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Valuation of a business

Introduction

A Sales Value is the Value that a willing and able buyer is prepared to pay for a business, with a given Net profit at a given time, considering micro and makro factors which have an influence on that business at that given time. 

 

At the end of the day it is market forces that have the last say and the sales value of a business is determined by the Net profit with micro and macro factors adjusting the final calculation.

 

Ask twenty “experts “to calculate the sales value of a small business and you will receive twenty answers. The value of a business is often nothing more than a perception. The buyer, the seller, the accountant, and the short-term insurer all have their own values. It is interesting to see the difference in the Value of a Business between the calculations of the accountant of the seller and the accountant of the buyer.

       

Misconceptions. (a view or opinion that is incorrect because it is based on faulty thinking or understanding.)

1 Multipliers

The desired price was calculated at three or four times the monthly sales. This method was particularly common in the food industry, such as Supermarkets and Restaurants.

The value of Fuel Stations was calculated at Rand per liter sales.

 

This method of calculating is defective in that the monthly sales can not determine the value of a business. You can have several businesses with the same sales per month, but each have a different Net profit. (The overheads, markup and stock holding all has an influence on the Net profit). Some businesses are open seven day a week; others are open only five days per week. Some businesses are in a very high security risk area others are in a shopping mall. Some businesses are vulnerable to influences such as change in Government legislation, weather, or public perception.

 

The main factor is the Net profit and not the sales or turnover that is used to calculate the Market Value of the Business.

 

2 Asset value plus goodwill.

A business can have an upmarket image with state-of-the-art assets, but it is running at a loss or is making a very small profit. If there is no or very little profit in relation to the asset value, why would anyone invest money in the business if the investor does not receive an acceptable return on his investment? You can attempt to determine the value of the assets and buy the assets, but as a business it has no value or little value. Further the value of the Goodwill is difficult to determine.

 

Does Goodwill exist?

Some financial institutions dispute the existence of Goodwill. Let us say you open a fast food restaurant called Rommel fast food, and you are next to a well-known Franchise restaurant. Rommel has operated for three months, but the well-known Franchise restaurant, which is distributed throughout South Africa and has been trading successfully for twenty years. Then surely the Franchise restaurant has built up a notable Goodwill compared to Rommel.

 

To start a liquor store, you need to apply for a Liquor License. You can pay rent on an empty shop for say six months before you receive your Liquor License. Then only can you fit the shop with fittings and stock the business.

If you start a new business, you never know how long the business will take to reach Break Even point. (This is when the Business does not make a profit or a loss). Say the Business takes two months to reach Break even point, then you had eight months “loss” before you start making a profit.

 

Now once your Business is running at a profit and you want to sell the business, the above factors must be brought into the equation. It is true that the buyer can not pay for your mistakes or set up cost. Therefore, a newly established business with a small profit can hardly be sold at the set-up cost. It is just too high.

 

Therefore, a well-established and profitable business does have Goodwill through its name, products, services, customer relations and customer loyalty.

 

There are exceptions. If you buy a Hairdressing Salon, the customers or Goodwill can be attached to the Hairdresser. Therefore, if the Hairdresser leaves very little or no Goodwill remains with the Business.

 

The following factors influence the value of a Business. :

1. Type of business
2. Asset Value
3. Trading Hours
4. Lease conditions of the site
5. Manager or self-management
6. Debtors and creditors
7. Stockholding
8. Method of payment for the business
9. How long has the business been trading
10. How long did the seller have the business?
11. Micro and Macro factors
12. Labour
13. Bee laws.
14. Location
15. Security
16. Contracts

          Let's evaluate each one individually.

1. Type of business

          During the last few years, well known successful franchise businesses achieved a higher selling             price. It is important to note that buying a franchise does not automatically guarantee success.                 Some franchises are, to say the least, not worth considering at all.

          Another factor is the required skills that the Buyer must have to run the Business. The higher the skills required of the buyer, the less prospective buyers are    available, and the price will be relatively lower.

2. Asset Value.

          Asset value plays a roll but is secondary to Net profit. A business with an exceptional high asset             value which is running at a loss has very little Sales value, except for the secondhand value of the          assets.

         On the other hand, you can have a Brokerage Firm with a high Net profit which is run from a one          room office with a few desks and a computer. The asset value of such a business is extremely low,         but he owner earns a hefty income each   month.

3. Trading Hours.

          If you compare two businesses which have the same profit, but the one business          is trading             five days a week and the other is trading seven days a week, then the   sales price must be adjusted          upwards for the five-day week business. Similarly, a  Business operating at office hours will be             more in demand than a Business   operating until 02h00 in the morning.

4. Lease Conditions.

          The reputation of the Lessor plays a roll in the pricing, as well as the lease  conditions and the              monthly rental charged for the premises. The buyer must take note of the annual escalation                     clause, the lease term offered as well as the clause allowing the owner of the business to sell the             business.

5. Is the Business Manager run or Owner Run.

          If the Business is Manager run, the owner has more time for himself. However, an    owner run             Business has more control over the business in terms of new initiatives, customer relations and             day to day business decisions.

6. Debtors and Creditors.

          Debtors. The age analyses of the business’s debtors have an influence on cash flow and cost of             financing the debtor accounts. Cash businesses are preferred. Debtors who include Government             (health, education, etc.) and Municipalities  have a negative impact on the price of a Business                 because of the perception of their neglect to pay within thirty days from invoice. The history of             the number of  bad debts will negatively influence the Sales value of a business. 

          Creditors outstanding will influence the price and cash flow of the Business.

7. Stockholding

          The cost of large stockholding and the cash flow required to maintain large stockholding is                     always considered. It must be remembered that on the day of the handover of the business from             the seller to the buyer, the agreed stock value might be present, but the fast-moving stock might be         depleted. This requires an additional amount of cash that must be injected into the bought                         business. 

          The buyer must ensure that the stock included in the Sales Price is calculated at Cost price and              not Sales Price or marked up price and if VAT on the price of the stock, which is included in the              price of the Business, is inclusive or exclusive.

8. Method of Payment for the Business.

          If the Business is sold on installment, the price will be higher than for a cash deal.

9. How long has the Business been trading?

          A business which has been trading for twenty years will have a higher price than a business which           has been trading for six months. (Even with the same net profit)

10. How long did the seller have the business?

          A Business which had four owners in six years will achieve a lower price  compared to a                         Business which had one owner in ten years.

11. Micro and Makro factors.

          Micro factors are factors that you as business owner can control. Makro factors  are the                         dangerous factors because you as a business owner can not control it.

          Makro factors can be:

·       the building of a new shopping mall which will draw away the business’s existing customers.

·       new major opposition opening around the business.

·       government legislation.

·       new trends, fashion, or styles

·       weather changes

·       labour unrest

·       BEE requirements

12.  Labour.

          Due to Governments draconian labour laws, the union’s unrealistic demands  and South Africans           low productivity, Business is steering away from labour    intensive businesses. The cost of labour           is just too uneconomical to employ a large staff complement in terms of wages, union demands,              strikes and low productivity of South Africans.

          The price of a Business is positively influenced when a business has less staff, and which is more             mechanized. 

13. Black economic empowerment.

          A business which requires compliance with black economic empowerment is avoided and                     achieves a lower price. It can be argued that a BEE compliant Business can deal with Government         and other Parastatal companies. The fact is that they are perceived that they fail to pay within thirty         days and the cost of doing business with them is sometimes too high.

         A buyer of some businesses buys the business for an income for his family and   to create jobs for          his/her children. He/she doesn’t want a stranger in the     business. In large companies this is not             such a big factor.

14. The location is important. A similar business situated at Kleinsee (which is a declining mine town with declining number of residents) compared to Vanderbijlpark can not have the same price.
15. Security plays a role in the value of a Business. Businesses situated at a Taxi rank are perceived a higher security risk than businesses in a shopping mall. It is also known that businesses at a Taxi rank have a high number of passing trade. Depending on the buyer the position can be seen as an opportunity or a threat.
16. Written and legally binding contracts that are profitable and which can be taken over by the buyer will affect the Sales Price in a positive way.

Determining the Value of the Business (Sales Value)

The most common calculation of determining the Sales Value of a Business is

calculated by means of three calculations namely:

 

1. Extra earning potential   
2. Return on investment
3. Payback period.

The tree results are added and divided by three to get an average. This average is then taken and adjusted considering:

1. The price achieved from the sale of a similar business with a similar net profit.
2. Considering the factors as stipulated in the sixteen factors influencing the Sales price of a Business mentioned above.

·       Extra earning potential

This calculation attempts to compensate for the risk of being in one’s own business. It is an attempt to calculate the reward which is an extra amount over and above what the buyer can earn if he/she invested the money or worked for a salary.

It considers the asset value, the net profit, the current interest rate one would receive from an investment, the reward from standing in the business (salary) and the length of time the Business has been in operation. This calculation gives an indication of the Goodwill value.

·       Return on Investment

          This method calculates the value based on a return an owner would expect for the risk he/she                 takes to run a business after allowing for a salary. The asset value is not a consideration.

·       Payback period.

          The Valuation is based on the period one would expect to recoup your investment times the net             profit. The asset value is not considered.

          At present businesses sell for eighteen to twenty-four times their net profit.

         Final determining of the Sales price of a Business.

        The above three values are added and divided by three to get the average.

        The average is taken as a basis and adjusted considering the sixteen factors mentioned above                 which has an influence on the sales price of a business.

        It must be stressed that this method is a method to estimate the Sales Price or Sales value of a                 business. Other methods can be used, but the influences mentioned above must be used to adjust             the Value to a more realistic figure.

 

We have been Business Brokers in the Vaal Triangle for twenty-one years. Contact us if you are a seller or a buyer of a business in the Vaal Triangle.