How to value a business
A profitable, healthy business will have a value which is a combination of its tangible net assets and intangible goodwill. Usually this will be expressed as a multiple of profits. The better the growth prospects of a business the higher the multiple factor will be. In determining a business value based on a multiple of profits the underlying assumption is that a normal level of working capital and fixed assets will be required to support the maintainable profits. It is usual therefore to see any offer for a business state a level of net assets to be acquired with the business. It is a common misunderstanding that the price to be paid for a business will be the value determined by a multiple of profits plus the value of the net assets.
In addition to the above description there is a raft of terminology that goes hand in hand with the business valuation process. In all likelihood owner managers will only sell a business once therefore we thought a little guidance on the typical jargon used would be useful…
When you read the Information Memorandum of a business for sale you will more often than not come across the phrase “Adjusted Profits”.
Most businesses are owned by the directors i.e. owner managers who might take higher remuneration rather than dividends and have management costs significantly higher than the costs which would be incurred if the work was performed by an employed manager.
It is only correct to add these excess costs back as they will not be incurred after the sale of the business. This means that the maintainable profits will be higher. There may be other one-off costs which can be added back but care must be taken to not stretch these to the extent that a potential buyer loses credibility with the added back costs. In this case it can have a negative rather than a positive impact as it could be taken as a sign that a business may have been dressed up for sale in other areas also.
Surplus Net Assets
An assessment should be made of the net assets and working capital to identify any assets which are surplus and not required to support the ongoing working capital requirements of a business.
A good example of this is surplus cash generated from the profitable trading activities of a business. In the normal course of events surplus cash would most likely be distributed in the form of an annual dividend. Any assets, usually cash, which are deemed to be surplus should be excluded from the completion date net asset target when determining the value of a business as they will, subject to appropriate tax advice, be capable of being retained by the vendor either by way of an additional dividend at completion or enhancing the consideration received for the sale of a business.
Cash free/ debt free
A valuation on a cash free / debt free basis is often referred to in written offers for a business. Debt free means that if there is a bank overdraft or loan then the vendor will be required to settle the liability to the bank at the date of completion or the purchase consideration will be reduced by a similar amount.
Cash free is the cash which is deemed to be surplus, as discussed above, will be extracted from the business by either way of a dividend or as an enhancement to the consideration payable upon completion.
If you require any further clarification on the business valuation process and the terminology used please email Clive Smetham (firstname.lastname@example.org) or Andrew Rose (email@example.com) from our corporate finance team, or give them a call on 0113 231 4131.