third most common mistake business owners make when selling their business

Mistake #3 – Not understanding how much their business is worth

Blog > 3 of 5 Mistakes Owners Make Selling Their Business


Not understanding how much their Australian SME business is worth?

Would anyone disagree with the basic concept that when selling something it might be handy to know what it is worth, but how do you know what your business is worth?

We could just trot out the usual bland statement that “your business is worth what a willing buyer will pay to you when you are a willing but not forced seller”. But that is not really much help, let’s look at a few of the major value drivers.

The first question to ask is do you actually have a business? We once saw a business sitting on $5m worth of property and $6m worth of inventory turning over $12m and earning an EBIT (Earnings before interest and tax) of $500k. It got worse, the earnings were declining!

To our mind that was not a business, the owner became much richer through selling the property and stock, collecting the debtors and then going on holiday.

Saleable businesses earn a commercial return on all the assets used in the business after charging market rate for the owner’s work. We are not going to over complicate matters by talking about the “capital asset pricing model” but suffice to say that the riskier the business, e.g. the less secure the customer and supplier relationships, the higher the return on assets must be.

Timing affects the alternate options available for buyers, the hurdle rate of return a prospective buyer needs to achieve, their appetite and funding capacity at that time and what risk premium they apply.

The inverse of their required rate of return becomes the maximum earnings multiple they will pay. So if they require a 20% return, then they will not pay more than 5 times or if a 33% return is required they will pay up to 3 times.

The overriding value driver

Businesses tend to be valued on a multiple of pre-tax, pre-interest (EBIT) profits. The size of the multiple will depend on many considerations but fundamentally the multiple, and hence what you get paid, is generally higher when:

  • sales are growing
  • the industry is growing
  • net profit margin is high
  • high level of annuity style reliable sales
  • low fixed costs
  • assets required to earn the profits are low
  • low dependency on the owner
  • dominant position in a niche market

When thinking of those characteristics Mr (Meat) Loaf comes to mind, “too much is never enough”.

Outside of boom times, only an exceptional SME private business (one that gets all the ticks above) will achieve greater than 5 times.

Some key valuation concepts

There are a few key concepts to consider when valuing a business.

1. You are not James Bond; you can only get paid once.

If you are being paid based on a multiple of the earnings stream your business generates, then you cannot also get paid for the assets required to generate this level of earnings. We call this the box approach.

Whatever needs to be in the box to generate the earnings has to be in the box you exchange for cash with a business buyer. The box typically includes your stock, debtors, prepayments, fixed assets, goodwill and also your creditors and accruals.

If the box is full beyond what is required, then you can either get paid extra for surplus cash or inventory or else sell it off prior to business sale completion.

Very small businesses are often sold on the basis of an amount for the business goodwill plus stock at valuation (SAV). The adverts might say “$500k plus SAV”, that approach is fine for selling a hot dog stall (awkward SAValoy pun intended) but is not the usual approach for selling more substantial businesses.

2. The second key concept is that there are industry buyers (they may gain strategic and synergistic benefits) and financial buyers.

If you prepare your business so both an industry buyer and a financial buyer can buy it, you will increase your chances of a successful sale. As Woody Allen allegedly said “bisexuality does double your chances for a date on Saturday night.”.

An industry buyer will often pay more, than a financial buyer, as they are looking beyond the economics the business currently presents. They typically operate in your industry or an adjacent market already, but sometimes not in Australia or in your niche. These buyers may gain substantial synergies through acquiring your business.

A financial buyer is evaluating the business purely on the financial and risk characteristics of the business and without a detailed understanding of the industry so they will probably apply a higher risk premium on their required return. The higher the perceived risk, the lower the multiple they will pay.

High business sale prices are often industry purchases based on ‘synergy value’ or as part of a ‘roll-up’. In roll ups a listed group often buys a number of smaller businesses at significant multiples and seeks to benefit from the higher public company multiple.

3. The third key concept is objective value.

The objective value is set by financial buyers. Financial buyers are looking at various investment alternatives, be it your business, another business or other assets classes entirely. They look at the multiples they would need to pay for other investments and will value your business by reference to those benchmarks after taking into account the growth and risk profiles of their alternatives.

4. The fourth key concept is the business value to you. You know the business, its strengths, weaknesses and idiosyncrasies.

You also know the advantages it gives you in terms of tax, family employment and so on. A buyer does not know the positives with the certainly you do and has to assume the worst. The less you have fortified the business, the lower the likely price. If the value of the business to you is higher than the objective value, then you should strongly consider not running a sales process. Any sales process involves risks with key customers, suppliers and staff.

A good adviser will be able to understand how your business makes money, who are the likely buyers and what it is worth. Before you start any sale process you should ensure that you also properly understand this. Make sure the advisor talks with you about the various valuation concepts and the overriding value drivers.

Read about the 4rd most common mistake business owners make when selling their business.

For a discussion on selling your business, please call either Tony Holley on 0417313136 or Michael Mahoney on 0410 285 318 anytime – we at Hamilton Rich understand these conversations can be difficult to have during business hours.

Blog > 3 of 5 Mistakes Owners Make Selling Their Business

Download the “Five Mistakes Business Owners Make When Selling SME Businesses” PDF