‘What is my business worth?’ This is one of the most common questions that business owners ask me. To most business owners, the idea of an outsider getting away with paying too little for their ‘baby’ is galling. Therefore, the aim often becomes getting the maximum amount possible for the business.
The question I often ask in reply is, ‘What do you need it be worth?’ You need to answer both questions if you’re going to put together a realistic succession plan. So, whether you’re planning to sell outright to an outsider, or considering going down an employee ownership route (like ISOP), you need to get a clear idea of the value of the business to inform your succession plan.
There are hundreds of ways to value a business. In my experience, the most common way is using the formula: business value = profits x price earning ratio
Breaking this formula down, the steps are:
1. Take the profits on your most recent annual accounts.
- Adjust these for non-commercial and exceptional items. Examples of non-commercial adjustments are salary payments to business owners above or below the market rate, or zero rent charges on business premises owned by the shareholders and provided rent free. Exceptional items are expenses or income not expected to be repeated, such as uninsured losses on fire-damaged assets or one-off income of some sort.
- This gives you a true, sustainable profit figure.
- Multiply this by the ‘price earning ratio’ (also known as P/E). The P/E for most small businesses is typically between three and seven, depending on factors like how independent it is of the business owner, the quality of the systems, and the lifespan of its products or services. A P/E of five is typical for good, small, privately owned businesses.
- The answer you arrive at is the theoretical value of your business. I emphasise theoretical because, just because that’s what it’s worth on paper, doesn’t mean that’s what buyers will be willing to pay!
- If the business has assets like investments that are not used in its everyday trade, these can be added to the total value of the company shares.
Say, for example, your accounts show £300k profits before tax and dividends. You pay yourself a minimal salary and take most of your money out as dividends. It would cost about £100k to buy in someone to do your job, so the real profit is £200k. After tax at 20%, this would give an adjusted profit of £160k.
In this example, with a P/E ratio of five, the business would be worth £800k (£160k x 5). You also have £500k in an investment bond that is not needed by the business for its day-to-day trade, so you add this to the value, giving a total of £1.3m.
You’ll definitely need to involve an accountant in your succession planning and they’ll be able to help you with creating a detailed business valuation. Before you work with an accountant though, check to see what is included in their fee. In particular, check to see if their fee includes agreeing the valuation with the tax office (as we do at K&H). That gives you certainty about your tax position.
Ultimately, keep in mind that valuations are subjective. There is no concrete answer to the question ‘what is my business worth?’ – except perhaps, ‘what someone is willing to pay for it!’
This post is based on an extract of my book Do More of What You Love: The New Approach to Business Succession Planning, out now.