Business valuations: Don’t bait the shark

You may have found yourself watching the program Shark Tank on television recently and wondering with intrigue, and sometimes amazement, at the lack of “science” some of the contestants have in working out the value of their business. You wouldn’t be alone.

I use the word “science” intentionally because valuations are part art and part science. This means that a valuation is part subjective (art) and part objective (science). The key is to ensure that the objective part can justify the subjective part.

Mathematically, the business valuation model is relatively simple.

Business Value = profit x risk.

Business value is the anticipated future profits to be generated, and a multiple reflecting the perceived risk of investing in that business, and hence the desired rate of return. But startups, like those on Shark Tank, can often lack certainty and clarity on both of the above.

An assessment of future maintainable profits can be supported by what’s happened in the immediate past. In other words, if a business has generated $1m a year in profit for the past 10 years, then there is a reasonable chance it will generate a $1m profit in the future. However, for startup businesses there is rarely a trading history. So, there is a huge degree of “blue sky” in some of the profit estimates.

For example, if a prospective purchaser perceived that they needed a 20% return to compensate them for the risk of investing in a particular business then the multiple is the inverse of this (i.e. five times). If the required return was 25% then the multiple would be four. If the future profits were assessed at (say) $1m then the business value is arguably $5m (being 5 x $1m).

However, as mentioned previously, business valuation is part art, part science. This means it is largely a personal value judgment. At the end of the day, it doesn’t matter what theoretical valuation you come up with, the only one that matters is the price a purchaser will pay and the price a willing vendor is prepared to sell for.

Focus on maximising and stabilising profitability

The first issue in the above equation revolves around how predictable your sales and profit are. The key point to understand here is a purchaser is buying your future profits, not your past profits. Rightly or wrongly, they form their views on your future profits based on your past profits.

Put yourself in the shoes of a potential purchaser. Do your profits fluctuate wildly from year to year or are they relatively stable? What certainty can they obtain that you will make a similar (or higher) profit next year compared to the past year? The more predictable your profits, the greater the comfort that a prospective purchaser has they will be able to make the same amount of profit in the future years. The importance of sustainable, reliable profits should not be underestimated. For startups, there is no certainty regarding future profits.

I also often hear that there are certain adjustments made to “normalise” the profit when there is a need to be made to the book profits to show the “real profit”. Adjustments just make a prospective purchaser nervous. Ultimately, the prospective purchaser or their adviser will make a call on the validity of these “adjustments”. You can eliminate this issue by removing “adjustments” in the years well before a business sale.

Reduce the perceived risk of the buyer

The second issue is the risk a potential purchaser perceives in your business. Risk can revolve around a number of issues but it can generally be put into three broad risk “baskets” – people, product or market, and processes and systems.

Reducing a buyer’s perception of these risks will not only play a significant psychological role, it will also limit their bargaining power in the negotiation process.

For startups, the perceived risk will always be high, as often only a very small minority of businesses actually make it.

Dependence on the current owner is a key risk in most business sales. If you are the owner, you can lower this risk significantly by removing yourself from the organisation well before the sale of the business or by having your business model not being solely dependent on you. In this way you can demonstrate to a potential buyer that the business can run without you. A happy, committed and competent management team will go a long way to allaying this risk.

Having profitable products or services in a growth industry is also important in reducing perceived risk. So consider your market – does your product or service only have a small market or potentially a global one? You need to do whatever you can to convince a potential buyer key customers are not going to walk out the door when you sell. Dependence on key customers is also a risk, so do what you can to reduce that.

Perceived risk can also be decreased by having sound processes and systems in place. This includes timely and accurate information to show that you have your finger on the pulse.

Also, ensure that valuable assets are protected with trademarks, patents and the like.

In summary, set your business up for sale having regard to the above tips, well before (at least two years) you intend to sell. For startups, be prepared for prospective investors to have a pessimistic view of your future profits and that their assessment of the risk of your business will be high – because it is.

But remember, 50% of something is better than 100% of nothing so don’t be afraid to “give away” some equity to get your dream off the ground.

Grant Field is Australasian chairman of accounting firm MGI.

The information contained in this article is general in nature and readers should seek their own professional advice in relation to these areas.

This article originally appeared on SmartCompany.

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