geographic area does sell for similar rates per square metre, with premiums and discounts applying for various features. This is much the same as for commodities, only not as strict.
Commodities vary from day to day, and tend to follow trends. But you can be sure that the price being asked at one end of town is very similar to the price at another end of the whole world, provided you are dealing in a recognised and economically viable unit. So it is very easy to go onto the internet and see what the price of gold is today, or oil, or rice, or pork bellies. If you put up ten Kruger Rands as collateral, your banker will know exactly what their worth is, and will also know that they are easily redeemable.
So people can easily see that if they buy one tanker full of oil, they will pay a gazillion dollars, but if they build a bigger tanker with twice the volume, they will pay two gazillion dollars. It makes some sense.
Many of us imagine that groceries work in a similar fashion to commodities, except that you get a discount for buying in bulk. This is a myth. Next time you are in Checkers or Pick 'n Pay or whatever your favourite supermarket is; take a moment to look at a few things. From time to time I make the following observation:
It is often cheaper to buy two small boxes of corn flakes, than it is to buy a single double size box. Large cool drink concentrates are more expensive per volume than smaller ones. Even sugar (a commodity), once it gets to the supermarket shelf has an economic miracle performed on it, and it becomes more expensive in bulk. Go figure.
So where is this going for business value? I'll come to that in more detail a little further down this page. But for now I want to deal with a few myths as they relate to what I have written above.
After I had been selling businesses for about seven or eight years in several different guises – selling my own start-ups, selling franchise units of businesses I was involved in, looking for investors for two different ventures to which I was a shareholder, and so on, I decided that Suitegum should step up a rung, and join a larger group as a franchisee.
In that training and in several months that followed I was repeatedly told that that a business value is 20 times its net monthly profit. That was it. So it all seemed very reasonable. “What are you taking home each month, Mr Client? R50,000? Your business is worth R1M.” Such a simple way of doing things. One of my first deals as part of that group happened to be the biggest the group had ever done. Part of the reason for the size of the deal was that I insisted on running a proper valuation for the client. Needless to say, my fellow franchisees had all lambasted me for taking it to the market at such a high price. But when the eventual selling price was worked backwards, it was calculated at something like 33 times the average monthly net profit.
So where does all that go wrong? And does it mean that a struggling business making no money, is worth zero times twenty equals zero? Or is a loss maker going to pay a buyer to take it off his hands? If you follow the formula, then the answer in both instances is “yes”. But clearly that particular answer is wrong, and does a great disservice to many business owners. Yet, this straight multiple nonsense is being fed to so many business owners by buyers and agents.
If one goes to the same group's web site today, there are many, many very small businesses listed, but not selling. They are overpriced. Their larger listings are selling quickly; these are under-priced, and while the big sellers are getting nice quick deals, they are leaving a great deal of their hard earned capital on the table. Such a shame.
And on that premise I will continue: The assumption is that if a seller is offered R10M he would prefer that, to receiving just R8M. The fact that less capital gains tax is payable is hardly a consolation to the R8M seller. Would you believe I have heard just such an explanation from an underperforming agent as he cheerfully pocketed his commission and went on holiday?
No thought in the “twenty times” rule goes into the basic elements of the balance sheet. How much inventory does the business hold? So for example, a manufacturer may have to purchase large stocks of imported raw products to make his own product economically viable. A restaurateur, on the other hand keeps the majority of his inventory down to only a few days' worth so as to keep everything fresh. And yet if they are both subjected to the “twenty times” rule, something just does not work out.
So the “twenty times” rule evolved to be exclusive of the inventory, and the typical advert would then read “Business nets 50,000. Asking price 1,000,000 plus stock.” The insinuation is that the business is perfectly capable of running very successful without its major balance sheet item. The next question then is: “How does this affect a business which does not need inventory?” This would typically be a software development house or a consultancy. Are these very divergent businesses to be valued on the same basis as a restaurant? Apparently so, according to the “twenty times” convention. But that cannot possibly be right. In fact it is very wrong.
I have only mentioned the one possible variable which makes a difference to the outcome of a proper valuation – inventory. But what about the business' exposure to that inventory? How about the fact that inventory risks becoming stale, being pilfered, running out, becoming redundant or degrading in some way? These are sub variables to inventory variable, and they all make a difference to the value of the business, because they all go down to the inherent risk in the business.
Other variables which the “twenty times” rule can never take into account might be things like:
- Reliance on premises
- Business scarcity
- Financial performance
- Compliance issues
- Customer exposure
- Supplier exposure
- And more
We have identified 26 broad variables which affect the value of any business, some of which can be broken down further into sub variables, so that there are about 40 considerations which are in no way reflected in the “twenty times” rule.
The braaivleis valuation
In much the same way as the “twenty times“ rule does business owners a disservice, so too the valuation that is put together in the club, at a social event, next to the rugby field or over the phone with a friend.
The conversation goes like this:
|Mike:||Hey Jim, have you heard that Fred sold his business?|
|Jim:||Really? Where is he? I need to talk to him because I am so sick of my business. Oh, there he is. Hey Fred, come over here; I hear you sold your business. Give me some tips, please man.|
|Fred:||Ja man, it's sold. We did the deal on Friday. We'll be paid out as soon as the due diligence has been completed, and the finance is through.|
|Jim:||Hey, that's lakka man. What did you get, if you don't mind me asking?|
|Fred:||I got 12 bar, man|
|Jim:||Hell, Margaret must be chuffed hey? What was the business netting?|
|Fred:||Well last year we paid tax on about a bar, but we've been growing nicely for a cuppla years, and that new product line is going to make an even greater difference. |
So what happens here? Well Jim gets totally mesmerised by numbers. In his head he sees 12 times annual net income. He does the sums and figures his business is worth about 9M. He goes home and announces to his wife that they are rich, and he's going to put the business on the market on Monday.
This is what he has missed:
- Fred's business is an employer of highly trained engineers who earn big salaries, keeping his overhead up. Their research and development over the last ten years has meant a lot of investment from Jim and his family, augmented by several large bank loans.
- The product is very tech intensive, and it will soon be in demand as the railways in South Africa are upgraded and invested in.
- The business has a high asset base.
- The business is housed in a generic warehouse and could be easily moved.
- Suppliers are from various continents, and can be easily switched from one to another.
- Current customers are limited to only ten, but it is likely that the railways will be using his product extensively in the very near future, provided he can bring the right empowerment credentials to the party.
- Fred neglects to tell Jim that he has only sold 75% of his company, and that he will remain on as CEO under a five year contract. Part of the 12M he is to receive pays for a restraint of trade, after his five year contract is up.
This what Jim has ignored:
- A due diligence still has to be completed in Fred's business
- A bank still has to agree to finance the deal.
- The financials of Fred's company have always reflected very accurately the real position.
- Jim's own business is a panel beater which makes good money, but requires Jim's constant attention, and a very high spend on legal fees.
- Jim only gets to go away over the end of year break when everybody else is on holiday.
- Jim cannot trust any of his employees to fill in, and his own wife does his books at night, after she comes home from her own work.
So how could these two businesses ever be compared on a value versus profit basis? And yet they are compared daily on both the “twenty times” rule and the braaivleis valuation methods.
Even more astounding: People make life changing decisions on these types of valuations because they are reluctant to invest in some decent professional advice.
“What we need” valuations
Another misconception of value is often that a business, at the end of a person's life in the business should be able to sell for whatever the person will need to move into the next phase of his life. So typically, the owner makes a simple calculation one Sunday evening, just as he's dreading hitting the office in the morning. He works out what he needs to have to start or buy into another business, after he's had a good holiday. Of course he will want to pay off his home loan and buy a new car. Then there'll be the question of feeding and clothing his family for six months or so. You get the picture. He comes up with a number which will work for him.
Next step is to fit the business to the number. Two scenarios arise; one in which the asking price is so high that he stands no chance, and another where the asking price is so low that the business is sold in weeks. Sometimes an undervalued business is not sold because the wrong people are attracted to it, or worse, buyers generally don't trust something which is too good to be true. Whichever way, the seller ends up losing. Very occasionally the seller hits the sweet spot, and sells his business for the right price in a reasonable time period.
“What it cost” valuations
There is a man out there who is not in any way linked to the estate agent or business selling trades, but who is a businessman. He has in the past taken me on as regards valuations, in public forums. He insists that the way to value any business is to simply calculate what it would cost to form an identical business next door, and get it to a similar financial performance. That is the value.
As I write this, I am once again slightly taken aback as to exactly how the logic of those calculations would work. Undoubtedly we only work with ideal solutions, and no losses over the many poor decisions which all business owners make, but which eventually help the business get to where it is today.
There is no scope for looking at cyclical changes and trends in the performance of the business. There is no value attributed to the knowledge and learning curve inherent in all decent businesses, or the fact that adding another similar business close by would inevitably squeeze margins a bit, put pressure on salaries. But I don't think that is his point.
Above all else, it strikes me as being a very impractical way of making a decision on your own capital, be it as a buyer or a seller.
We most often see this sort of valuation being used when a person phones me, desperate to sell his six month old business with a two year lease. It is usually presented as a winning opportunity which has run out of working capital too early. The seller usually wants to “concentrate on another venture”.
Similarly, he never mentions that his landlord is chasing him hard for the rent, and won't let him off the balance of his lease. Besides, he wants to get back his ill-advised investment.
So what is the best approach?
On many occasions recently there have been news reports of the total value of Facebook, or the fact that Apple is now more valuable than Microsoft, and so on. These valuations are calculated very simply by taking the number of shares in issue and multiplying by the last price any of the shares recently sold for. That is called the market capitalisation.
For private companies the approach has to be somewhat different. First of all, the shares of the private company are not easily tradable (with a phone call to a stock broker). Nor are the affairs of privately or closely held businesses scrutinised as closely as they might be if the company were listed on an exchange for anybody to buy or (more importantly) sell whenever the urge took them.
It therefore calls for an experienced, knowledgeable and exposed professional to estimate accurately what each individual business might realise on the market, at any particular time, within the confines of what the market is doing at that time, influenced by so many variables.
We have dozens of accountants, business rescue practitioners, and attorneys referring businesses to us for valuation, because although all of them are skilled in various aspects of working with businesses in various states, they are not exposed to the actual selling of businesses very often.
The valuation process involves the supply of financial statements to us. These are reduced into our model which we have developed over several years, and which we continue to improve. The model will highlight some issues which bear further investigation. Those issues, as well as a fairly standard list of questions pertinent to most businesses are the subject of a valuation interview, which generally puts all things into perspective.
From there we proceed to the full valuation. That's a lot of work, but far more accurate than a quick multiplication by 20, don't you think?
Business owners owe it to themselves to have their businesses valued on a regular basis. Imagine coming to the end of your career, assuming that your business will be sold for enough to finance your retirement plan, only to discover that it falls way short of that goal? That is a disaster in anyone's book. On occasion we have been able to suggest that the businessman will get substantially more than he's aiming for, which is good news. That in itself has meant though that he could have retired at 60, and not at 70. These are life defining mistakes.
Often businesses are referred to us for valuation for reason of divorce settlement or partnership dissolution. In these instances, we might be called to court as expert witnesses. For this reason we have to get our facts right, and be able to defend our results.
The model we have developed over the years fits the requirements of the courts, complies with USPAP standards and is presented in a step by step fashion, easily followed by your oponent's attorney – the same guy who has understood very little you have told him so far!
If you require a professional, realistic, market-related valuation of your business please call
011 875 2330 or complete this form.