Business Valuations: A General Overview
Business valuations are expert reports providing comprehensive yet concise guidance on the value of a business, clearly explaining the rationale and methods used in determining the business’ value.
Business valuations are designed to be user friendly and compiled with the end purpose firmly in mind. On this basis, business valuations compiled for use in the courts may take a different format to those written for confidential use by business owners for the purpose of planning for the future.
Why Get a Business Valuation?
Business valuations are required for a range of different purposes including:
- Business sales
- Share transfers
- Planning for the future
- Partnership disputes
- Family law matters
- Estate planning
- Evaluating merger synergies
- Insurance claims
- Business loan requirements
- Company restructures
- Taxation purposes
What Should A Business Valuer Consider When Forming Their Opinion?
Business valuers should consider all manner of financial, non-financial (including but not limited to operational matters, contracts, employees, suppliers and customers), industry and broader economic factors in forming a justified and defendable opinion of value.
Who Can Value A Business?
Business valuers should have sufficient experience and expertise enabling them to provide logical and defendable valuation advice.
Although there are no licensing requirements for business valuers offering their services in New South Wales, it is imperative that your valuer has completed education relating specifically to valuation matters. Such education can be completed through accounting bodies (including the Institute of Chartered Accountants) and the peak industry body for Business Brokers, the Australian Institute of Business Brokers.
Business Valuations: Key Considerations
Regardless of the industry or business type, there are a number of key considerations that have almost universal applicability to the value of all businesses.
The considerations discussed below have a direct impact on the risk profile of most businesses and accordingly, the value of most businesses.
Real Property Leases
Business arrangements concerning leases for real property will generally have a major impact on the risk profile of a business. Key items that should be reviewed as part of a valuation are discussed below.
Length of Lease
The timeframe remaining on a lease can have a major impact on the value of a business. If the remaining term on a real property lease is quite short a risk may exist to the future operation of the business beyond the remaining term of the lease. Further, the business may encounter costs should there be a requirement for the business to be relocated. Risks such as these often discount business values.
Restrictive Covenant Clauses
Consideration should be given to any restrictive covenant clauses contained within real property leases. One of the most common such clauses is a demolition clause, which generally allows a landlord to demand that a tenant vacates leased property under certain terms.
Clauses such as these should be assessed on a case-by-case basis, however they can present a major risk to businesses where they exist and accordingly, can mean that business values will be discounted.
Oftentimes, businesses will lease real property from a related party. An assessment should be made as to the commerciality of rent being paid by the business to the related party – If the rent is not in line with market norms, an adjustment will be required.
All business owners understand that good employees are vital to the success of their business. Quality employees take responsibility, build strong relationships with staff and suppliers and inspire other staff members to put in their best efforts at work.
Many business owners have also experienced the damage and havoc that can be caused by one or two rogue staff members.
Based on this, the quality and reliability of a business’ employees will have a direct impact on the value of a business.
Key considerations that should be made with relation to a business’ employees are outlined below.
Roles and responsibilities
What roles and responsibilities do individual employees have in the business? Further, What degree of cross training exists between different employees? This is especially important for employees who take on managerial responsibility or team leadership roles and for employees with unique and important relationships with customers or suppliers.
In circumstances where there are employees who play a unique role within a business with limited capabilities amongst other employees or in the broader job market to assume those responsibilities in an effective manner, a notable risk exists to the business’ future performance. Should the employee exit the business, key skills may be lost and customer or supplier relationships may be fractured. Accordingly, these risks will likely have a negative impact on the business’ value.Risk of exit
What is the likelihood of employees exiting the business? Normally when assessing this it is important to consider:
- Employee turnover data: That is, on average how long will an employee stay with the business, and what percentage of employees generally exit the business on an annual basis? These measures help in making an assessment of the chances of employees leaving in the near future, as well as the likely number of employees to do so. If employee turnover is quite high compared to similar businesses, there may be a negative impact on the enterprise’s value.
- Age of employees: How many employees are approaching retirement age? What is known about individual employee’s plans for the future? If key employees are approaching retirement age, there may be a negative impact on the business’ value.
- Promotion and career advancement opportunities: What opportunities can the business offer to skilled and talented team members? What is the chance that capable and experienced employees will leave the company to further advance their career? This is a difficult factor to measure, however careful analysis of key personnel is required in order to measure what risks may exist.
Customer and Client Considerations
A business’ customer or client base can impact on the value of the enterprise. Key considerations that should be made with relation to a business’ customer and client make-up are discussed in detail below.
Spread of Customers
Businesses that have a few major customers that make up a large portion of their annual revenue can be rather risky. Its useful to assess each major customer on a case-by case basis, and give consideration to the nature of the business’ industry when assessing the impact of such risks.
Contracts and Relationships
Customer contracts should be assessed on the basis of their materiality, the term remaining, and the strength of exit penalties. Often, long-term customers will not be retained on a contract basis – they simply remain with the business owing to a strong relationship.
Where customers remain with a business on a relationship basis only (that is, no formal contract in place), an examination of the nature of the relationship should be made. Is the relationship with the owner of the business? Could a salesperson in the business take the relationship with them to a competing firm? These relationships should be assessed on a case-by-case basis.
The strength or weakness of a business’ supplier base will greatly impact on the business’ value.
Does the business have the freedom to choose from a multitude of similar suppliers with similar products or services, or are they tied to one or two key suppliers.
When a business is tied to one or two key suppliers, with limited opportunity to source goods or services elsewhere an assessment of those supplier’s stability, in conjunction with an assessment of risks contained within supply agreements is needed in order to determine the impact on the business’ value.
General Economic Matters
What is the current state of the economy? What will the economy look like in the foreseeable future?
Macro-economic factors will likely impact on the stability and success of businesses throughout the broader economy, and should be accounted for in any business valuation.
Personal Goodwill of Directors and Shareholders
How integral are the Directors and Shareholders of a business to that business’ success?
‘Owner-operator’ businesses where one or two working proprietors hold a significant amount of non-transferrable knowledge are generally difficult to sell in the marketplace, meaning their values are normally discounted.
On the other hand, businesses with a strong management structure in place, and proven systems and procedures are often easier to transact in the marketplace and generally attract a premium among business buyers demonstrating a positive impact to business values.
At its simplest level, the valuation of a business is the value of the future cash flows the business can generate. For most small to medium sized businesses, it is generally (but not always) assumed that ‘past financial performance (or earnings) are an indicator of future financial performance (or earnings)’.
In consideration of this, the way in which a business’ earnings are measured is of fundamental importance when assessing the value of a business. For many businesses, the reported net profit (as shown in the profit and loss statement) is a poor measure or gauge of the business’ real commercial earnings and performance. Accordingly, in order to assess the business’ true commercial earnings a number of adjustments (or add-backs) need to be made. These adjustments may be made in consideration of a number of items, including:
- Abnormal expenses or incomes (for example, one-off legal fees incurred by the business)
- Non-commercial expenses (for example, motor vehicles owned by the business, however used by the shareholders for purposes other than operating the business)
- Related party transactions (for example, management fees paid to a company also controlled by the shareholders of the business under analysis)
Beyond those adjustments (or add-backs) detailed above, consideration should be made as to the best measure of earnings for the business based on its industry, reliance on capital assets and size. Outlined below are the four most common measures of earnings that are applied when assessing the value of small to medium sized businesses, with commentary provided on their applicability to various industries and business types.
PEBIT is Proprietor’s Earnings Before Interest and Tax. In practicality, this means it is a measure of what the business is reasonably assessed to return in total earnings to one working proprietor (including their salary and superannuation) after making standard adjustments (or add-backs) and after removing interest expenses.
This measure of earnings is mostly applicable to small businesses with revenues of under $1 million, where the proprietor plays an active role in the day-to-day operation of the business. Further, businesses that lend themselves to a PEBIT measure of earnings normally have a requirement for regular upgrades of their physical asset base.
A good example of a business that would be suited to PEBIT as a measurement of earnings would be a small trucking business operated by an owner-driver.
PEBITDA is Proprietor’s Earnings Before Interest, Tax, Depreciation and Amortisation. In essence, this measure of earnings is the same as PEBIT, however depreciation and amortisation expenses are also removed during the adjustment (or add-back) process.
As with PEBIT, this measure of earnings is mostly applicable to small businesses with revenues of under $1 million, where the proprietor plays an active role in the day-to-day operation of the business. In contrast to PEBIT however, PEBITDA is generally used in circumstances where there is limited need to constantly update physical assets that are used by the business.
A good example of a business that would be suited to PEBITDA as a measurement of earnings would be a small HR consultancy business which is operated out of a small office with minimal use of physical assets.
EBITDA is Earnings Before Interest, Tax, Depreciation and Amortisation. This measurement is identical to PEBITDA, however it includes a market salary and superannuation expense for the role of the working proprietor.
EBITDA is mainly applicable to businesses with revenues of over $1 million that do not have a major reliance on physical assets.
A medium-sized accountancy practice would be well suited to EBITDA as a measurement of its earnings.
EBIT is Earnings Before Interest and Tax. This measurement is identical to PEBIT, however includes a market salary and superannuation expense for the role of the working proprietor.
This measure of earnings is generally most applicable to larger businesses (with revenues of over $1 million) that have a large physical asset base integral to the day-to-day performance of the enterprise.
A great example would be a truck company that relies on a large fleet of trucks that need to be updated periodically in order for the business to continue to trade.
Putting it All Together
The following example shows each measure of earnings detailed above in its application to a hypothetical business’ profit and loss statement: