This article looks at Valuation and Exit options for SME's.
The End Game
When it is time to exit, what is my business worth and what is the methodology for determining value?
Valuation Methodology
As we have covered previously, when looking at the value of your business you need to determine whether you have a “Business” or run a “Self-Employed” model.
Business - Can be leveraged from the owner. Valuation methodology based on a Multiple of EBIT or other Valuation methodologies.
Self Employed - Generally, where there is little or no leverage outside the owner. Valuation methodology is more limited and focused on the existing customer revenue.
Valuation Inputs
Determining a value for the business is not an exact science. A buyer will have a range of motivations and objectives in assessing the price they will be willing to pay.
In most cases, an educator purchaser will consider both the numbers (quantitative) and other factors (quantitative) that will create a view of the business.
Multiple of Adjusted Earnings Before Interest & Taxes (EBIT)
This is a common method for many SME’s, despite the typical size and unleveraged nature of these businesses.
Where earnings are robust and consistent, this methodology should always be a consideration and may deliver a more realistic valuation outcome compared with just looking at total revenue.
This typically involves determining the multiplier to apply, and also to “normalizing” Earnings as they are often inconsistent.
Generally, in a small business, the multiple used is significantly lower than larger or publicly listed companies.
As a rash generalisation, a range of around three to five times a normalised EBITDA would be considered for an established business.
Of course, all SME will have different cost bases, largely dependent on the “will and skill” of the owner. When looking at a business value on the basis we need to go past the Profit & Loss. This means making the adjustments to “normalize” the net earnings.
Commonly, the most material adjustment from OPBT is adding a market salary to reflect the contribution of the owner.
This is a common oversight when presenting a business for sale, the existing owner needs to be costed for both the value and the time they spend in the business.
One common goal for owners is to migrate from self-employment to business owner. The extent to which this is achieved will have a material impact on the appeal and value of the business.
The next step is to apply a “multiple” to the Adjusted Earnings as below:
Determining the appropriate multiple of earnings is not a simple exercise. A multiple at the higher end for a small business is rare as there is not the expectation that earnings will sustain easily.
There are some participants in the industry where information is freely available, such as entities listed on the Australian Stock Exchange; however, they rarely represent appropriate comparisons to the typical SME.
Their accounting treatment is also very different to most SME’s. For example, applying accounting standards means that these “reporting entities” allocate the future value of some income on their balance sheets as an asset. A typical SME would not do this as there is no driver or taxation implications in doing so.
When looking at a business on this basis make sure that you seek the appropriate advice.
Multiple of Recurring Income
This is a common valuation methodology that applies in the service industry in particular.
This is generally utilized as:
• The majority of valuation/sales transfers for small businesses;
• The businesses may not include any goodwill outside of the contribution of the owner(s); and
• The businesses are not growing materially.
Percentage of Revenue
This methodology is not common for some industries, as it typically applies to professional service firms like accounting and legal where the client base is highly portable.
We do not see this as an appropriate methodology for many trading businesses.
Do Nothing Option
Of course, an alternative option when looking at succession planning or selling your business is to "do nothing". This implies the ability to quit costs and reduce the level of service provided to existing customers.
Leaving the ethical consideration aside – from a purely financial perspective it might be a viable option. Though bear in mind:
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Consider the discount rate or opportunity cost of the value of money now, as opposed to collecting this over future years.
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Determine the resultant annuity costs that cannot be quit in order to facilitate the ongoing receipt of Revenue.
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The obvious compliance and business risks that are associated with this strategy.
Final Considerations
If you are reading this Blog, congratulations on the progress of your business to date. It may stimulate some thinking on some of the following issues:
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Is it worth investing to reduce future reductions in Revenue?
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Can you create value in the business beyond the customer base?
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Consider building your business so that a valuation based on a multiple EBIT is a realistic option.
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When considering a pivot to providing other services, make sure you have both the will and the skill to do so.
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If you are to Exit – get the timing right and do not leave it too late!
It is rare that Business Owners have a clear and documented exit strategy. That may be understandable in some instances, but it is not ideal. The optimal time for each owner to exit will vary based on a number of factors.
This plan can be fluid, but it should be updated regularly.
Again, this is where good advice is so important. Succession planning should align with other related objectives such as:
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Retirement Goals;
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Asset Protection;
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Estate Planning; and
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Taxation Planning
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For many SMEs, their business is their biggest asset outside of property interests.
More Information?
E - enquiry@mcpgroup.com.au
W - mcpfinancial.com.au