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How to value a business

MULTIPLIER METHOD

If you're looking to buy a business, sell a business, work towards your exit strategy, or simply curious as to what your business would sell for today, the Multiplier Method is one of the most simplest and widely accepted methods of coming up with an expected sale price for a business in the SME (small to medium sized enterprise) market.

This method multiplies the maintainable Trading Net Profit of a business by a multiplier generally representative of comparable recent sales and prevailing market conditions.

 

WHAT IS MAINTAINABLE TRADING NET PROFIT

Maintainable Trading Net Profit is the reasonably expected profitability of the business for the short to medium term and is popularly represented as Net Profit after expenses, before Company/Income tax, and after normalisation/addbacks (as with all businesses, some expenses actually paid by the business are either of a personal nature or are a one-off expense, i.e. an expense that is extraordinary, and in normal trading periods will not be incurred again. Add-backs normally include private financing costs, owner's salaries, and depreciation allowances. All financial institutions, including banks, take into account and fully accept items listed as add-backs, providing the add-backs can be verified and are reasonable. An add-back schedule will allow a prospective purchaser and his financial adviser the ability to recognise the actual operating profits of the business before personal expenses and salaries of the business owners).

 

HOW TO CALCULATE MAINTAINABLE TRADING NET PROFIT

Step 1.
Line up at least three years worth of Profit and Loss. If necessary, annualise your most recent Profit and Loss if a full financial year has not been completed (normally makes sense to do so if you're more than a quarter of the way through a financial year. Make sure you recognise the impact of certain trading patterns, margins and expenses over a full year. That is, some expenses may be already paid in full whilst others may not increase relative to sales, or perhaps your sales are stronger in the first half of the year compared to the second half, and so forth).


Step 2.
Identify once-off/extra-ordinary income/expenses that appear in your Profit and Loss statement (cash basis preferred over accrual) that are not directly related to the business or, in normal trading periods will not be incurred again and ADD/REMOVE these from your Net Profit. These income/expenses MUST be accounted for on the Profit and Loss statement (as opposed to the Balance Sheet) for you to be able to add/remove them from the Net Profit.

These may include:

  • Bad debt (normally acceptable to add to Net Profit if it has only happened once or twice over a long period and not likely to occur again)
  • Borrowing costs
  • Depreciation (normally acceptable to add to Net Profit if the business is not heavily reliant on Plant & Equipment)
  • Donations
  • Entertainment (normally acceptable to add to Net Profit if the business does not rely on Entertainment to conduct business)
  • Fines
  • Hire/Lease Expenses on Plant & Equipment (normally added to Net Profit if the Plant & Equipment currently on hire/lease is to be paid out on settlement and title is transferred to the new owner unencumbered, or the hire/lease term is due to complete in the current financial year and therefore will no longer be a trading expense).
  • Income from other activities
  • Income from bank interest
  • Interest from borrowing
  • Rates
  • Travel and Accommodation (normally acceptable to add to Net Profit if the business does not rely on travel and accommodation to conduct business)
  • Wages and associated employment benefits/costs for owner/s of the business (refer to Step 3 for further discussion)

Note that you need to be reasonable with your adjustments as these can be questioned during Due Diligence investigations.

Step 3.
After adjusting/normalising the Trading Net Profit, you can now represent the profit one of two ways:

  • Trading Net Profit to a single working Owner/Operator (owner works a normal 38hrs per week in the business).
  • Trading Net Profit Under Management (owner relies 100% on management and staff to run the day-to-day operations of the business).

The method employed must be reflective of the true trading ability of the business. That is, you cannot simply represent the business Under Management if it is unrealistic in practice to do so. If you currently work in the business part time/full time in the business and simply oversee the business or perform a non-critical role AND you currently have management and staff in place who can run the day-to-day operations of the business in your absence, then it is generally acceptable to represent the Trading Net Profit Under Management).

If employing Trading Net Profit to Owner/Operator, the Trading Net Profit is shown as after addbacks/adjustments as per Step 2; and NO allowance for employment expenses associated with a single owner working normal full time hours (38 hours per week) in the expenses. That is, a working owner would take profits from the business as their income and would not record employment expenses such as wages and super in the Profit and Loss. If a single working owner currently records employment expenses from the business, you may ADD this to the Net Profit. If there are two working owner/s in the business, you need to leave the employment expenses associated with the second owner in the Profit and Loss as the second working owner is considered a normal member of staff. If the second owner works more than 38 hours of normal full time work then the Profit and Loss needs to be adjusted to reflect a single full time working owner PLUS allowance for extra staff to take on the extra hours. That is, you need to DEDUCT a representative amount from the Net Profit for employing additional staff hours.

If employing Trading Net Profit Under Management, the Trading Net Profit is shown as after addbacks/adjustments as per Step 2; NO allowance for employment expenses associated with a single owner; and if necessary, allowance for staff to run the day-to-day operations of the business in the owner's absence (for example, if a single owner currently works less than full time hours in the business, however, the business currently employs management/staff capable of running the day-to-day operations of the business or at least one staff member is capable of performing the current activities of the owner, then the associated employment costs of the working owner is ADDED to the Net Profit HOWEVER, the associated employment costs of replacing the owner MUST be accounted for in the Profit and Loss).

Step 4.
Now, you need to establish "what is the maintainable Trading Net Profit?". Generally accepted methods of arriving at the Maintainable Trading Net Profit:

  • Consistent Trading Net Profit = Normalised Trading Net Profit averaged over three years
  • Decreasing Trading Net Profit = Normalised Trading Net Profit averaged over three years, or if prevailing market conditions are sensitive to businesses showing poor performance it may be more acceptable to rely only on the most recent or current normalised Trading Net Profit.
  • Increasing Trading Net Profit = Normalised Trading Net Profit averaged over three years, or if prevailing market conditions are favourable for this type of business then it can be very acceptable to rely on the most recent or current normalised Trading Net Profit.
  • No Profit = Normalised Trading Net Profit averaged over three years (if it makes sense to do so), or more than likely, No Net Profit, in which case it would make sense to attempt to sell the business, or buy the business, for asset value.


MULTIPLYING THE MAINTAINABLE TRADING NET PROFIT

Here you multiply the normalised Trading Net Profit by a multiplier. The multiplier will depend on various factors such as:

  • Maintainable Trading Net Profit of the business;
  • Level of owner's involvement;
  • Recent comparable sales in the industry;
  • Comparable businesses on the market;
  • Size of the business;
  • Barriers to entry;
  • Strengths/weaknesses/opportunities/threats of the industry;
  • Strengths/weaknesses/opportunities/threats to the business;
  • Buyer sentiment and activity in the business sales market;
  • Willingness of seller to sell the business;
  • Willingness of buyer to buy the business.

To determine the multiplier, you will need to be educated on the various factors indicated above. As a general rule, the multiplier will be higher for businesses in a strong position and under management, even within the same industry. You cannot simply apply the same multiplier across a blanket of industries or types of businesses.

A Business Valuer is the best person to provide you with a formal valuation, however if you wish to simply gauge a likely sale price then you can refer to a Business Broker or Accountant for this. It is recommended you choose someone who is educated on recent comparable sales in the industry as well as being in tune with prevailing market conditions.

If you wish to achieve the highest possible price for your business then you should consider using an experienced Business Broker as they can demonstrate business sales where prices achieved have been well above conventional multipliers. Business Brokers tend to be well educated on factors that could make or break a business sale transaction; well equipped with the tools and resources to package and present your business properly for sale; have access to contacts and buyers who may be willing to pay a premium for your business; and possess strong negotiation skills to massage the deal through to settlement.

No matter how good or bad a business seems, the strongest driving factor for any multiplier is the willingness of the seller to sell the business, and the willingness of a buyer to buy the business.

 

Copyright. This material has been written by BizClassifieds and is not to be used or duplicated in part or full.

Disclaimer: The information provided above is to be used as a guide only. No person should rely on this information. BizClassifieds recommends persons seek their own professional advice, and accepts no liability for any loss or damage which any person or business may suffer arising from any negligence on our part.