Valuation Methodology Principles for Selling a Small Business

Part 2 of 5

Yesterday I introduced you to Toaster Installers Inc, the Australian business client of mine that I helped sell for a multiple of Profit x 250!

When we had a closer look, we discovered it was really ‘only’ 26 times profit. Which still beats the 2-4 times average you will often see.

At this point let me be clear: I am not an accountant. I think some accountants are amazing, and while you don’t have to be an accountant to be a good business advisor some accounting awareness is valuable, and I was a partner in the accounting firm named Xero Partner of the Year in 2017.

There’s an old joke that to value your business an accountant will transfer all of your financials into a spreadsheet, run it through several complex models based on industry trends and market forces, then delete that spreadsheet and just multiple your profit by 3.

That’s obviously disingenuous … because sometimes they multiply by 2.5 instead.

Think of Selling your House

In some ways, selling your business is like selling your house.

First you might want an indicative valuation – you can go ballpark (real estate agent / general accountant) or you can get a proper Valuation (registered valuer / business valuation specialist).

If you’ve recently had your house valued by a registered valuer, you know the limits placed upon them. They can only formally value your property based on other comparable sales. But when there is limited stock and prices are rising fast, recent local comparables are not telling the full story.

In my 20+ years around real estate investing, I’ve had plenty of chats with valuers along the lines of “I’m telling them $800,000 because that’s the best I can justify; if you went to auction tomorrow you might get $900,000.”

Accountants are similarly restricted. If you think it’s hard to find comparable house sales, try finding comparable Toaster Installer businesses to work out the price!

Generally Accepted Accounting Principles

So the accounting industry has developed some Generally Accepted Accounting Principles, to give some idea of how to do their work – in many areas, including business valuation.

I’m not going into these, except to say that they hugely handcuff an accountant who has to give a realistic valuation while also being able to justify their methodology in court (say, during a tax audit or a messy divorce case).

If you want to know how much of a handcuff it can be, have a look at the bottom of your Balance Sheet for the line item “Net Equity” (or similar). That’s the Assets your accountant can justify, minus the Liabilities they can calculate … and I’d be happy to bet it’s a number that in no way represents the true “Equity” of your business if you were to sell it today?

Even accountants know this (I told you they weren’t idiots). So they had to introduce this amorphous concept of “Goodwill” to explain the difference between Net Equity and any actual sale price. If you want to watch someone’s head explode, ask a mediocre accountant for 3 ways you can improve the Goodwill of your business!

More than Goodwill

Someone buying your business isn’t paying you more out of “good will”. If they pay more, it’s because your business is worth more to them.

So let’s get super simple. As you’ve seen so far, most privately-owned, small and medium-sized businesses sell for a multiple of profit. We can even make the formula really simple:

Valuation = Profit x Multiple

There are exceptions. In some commodified industries, like accounting or property management (in Australia anyway), common Valuations are Revenue x Multiple; although it doesn’t really matter much, because “Revenue x 0.97” in a an industry with an average profit margin of 32% is the same outcome as “Profit x 3” – pricing based on Revenue is the buyers way of saying “I will run your business like I run mine, so your profit margins are irrelevant”.

You will also hear a Valuation version of “Profit divided by a Risk Factor”. We will talk tomorrow in detail about Risk, but again this doesn’t change the thinking – a Risk Factor of 33% is mathematically equivalent to a Multiple of 3. (Don’t believe me, divide your own profit by 33% … then separately multiply it by 3 … same outcome?)

The Final Huge Accounting Myth

I’m picking on accountants a lot, and only some of them deserve it. But here’s the last big myth they push onto their unsuspecting small business clients.

“You can control the Profit, but the market defines the Multiple.” WRONG

They want you to believe that you can do things to improve your Profit – more sales, lower costs etc – and you absolutely can. It usually takes time, but that’s why I work with so many fast growth clients for the long-term – there’s always more ways to increase revenue, and/or increase profit.

While many industries do have benchmark multiples, telling you that “that’s the standard” and “there’s not much you can do about that” is a fallacy.

Let’s go back to selling your house. Maybe in this market it is worth $900,000 – but your dream scenario is two (or more) very enthusiastic bidders with deep pockets. If they all want your house and can afford it, then on the day you might sell for $1 million or more!

So it is with selling your business – for all the Generally Accepted Accounting Principles or the Benchmark Multiples, there’s no forecasting how high the price might go with multiple interested parties.

And in some ways selling your business is not at all like selling your house. It’s like selling a house that’s located on top of diamond mine. And while many parties – including risk-averse accountants with their handcuffs on – can and will only value the house … someone buying the diamond mine doesn’t give a rat’s arse what the house is worth.

A good business advisor helps you find your diamond mine. And when the sale is done and dusted, the people who valued the house are left confused. They don’t understand where all that “Goodwill” came from. They’re left staring at the Profit number and the Multiple they expected, and they can’t reconcile those against the final price you achieved.

You might not be able to reconcile it either – but of course it’s hard to do math when you’re busy living the rich life you’ve earned!

Want to see more details, including the specifics? Click here to read Part 3 “Profit is Past, Risk is Future – Why the Buyer Paid More”.

3 Comments

  1. […] Click here to read Part 2, all about valuation methodology principles for privately-owned businesses. (Alternative title: “He’s not an idiot, he’s just an accountant.”) […]

  2. […] (Click here for Valuation = Unadjusted Profit x 250 | Or here for Part 2 on valuation methodologies, aka ‘He’s not an idiot, he’s just your accountant’) […]

  3. […] up on Part 1 – How we Sold a Business for Profit x 250 | Part 2 – Valuation Methodologies for Small Businesses | Part 3 – How we convinced the Buyer to happily pay more | and Part 4 – How the […]

Leave a Comment





This site uses Akismet to reduce spam. Learn how your comment data is processed.