How to value your business

Shaun Reeves: Hello, I'm Shaun Reeves. And welcome to this presentation about how to value your business.

I'm Shaun Reeves, director of SRJ Walker Wayland, business advisors, tax agents, accountants, auditors, and all other things business related.

Welcome along today to our discussion with Tony Brown, about how to value your business. Tony, perhaps you could tell the people a little bit about yourself.

Tony Brown: I'm a director and founder of Divest Merge Acquire, which is a mergers and acquisitions transaction advisory. It sounds a lot, but basically we help people buy and sell businesses both nationally and internationally, and we’re based in Queensland.

Shaun Reeves: So I guess, you do a fair bit of work on talking to people about valuing businesses?

Tony Brown: The core of our businesses is helping baby boomers retire and we help others acquire businesses, or buy themselves in for various reasons.

Shaun Reeves: It’s great to have an expert with us today. Tony, to set a scene: I'm having a discussion with you about my business, and I've said I wouldn't mind getting a valuation.

Why would I want evaluation for my business? What are the situations where evaluation's going to be relevant?

Tony Brown: Well, any business owner, from my perspective, should get an evaluation (even informally) done with their accountants every year. A lot of people we come across have been working in their businesses for up to 30 years and they’re thinking maybe I don't want to do this anymore, and have no idea of what their businesses are worth.

It's a very useful thing, to have a ballpark understanding of what your business would be worth every year after you get your accounts done. So that's a good reason. There could be a lot of other reasons retirement, a change of partners, somebody could want to exit, somebody might want to buy in, but there's a whole lot of reasons. A simple business restructuring can sometimes require evaluation to be done for the tax office.

Shaun Reeves: Also for the office of state revenue, for example, for stamp duty reasons as well.

All of those government and administrative bodies looking to make sure that we're doing the right thing when transactions are made.

Tony Brown: But it's also a significant asset to the business owner. And they should know, like every other thing. You know what your properties are roughly worth, and businesses that are exactly the same.

They're a significant asset. And it's useful to know what they're worth at any point in time.

Shaun Reeves: I guess it's also important too, for example, for insurance purposes, if you're saying, I've built a significant asset, but at the moment, a lot of it relies on me. What happens if something happens to me? What does it mean for my family? So I guess you need to know in order to be able to insure properly as well.

Tony Brown: That's exactly right, Shaun. Most of our business is helping people sell or buy, but all the other reasons you're talking about are reasons why people would get (in many cases) what we'd call a formal valuation as opposed to an informal evaluation.

Shaun Reeves: You're talking about a formal valuation, which is a lovely segway into what was going to be my next question. Where do I start? Do I go straight to a registered valuer? Or is there other work to be done or other people to speak to?

What's the starting point in getting a valuation done?

Tony Brown: So a formal evaluation should be done by a registered business valuer. They sometimes have the same qualification as a property valuer, but usually they don't. It's a special skill. You're valuing different things as opposed to tangible assets. You're valuing the cashflow in the profit of the business. We can cover that in how to value a business, but definitely you need to go to someone who's got some credibility or qualifications in that area.

Shaun Reeves: If I'm going to approach someone to do that, what information are they going to need from me?

Tony Brown: There's certainly going to need financial statements. Minimum from the last three years. It's always helpful to have your accounts in a good state and to have timely accounts prepared.

Also the assets of the business are important - the tangible assets, for example the plant and equipment, stock and other things. It is very handy to keep good quality financial records. Obviously the minimum anchor point is annual accounts. Some businesses are well geared up to doing monthly accounts and management reporting, which adds another level of checking and capability, particularly if, one of the reasons you were selling it was you evaluating was to sell because you do need those interim reports.

Shaun Reeves: I know that you’re mentioning financial statements and from a tax accounting point of view, I know that when accounts are collated, quite often they're collated for tax purposes. Where we've got instant asset write offs or pooled assets, we don't have very good asset lists, or appreciation schedules.

Is it as easy as three years worth of financials, or is there a lot more that's got to happen around that?

Tony Brown: The sort of checklist that we have to produce even an informal evaluation runs to quite a large number of items. So we do need to understand the financials and then adjust them for factors that are not likely to continue.

There's a lot of information, a whole lot of questions that someone doing the job properly would be asking the business owners.

Shaun Reeves: In respect to the information that we've got to put together, is it all financial?

Tony Brown: In evaluation, it's primarily financial. But there are other factors like the quality of the lease that might be in place if it's a location-sensitive business. The customer concentration [could be considered]. You can imagine a business that has one customer is potentially a lot riskier, for anybody involved in the business than someone that has a larger customer base. If the largest customer was 1% of turnover of sales, that's a safer business or more resilient.

There's a whole lot of things like whether you have customers that are contracted, whether you have a strong supplier chain distribution channels, there's many factors that affect how people would assess a business.

Shaun Reeves: I'm getting a sense there that two of our main value drivers – and we might be able to break these down a bit further - are risk and return.

So we've talked about return - that's the financial stuff. You've started talking about risk, which is really interesting. Is it easy to measure risk in a business?

Tony Brown: It depends on who you are. If you were looking to sell a business, then a buyer who's come from your industry, who understands what you're doing, and has already expertise in that area, would see that risk as much lower if they can assess your business, better than somebody who is completely outside that business. And the further you get outside of your history, and your knowledge and your area of expertise, the risk factors go up exponentially. So it depends on who's assessing the business.

When we're selling a business, we look and say the people that are going to pay the most. In other words, who it's worth the most to, are the people with the most to gain and the least to risk. And it's usually people already doing what you're doing and they also understand it. And they've got more to bring to the business and more opportunity they see in the business.

So risk and return are in the eyes of the assessor. Of the person who's perhaps going to be involved with a transaction with that business.

Shaun Reeves: So the buyer is a really important concept, which we'll get to in another video - How to sell your business.

But for the moment we'll stick here with what we've got on the financial and non-financial value drivers. How is the financial return for my business calculated?

We use this term normalising profits.

What does normalising profits mean?

Tony Brown: So normalised profits are the result of taking the actual profit reported and adjusting it for anything that won't affect the business going forward, either a new owner or the current owner in new circumstances.

So we're adjusting for some unusual things, extraordinary items, or abnormal items. For example, an extreme bad debt, or a fire, or something that took the business out of action for three months. If you took that historic set of profits, you wouldn't expect that to be repeated going forward, for example.

So we're predicting the future maintainable profit of the business, or future maintainable earnings, using the current and recent past performance and the trends as a guide.

Shaun Reeves: So that's an important concept, isn't it? Future maintainable earnings. And we'll get into a few buzz phrases here because us, financial and business advisors love buzz phrases.

We're talking about future maintainable earnings. Future means we've got to try and look into a crystal ball and predict what's going to happen. So what you're saying there is that the best way to do that is have a look at recent past and adjust for those things that aren't necessarily relevant for the future.

Maintainable means we've got a confidence that it's fairly predictable that that's where we're going to be. And earnings is about the return you're getting from the business.

Now, another little acronym, EBITDA. So we use EBITDA to normalize and then calculate future maintainable learnings.

Perhaps you can enlighten us on what EBITDA is and why we do it that way

Tony Brown: We'll start with EBIT and we'll go to EBITDA. EBIT is earnings, which is a form of profit. As an accountant we can say whatever you want the profit to be, but the important point is that we have to define which profit it is. And that is:

EBIT is ‘Earnings Before Interest and Tax’

It's the earnings before interest, which is all finance costs as though the business assets were debt-free.

And tax. So because the tax regime of the business might be entirely different from one business to another.

Now, EBITDA is Earnings before interest and tax, depreciation and amortization.

You really don't have to worry about amortization. It's like depreciation. Except it's of intangible assets like leases.

So EBITDA is before interest tax depreciation.

Now, the reason why people would add back depreciation, and come up with a profit before depreciation, would be because depreciation is a non-cash item. So the true cashflow of the business before paying for depreciating assets, which is a non-cash item is EBITDA.

Shaun Reeves: So we’re trying to capture the earnings from the business before the interest tax depreciation, because we want to see what the cash earnings of the business are in order to assess the return that that business is going to provide us. And then we can build in our own financing costs?

Tony Brown: It also depends on the type of business. EBIT is ultimately the truest form of assessment, but we don't just take the depreciation. This is where it gets a little bit more complicated. We'll add back the actual accounting, non-cash depreciation, and we'll replace it with a real depreciation called a provision for capital replacement.

Now let's say you had a car rental business. And you probably have two costs. One is some labor, but the biggest cost you got in that business's depreciation on the vehicles. So if you just took EBITDA in that particular kind of business, you wouldn't really be showing the true performance, because you have to keep buying new assets and they depreciate. So the capital replacement to come up with EBIT, ultimately is a more generic measure across all businesses.

Shaun Reeves: So, sorry about two accountants talking with each other, getting into some nitty gritty, but suffice to say businesses are really the same when it comes to calculating the normalised profits. It does pay to get a little bit of direction around where that's at, but at least we've given people a bit of an idea about how to calculate that return.

Tony Brown: The one thing we talked about was it starts with profit. And the key driver of the value of a business is its cashflow/profit.

We just talked about the different variations of how you measure it, but it all comes down to the profit first of all, which is the return the business will generate.

Shaun Reeves: So let's talk about risk then.

How does risk come into the equation?

Tony Brown: So the lowest risk kind of assets or investments might be money in the bank.

Very low risk and very low return. At the other end of the spectrum is going to be probably an active working business where the business has a high amount of, variable or variable volatility due to the influence of the owners, the customers, and many things that are inside and outside the owner's control.

The higher the risk, the higher the return people expect. Somewhere in there is property. That's a fairly low risk, lower return asset. And you'll see that businesses are generally on this at the end where you wanting a much more solid return, because it's what we call an active asset versus a passive asset.

Shaun Reeves: If I'm looking at a business in nice round numbers, that has an EBITDA or normalised of a million dollars. And I'm looking for a return on my investment, if I'm going to invest in that business, of say 25%, because that's how I've assessed the risk.

What does that do for what I'm prepared to pay for the business? $1 million dollars, I'm looking for a 25% return.

Tony Brown: Well, clearly you could afford to invest 4 million, which is a 25% return. 4 million is 1 million. So basically you look and say what's the profit of the business.

It's $1 million divided by 0.25 or 25%, which is the same as multiplying by four. But the multiple (x4) would give you a 25% return, so you can afford to invest $4 million.

Shaun Reeves: So ironically, the lower the return that I'm going to expect to get from this business, the higher the multiple.

That does confuse people at times. Well, my capitalization rate, which is the rate of return you're looking for comes down, but the multiple goes up. I don't get that. That just means that if you have a look at that equation, it's the flip side.

A 33% return is a three times multiple, a 50% return is a two times multiple. So the higher the percentage of return you're looking to generate from the business, the lower the price you prepared to pay for it, because of the risk factors.

Tony Brown: If someone's happy with an 8% return on the property, the multiple will be roughly 12%

Are there any rules of thumb that we can use or is that a bit of a danger?

Tony Brown: There are some rules that apply and relevant to different industries, but when it all boils down to it, the only general rule would be probably between three and four times EBIT.

It's the only safe one you can apply. Most businesses are with that kind of range, unless it's Telstra or something quite large.

Shaun Reeves: Unless it's a large takeover or a company in a very special position either with very low risk or very high risk.

Tony Brown: Some businesses sell on a multiple of turnover, but when you do reduce it back, the profit generally becomes a roughly three to five times EBIT multiple.

Shaun Reeves: So I've gone through this process and I've sought some advice and I've come up with my $4 million amount for my business. Is that a lock-in? If I turn up, am I going to insist somebody pays $4 million or is it trickier than that? As far as the market's concerned.

Tony Brown: There's many, many things.

Every business is different and that's why it's always hard for a valuer to try and get precedence like they do with commercial properties, for example.

It could be that customer concentration we're talking about; the stability of the staff; the dependence of the business on the owners. And the more dependency that the business has on the owners - who may want to leave - then the riskier it is for someone else coming in.

Shaun Reeves: So it's a function of perception of risk on the part of the buyer and what they perceive at risk may perceive as risk may affect what they're prepared to pay for the business. So we're really talking a willing, but not anxious seller and a willing, but not anxious buyer and where they meet as far as the negotiation goes. My $4 million is not necessarily a lock in.

Tony Brown: Not necessarily. You can't just say that every business is going to get you that amount.

Shaun Reeves: Just one last little question before we close. There is a lot happening at the moment around angel investment and startups.

Do we value those the same way as we value other businesses?

Tony Brown: You certainly don’t. Can you imagine we just talked about businesses valued on their cashflow - historic and projected cashflow.

If you look and say that businesses are within a spectrum. So at one end of the spectrum, there is a business based on its cashflow, with not much intellectual property or IP as we would call it.

Then on the other end of the spectrum of a business that hasn't started, it could just be an idea or a concept. And at that end of the spectrum, there's no cash flow. There's no historical earnings.

So most businesses are actually somewhere in that spectrum. Most businesses have intellectual property, but if there's a business or a that's just starting out and it's only in its prototype stages or it's one or two years out, you can't possibly rely on historic earnings. So you have to forecast. Try and come up with some method or way of credibly projecting what you think the possibilities will be. Obviously there's higher risk, so people are going to want a higher return. So they won't pay the same multiples that they would on historic returns.

Shaun Reeves: What we're doing is we're getting back to that crystal ball again in a much bigger way. And we're saying, that I haven't got the financials here to show you, but I'm going to show you what I think it'll look like. And I guess it's up to the buyer to see how much they buy in to the story as opposed to actually physically buying into the business.

And there's a lot of perception and emotion involved in that investment decision as opposed to cold, hard financials.

Tony Brown: And just as we talked about the knowledge of the buyers - the more they understand that industry and have more confidence with it and understand the possibilities of this startup, then the more likely they will come up with a valuation and therefore more likely to proceed. So, if you are looking for an investor in angel capital, you want somebody who knows who and who can bring more to the table than just money who can actually bring expertise to help grow that business.

Shaun Reeves: Tony, thanks for that. I know we've been through a little bit of technical stuff, but hopefully we've given the audience a really good idea of what we've got to go through to collate information, to normalize it, to assess risk. To put what we hope is a value guide on a business, and then have that value guide to use to sell a business, refinance it, and/or to have a look at what it's worth for us in retirement.

So I hope you've, you've had some benefit out of this. Thank you again, Tony. Tony will be joining me for selling a business. Please look out for that video as well. This valuing of business is a subset of the selling. We look forward to catching you if you decide to take valuing further and have a look at the sell process.