How to Assess Business Value in Small- to Medium-Sized Businesses

Transcription

1 How to Assess Business Value in Small- to Medium-Sized Businesses By James Price, BBM

2 Table of Contents 1. What are Sustainable Earnings?... 4 The diesel engine analogy... 4 Sustainable Earnings a practical example How to calculate Sustainable Earnings... 6 What is Multiple of Earnings? Six key determinants of Sustainable Earnings... 8 The challenge for owners... 9 How to extract value along the way... 9 What does not determine Sustainable Earnings Why information is critical in driving business value key pieces of information to include in the sale process Don t try to hide your skeletons No one wants to pay for goodwill anymore What is your Point of Difference and Competitive Advantage? What does Point of Difference and Competitive Advantage mean? POD and Competitive Advantage practical examples Don t fall into the POD trap! Disclaimer: The information contained in this ebook is general in nature and should not be taken as personal, professional advice. 2 jpabusiness.com.au

3 How to Assess Business Value in Small- to Medium-Sized Businesses By James Price, BBM In this ebook we take a look at How to Assess Business Value. There are 3 key questions to ask when assessing the value of your business: 1) What sustainable earnings does the business generate? 2) How much meaningful information do you have on the business s performance and overall business model? 3) What s the point of difference and competitive advantage in the business? Sustainable Earnings is a tricky concept, so we ll consider it first and split it up over several chapters. jpabusiness.com.au

4 1. What are Sustainable Earnings? Sustainable Earnings is often the way the market values businesses, particularly small- to medium-sized businesses. Larger businesses traded on the stock exchange have a value attributed to them day by day, minute by minute, in the share price. The share price reflects the market s view of the ability of the business to generate earnings into the future. In this ebook we re talking about businesses that are not traded on the stock market, but we re essentially measuring the same thing: Sustainable Earnings, or the ability of the business to generate earnings into the future. The diesel engine analogy Think of your business as a diesel engine. The fuel in your business/engine is Sustainable Earnings. If I buy your business/diesel engine and I turn it on the day you leave and just run it, how long would it run for? How full is the fuel tank when you hand the business over to me? How long will it run at its current capability before it needs intervention, such as me having to go out and find new customers, invest in new equipment, etc? Essentially, that s the value that you as a business owner are building in your business. You are putting fuel in your engine Sustainable Earnings in your business that will continue to appear beyond the transfer of the business to someone else. 4 jpabusiness.com.au

5 Sustainable Earnings a practical example Business 1. I am a sole operator running a lawn mowing business. I have a lawn mower, a catcher and a ute. I drive around and knock on people s doors and say: You re lawn looks long, would you like me to mow it? I mow it and I get paid for the work I do. This business does not have significant Sustainable Earnings because the minute I get sick or decide to have a day off, I get no earnings. Business 2. I own a lawn mowing business that has a client base of 200 people. It does maintenance work for large business and government installations. It has contracts relating to that maintenance work that say: You will do my lawn mowing for six months and we will pay you XYZ. It has staff that assist in undertaking the work. It generates a return over and above paying wages. If I sold that business tomorrow the existing contracts for lawn mowing and maintenance may represent a significant dollar amount and may run out over time, regardless of me not being in the business. This business does have Sustainable Earnings and the market will consider those earnings in valuing the business. jpabusiness.com.au

6 2. How to calculate Sustainable Earnings Sustainable earnings don t appear on your tax accounts, your P&L statements or balance sheet, and they typically don t appear on your management accounts. We often drive our management accounting systems to assist with our normal tax requirements, but if you re really thinking about business value you need to consider Sustainable Earnings and you should be measuring it. Sustainable Earnings are calculated using the following formula: Revenue cost of goods sold = Gross Profit operating, finance and non-cash expenses = Net Profit before Taxation + interest, depreciation, abnormal or non-business expenses not related to the business owners wages (including a reasonable marketrelated amount for owners working in the business), non-business income or windfalls, other abnormal income = Sustainable Earnings This formula gives you the basis for determining Sustainable Earnings, or Adjusted Cash Earnings, of the business. This calculation is often done on the previous three years performance and then looking forward to at least the next 12 months. As business owners looking to drive value in a business, the stronger and more consistently you can build the picture of Sustainable Earnings and show that it is robust, the better your chances of driving greater value when looking to sell, all other things being equal. 6 jpabusiness.com.au

7 What is Multiple of Earnings? Business purchasers want to know: If I buy a business today, how long will it take me to get my money back? Remember, the purchaser doesn t want to pay for opportunity that they create in the future. They only want to pay for what has been built up by you. In the small- to medium-sized business market, purchasers are generally looking from one, to four and a half years, to recover the money they ve invested. Multiple of Earnings is the term for how many years or months a purchaser is prepared to wait before they recoup the value they paid the outgoing business owner. Imagine you re selling your business for $1m and I ve assessed it as having an average Sustainable Earnings, looking forward, of about $300,000 a year. If I buy your business it s going to take me three and a bit years to get my money back. That means I m paying a Multiple of Earnings of about 3.3. The Multiple of Earnings is also a proxy for a purchaser allocating a risk factor when considering their investment appetite. The lower the multiple, the higher the risk. jpabusiness.com.au

8 3. Six key determinants of Sustainable Earnings Sustainable Earnings are determined by a number of factors; here are some of the major ones: 1) How much fuel is in the tank Does the business have contracts and work in the pipeline, and are they transferable? 2) Business assets and management systems How does the business manage its contracts and schedule its work to ensure there is no break in the chain where customers are not serviced appropriately? Does the business have sufficient plant and equipment and capability to deliver and what is the utilisation rate? 3) Is it reliant on one person Even though there are contracts, does the owner do the most of the work, or is the owner a co-ordinator and there is an experienced 2-I-C and/or team to assist? 4) Does it have quality Sustainable Earnings You could have two businesses each with Sustainable Earnings of $500,000 a year. One business has done $500,000 a year every year for the last five years, and is projecting the same for next year. The second business did $500,000 this year, had a negative $200,000 the year before, a positive $150,000 the year before that, and the year before that they had a break even. Clearly the former business has a greater ability to repeat performance and consistently deliver Sustainable Earnings. 5) What is the state of the market You may have very positive Sustainable Earnings that have grown steadily from $200,000 to $500,000 over the past few years, but you re in a market that is suddenly becoming ultra-competitive. There is massive consolidation and big players are entering the market, which will affect your ability to extract earnings into the future. 6) How much cash does it generate We talked about Cash Flow in a recent ebook. Cash earnings are important because they help fund the business operating requirements and contribute to profits. If a business generates positive cash earnings that s a good sign there is sustainable value in the business. 8 jpabusiness.com.au

9 The challenge for owners It s often challenging for business owners because they look at their performance and say: Hold on, we ve made this much money, so this business must be worth X. But the bottom line is a smart purchaser isn t looking in the rear vision mirror when they buy a business. They will look in the rear vision mirror to give them a sense of how this business has performed and then say based on that history and based on all these other factors, how will Sustainable Earnings track in the future? They don t consider what they plan to do in the future to enhance the business, but instead assess what you have left in the tank to run out and how it is going to run out in the future. They will then base their price on their assessment of those future earnings. How to extract value along the way I often say to business owners: Don t just think that you get value out of a business when you sell it or transfer it within your family. Value can be extracted from a business in a number of ways. Business owners who are focused on business value all the time not just when they go to sell know this, because they know year by year how much value they re generating in the business. And usually, a strongly performing business will allow the business owner to extract value along the way. jpabusiness.com.au

10 What does not determine Sustainable Earnings The amount of borrowings, or the money you ve invested in the business, is not overly relevant to the price you ask when you go to sell. So often I come across business owners who want to put a value on their business which is largely linked to the size of their loan. I can understand why that s important to an owner who wants to retire their debt, but the market simply doesn t see it that way. A purchaser will not look at the size of your loan when they look at the business value they will look at the Sustainable Earnings and what those Sustainable Earnings might like in the future. 10 jpabusiness.com.au

11 4. Why information is critical in driving business value You re not going to sell a business if you hide it under a bushel and you re not going to have a confident purchaser willing to bid up strongly on your business if you don t have solid, robust and transparent information to support the performance of the business. When a purchaser does due diligence on a business, among other things they re really looking to confirm: the veracity of the Sustainable Earnings; confirm the risks around shocks in those numbers and performance; identify opportunities in the business; understand how the business ticks what makes it do what it does; understand the solidity of the business model i.e. the management systems, the people, the customers, the contracts, the products and services, the plant and equipment, and the supplier relationships. The crisper and cleaner you can describe and present that information in the business sale process, the more chance you have of actually driving business value. Remember, for a business person, information can reduce risk. jpabusiness.com.au

12 10 key pieces of information to include in the sale process 1. What your Sustainable Earnings look like and what they have looked like over the most recent 3 financial years, and whether the business working capital and operations have been funded by surplus cash earnings, or debt, or both. 2. What your pipeline looks like into the next 12 months. 3. A description of your client base and its diversity and any key contracts. 4. An explanation of your supplier relationships evidence of how you secure your suppliers, particularly key suppliers that impact your ability to service your customers. 5. A description of your staff, employees and their roles in the business, including the owner s role this could take the form of an organisational chart, but should also detail the quality of your team. 6. An explanation of the market you operate in and why this business delivers what it s able to deliver. 7. At least the last two years tax accounts. 8. Profit and Loss statement and balance sheet. 9. Up-to-date list of plant and equipment and information about its utilisation in the business. 10. Up-to-date documentation of any premises lease. All of the above should be summarised into a professional document that provides a credible commentary on the performance, track record and future prospects for the business you ve built. 12 jpabusiness.com.au

13 Don t try to hide your skeletons Every business is different and they all have their skeletons even the bestperforming businesses. Don t feel you need to hide those things; instead be transparent and open. Sure, you can put a positive spin on things and you need to ensure the person assisting you in marketing your business is able to do that effectively, but don t try to hide the reality. Credible, robust, transparent information is critical to allowing a purchaser to get comfortable with the risk and opportunity they re about to take on in paying you a significant value for your business, particularly when you re asking value for future or projected Sustainable Earnings. No one wants to pay for goodwill anymore Goodwill is an intangible value associated with businesses. Stock, plant and equipment, and other fixed assets are tangible items that can be relatively easily valued on a market. Goodwill is intangible; essentially it is the risk premium around how and what Sustainable Earnings will be delivered into the future. I often hear people say no one wants to pay for goodwill anymore. Let me assure readers, the market is willing to pay for goodwill, but they ll only pay when they have confidence in the information that suggests there is goodwill: a future flow of earnings beyond the current owner. jpabusiness.com.au

14 5. What is your Point of Difference and Competitive Advantage? Point of Difference (POD) and Competitive Advantage are critical to ensuring a business is saleable, but also that there is strong business value. If Sustainable Earnings are generated from a business, often that is a proxy for a POD. In the chapter Six Key Determinants of Sustainable Earnings we discussed the way changing market circumstances can impact the quality of earnings into the future. Competitive Advantage occurs where businesses have a POD that will protect their earnings to some extent into the future. Examples of POD and Competitive Advantage: Solid relationships of a long-term nature with customers or suppliers A patent or exclusive distribution rights over a piece of technology Exclusive distribution rights, for example, enable a potential purchaser to see that for this particular product or service, the business has a market power advantage. Of course, that is only of value if the Sustainable Earnings show there is value being generated from it and forecast to be generated into the future. It s one thing to have a patent or exclusive rights, but if they re not flowing through to value in terms of Sustainable Earnings, then they won t be valued in the sale process. 14 jpabusiness.com.au

15 What does Point of Difference and Competitive Advantage mean? First we will consider what POD and Competitive Advantage is not: It is not being in business for 40 years It is not having a well-known brand It is not having a large turnover It is not being located in a regional market where there are few competitors All those factors assist in driving business value, but POD and Competitive Advantage is something a little more special than that. It s about having the systems, processes, technology or differences that others have to invest in and which will take time in order for them to catch up to you. POD and Competitive Advantage practical examples Example 1. I am a retailer operating in Sydney s Pitt Street. I am the only retailer within a 10km radius selling a new mobile payment device. This is my POD, but other retailers could start selling the device if they wanted to. I then go to my supplier and negotiate three-year, exclusive distribution rights for the Sydney market. I now have POD and Competitive Advantage. jpabusiness.com.au

16 Example 2. Imagine a coastline of 4000km, but there is only a 1km stretch suitable for the establishment of a deep water port to service large cargo ships. The first business to build a port on that 1km of coastline and invest the millions of dollars needed to establish facilities around the port, will have a POD and a Competitive Advantage. Right or wrong, it will be hard for other players to enter that market quickly because: 1) they have to come up with hundreds of millions of dollars, and 2) there are limited sites available because there is only 1km that has deep water. So, everything else being equal, that business has a POD and Competitive Advantage that is going to be hard to compete with and, if it s run well, will be able to secure Sustainable Earnings. Don t fall into the POD trap! Make sure the product or service or other element that gives you Point of Difference is actually a POD that people will value! This is where understanding your customers and the market is vital to adding business value. 16 jpabusiness.com.au