Pricing: The eternal dilemma

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DILEMMA: The eternal dilemma for brokers and business owners is finding a fair market value of a business that all parties can agree on.

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OPINION: The eternal dilemma for brokers and business owners is finding a fair market value of a business that all parties can agree on.

That is probably impossibility, but finding a fair market value that all parties can live with is more achievable.

Drilling down to identify the intangibles (sometimes referred to as goodwill) seems to be the most successful way for us to give comfort to the purchaser and their advisers and financiers. At the same time that shows the owner how their business is affected by market forces and to be able to reasonably manage the value expectations.

It can be like walking a tightrope, but when acceptance is achieved, the sale process is more efficient and pleasant for all parties. Take two manufacturing businesses, each with an annual turnover of $2 million and an EBIT of $500,000, for example, which are located in the same city with identical plant and stock values worth the same. If you looked at the normal methods of business valuation (earnings, comparative or assets) you would have to assume they would be similar at least.

But this really couldn't be further from the truth. There are so many other factors at play that will affect the risk profile of each of these businesses and, consequently, their value. The most important factor to consider is the sustainability of the income or profits. So really, most factors that you would try to identify would be measured on whether they affect the sustainability of future profits negatively or positively and to what degree.

This probably sounds simple, I know, but it takes work and experience and it means you have to take a position that you feel you can defend.

Take our two manufacturers. What factors could affect the future maintainable profits of these businesses?

1. Cashflow/quality of debtor book: Who are the customers? What are the terms of trade? Do they collect monies owed as agreed?

2. Income risk: Is income contracted? Are margins secure?

3. Working capital requirements: Any stock requirements? Terms of trade from suppliers?

4. Growth prospects: Is the business growing, stable or in decline? Is there anything unique about the business? Does it have new products/services?

5. Competition: Where does this business sit it relation to competitors? Is the business at risk from competitors?

6. Transition: Will the current owner stay on to ensure transition? Are supply agreements assignable? Will staff accept new owners?

7. Barriers to entry: Is there a barrier to entry?

8. Location or lease: Is the location suitable for a current business and for growth? If so is there a good lease available to a new owner?

9. Capital expenditure requirements: Is the plant and equipment current? Are there capex requirements in the business?

10. Concentration risk: Is there a good spread of clients? Does one client make up more than 20 percent of sales? Is the business at risk to any of its clients?

Obviously there will be more factors to consider when looking at specific businesses, but these provide a good start when setting a capitalisation rate or multiple for your business.

As an example, we were recently referred a business that was primarily a service provider but also designed and built solutions for SOEs and large businesses primarily in the North Island. The factors we took into consideration in setting the value were as follows:

* One of few businesses we had seen where the result for the 2009 year was up on 2008.

* Vendor will stay on indefinitely as an employee to ensure successful transition.

* At least 30 percent of income is long-term contracted work.

* Significant barriers to entry with both the technical nature of the business and the market acceptance.

* Multiple income streams, no concentration risk.

*Quality debtor book with government departments, SOEs and large private sector companies. Over 90 percent of debtors inside 30 days and a significant portion inside 14 days.

*Great growth prospects on the table for a new owner to benefit from.

*No capex requirements.

After taking these factors into consideration we advised the owner that we thought a fair market value for that business would be set at 3.1 times (30 percent cap rate) 2009 EBITDA ($420,000) or 3.3 times (32.3 percent cap rate) three year average EBITDA ($453,000), which gave us a value of $1.4 million.

This multiple/cap rate we believe is on the high end of what is achievable in the current market, but after taking into account the factors above we felt it was fair. When we marketed this opportunity we advised all parties that these were the factors we took into account in setting that multiple or cap rate.

The business was on the market for 10 days, we had four offers and the business is currently in due diligence.

So if you are a business owner and wondering what the fair market value of your business would be, what factors might influence the value of your business and how you could enhance them and/or how you might go about selling your business, you should look at the factors listed above and see how your business measures up.

Then you should call an experienced broker and get them to spell out the process and agree on a fair market value for the sale of your business.

Conversely, if you are looking to buy a business, the factors above will help you analyse whether the opportunity is worth the asking price. You should always ask the broker to advise what factors and assumptions they took into account when setting the fair market value and asking price on the opportunity they are marketing.

David Newport is a principal at Switch Business

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