Five common mistakes when valuing your business
The BBC’s Dragons’ Den is now in its 16th season with the highs and lows of building, running or expanding a business remaining compelling viewing. It entertains and can be excruciating in equal measure, particularly when the Dragons roll their eyes following a wildly optimistic valuation of the hopeful’s business. So why is it so difficult to value a business? Partner Tom Wacher highlights some of the more common mistakes.
Mistake 1: unrealistic sustainable revenue and profit projections
There are many ways to value a trading business, most of which are broadly based on multiples of revenue and/or profits. Such valuations should be based on what the business is expected to achieve in the future rather than what it achieved in the past.
With established businesses that have a trading record and no expectations for significant change, determining this is a relatively straightforward exercise with years of historic data to draw upon. Where the past results are not representative of the future, or with start-ups and fast-growing businesses, this is not the case.
Evolving businesses, ambitious start-ups and fast-growing businesses will often forecast rapid growth – the ‘hockey stick’ projection – but there are very obvious risks that those predictions will not be achieved, projections need to be credible rather than overly aspirational.
In these circumstances, a valuation is likely to be based on cash flow projections, discounted for the risks associated with the industry sector, the size of the potential market, the company’s own management team and their track record, and its strategy to achieve that growth.
Mistake 2: underestimating the needs of working capital
Businesses need working capital, and the more they grow the more working capital is needed. Underestimating the need for future working capital can result in over-inflated free cash flows and can jeopardise the sustainability of the business.
A clear business plan will outline future cash flow projections including fixed, stepped and variable costs and, of course, future tax liabilities. It will also set out fixed asset purchases and working capital requirements including cash, debtor and stock levels. Higher levels of working capital will impact valuations, driving cash inflows down, but more importantly they can stunt growth and impact the chance of success for a business.
Mistake 3: comparing your own business to others
While finding a comparable business can be fundamental evidence of value, comparing a business to that of an immediate or apparently similar competitor requires a detailed review. Otherwise, it is a valuation based on assumptions that does not necessarily take into account differences in reputation, customer portfolio, patents, property, other assets, overheads and circumstances of both the company and the competitor company.
It is also worth keeping in mind that an established business with a similar turnover and profit to an evolving or younger business still in its rapid growth phase is likely to have a lower value. The comparison approach is only as good as the comparators used for the valuation.
Mistake 4: defining what exactly is for sale
Failing to define exactly what is for sale can also cause problems. For example, the valuation may be required of company shares rather than just the underlying trade of the business, in which case it is necessary to consider any debt owed by, or any surplus property or assets held in the company.
Alternatively, it is not that uncommon for a business owner to decide to sell a business but keep hold of patents and other intellectual property to then discover the value of the business is less than expected.
Consider and define first what it is you are actually looking to sell and what will be held back before valuing a business.
Mistake 5: the reason for a sale
Whilst this is perhaps less of a mistake made in valuing a business, the reason for and the timing of a sale may impact price.
Selling a business when the economy is depressed or when funding is scarce will inevitably depress valuations. So too may prices fall if it is a forced sale – for example if a husband and wife in a family run business are separating. Conversely, in some circumstances, significant premiums may be achieved depending on the acquirer’s need.
There are many different ways to value a business and many mistakes that can be easily made.
Choosing the right accountant or adviser to assist is critical in achieving the best and a fair valuation. They will typically value a business via two or three different models to arrive at an accurate valuation, together with drawing upon their experience of similar businesses in the same sector and geography.
For further information please speak with your usual Kreston Reeves adviser, or Tom Wacher here or on +44 (0)330 124 1399.
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