If you’re thinking of buying – or selling – a garment decoration business, Michael Best has some timely words of wisdom for you
The second thing to know is that there is no magic formula for calculating the value of a business in the real world. People will talk about multiples of sales and other such glib formulas and while there are methods for valuing businesses, most of the time, anyone other than a skilled professional doesn’t have a clue what they’re talking about.
The third thing you must know is that buying or selling a business is not just about the numbers: a good deal of emotion can find its way into the mix too. Then there are intangible factors such as how badly the seller wants to sell and how badly the buyer wants to buy.
Setting the benchmark
When you decide to buy or sell a small business, you need a starting point, a rough idea of what it’s worth. Unlike in the housing market, however, comparable sales to provide a market value benchmark are rarely available. So, how do you determine a likely value to serve as a starting point for buy-sell negotiations?
At any one time a business falls into one of three value categories: going concern, asset value or liquidation value.
Going concern A going concern is most commonly assumed to be a business cruising along, routinely doing business and turning a profit. One could easily become mired in a discussion about the definition of profit, but for the purposes of this discussion let’s give it the widest possible definition in the context of a small business and say that it is making money for the owner either as a salary, bonus or dividends.
Asset value If the business is not making money, and it will take the ingenuity and hard work of a new owner to return it to a profitable state, then one might say that the business is worth the market value of its assets, which may include property, equipment and vehicles. This assumes that the buyer is acquiring the assets for the purpose of carrying on the business, probably in situ. Usually this amounts to a lesser value than one would pay for a profitable going concern.
Liquidation value The lowest value for a business would be a liquidation value. This would assume that there is no buyer for the assets intact with the intention of continuing the business.
It assumes a sale under duress: a fire sale. Most often this means an auction at which items are sold to a large number of different buyers with varying intentions that might range from re-purposing the assets to scrapping them.
A going concern
The asset and liquidation values are relatively uncomplicated. A going concern valuation, on the other hand, is a different kettle of fish. If you’re buying or selling a print or embroidery shop, it’s most likely a going concern, so let’s focus on that valuation.
The easiest way to view a going concern valuation is from a buyer’s perspective. Let’s say we are a buyer with a sum of money to invest. We are toying with two options: park it in a bank or some other blue chip investment; or buy a screen printing shop. At this point, to keep it simple, we’ll take the emotional aspects out of the discussion and treat it purely as a cold-cash economic exercise. We’ll have to re-introduce the emotional aspects later, however, because they can’t be ignored.
The key elements in our economic decision as to where to invest our money, as well as in the determination of the screen shop value, are risk and return. The higher the risk to our investment, the higher the return we would expect. For instance, if the money were invested in a low-risk blue chip investment, in today’s market we’d likely earn a relatively low return, say about 2-3% per annum. However, if we invested it in a screen printing business, we’d want a much higher return because obviously a screen printing business is a higher risk than a blue chip investment. The question is, how much higher?
Let’s assume that we decide that the sustainable earnings number is £60,000 (the expected annual net pre-tax profit). So now that we know what we are going to receive as a return on our investment, we can calculate what that investment should be if the £60,000 is to equate to a 20% annual return. Do the maths and you find that the investment should be £300,000. That is then our calculation of the theoretical going concern value of the business.
Because there are assumptions to be made in determining a theoretical going concern value, you can see why business valuation is referred to as an art rather than a science.
The price of goodwill
The amount by which a going concern value determined by capitalising earnings exceeds the value of the tangible assets (equipment and so on), is an intangible value often referred to as ‘goodwill’. In theory it’s the value ascribed to the business’s good name, the customer list and other intangibles that make the business profitable. It’s legitimate to pay for goodwill if it’s expected to continue to exist after the business has changed ownership.
The nature of the goodwill must be identified to ensure that it is not ‘personal goodwill’. Personal goodwill describes the goodwill that can be attached to the presence of a particular individual (say, the owner) instead of a product or service. If he or she is not there after the change of ownership and the customers no longer have a reason to do business with the shop, the goodwill is personal goodwill, which will disappear and be of no value to the new owner. In that case, the buyer would be foolish to pay for the portion of the goodwill determined to be personal goodwill.
If you plan to sell your business as a going concern for anything more than the tangible asset value, you must distance yourself from the identity of the business. You don’t want the success of the business to depend on you – that’s creating personal goodwill for which a buyer will not want to pay.
If you’re buying a business you want to avoid paying for potential. If the potential hasn’t been realised and you will have to do the work to realise the potential, why would you pay someone for the work you’ll have to do? It’s a bit like a house seller expecting the buyer to pay a premium for the house because with new windows and a coat of exterior paint it has the potential to look fabulous.
If the buyer is going to work in the business, then a fair market-value salary should be taken into account when determining projected sustainable profit upon which value is calculated. The profit upon which the theoretical value is calculated should be a return on the owner’s investment only and must not include wages for the working owner.
A theoretical going concern value is only the starting point. If properly prepared using a fair set of assumptions (remember, it’s an art more than a science), then the negotiation of a price for the business can be discussed around this theoretical value. And this is where the emotional elements start to affect the determination of price.
When a theoretical value is determined for a private business, the aim is to arrive at a fair market value assuming an open and unrestricted market; informed and prudent parties; parties dealing at arm’s length; and parties under no compulsion to act.
But that’s the theory. In practice it doesn’t work that way because these ideal conditions are unlikely to exist and then there is the elephant in the room, human emotions.
Assume that a theoretical valuation has been performed, its conclusion is known to both the buyer and the seller, and it’s being used as the basis for negotiations. Here are possible real-life influences on the negotiated price that will make it different from the theoretical value:
- The seller may be desperate to sell for any number of compelling reasons: they may be tired of the business and the industry and keen to undertake something completely different; be seriously ill; or in the process of a divorce, to name just a few. In such a case the seller would almost certainly be prepared to settle for something less than the theoretical value just to conclude a deal.
- The buyer may be determined to buy the business for as many reasons as the seller wants to sell. They may have expansion plans in mind or have always wanted to print T-shirts. There could be any number of circumstances motivating the buyer, in which case they may be prepared to pay a premium over the theoretical value to conclude a deal.
- One might be a much more skilled negotiator than the other.
Once all of these and other influences are thrown into the negotiating process, inevitably the final settlement is different from the theoretical value. This is normal.
Buying and selling a business is not just a matter of crunching the numbers, determining a theoretical value, and concluding a deal at that value. It’s not just about hard, cold economics. Human emotions motivated by any number of circumstances play a big part as well.
Michael Best is a chartered accountant who owned and managed a screen printing supplies distributorship for 23 years. He currently writes, speaks, advises and blogs on small business. He is writing a book titled The Characters Who can make or Break Your Small Business.
Reproduced with permission from: www.insidescreenprinting.com