Knowing the value of your company is a key piece of business intelligence as an owner-manager. If you’re planning to sell up, hand the business to the next generation or retire from the company you need a good estimate of both the business value, and the equity within it. But when, and how, do you carry out this business valuation process?
Steve Brown, Partner at HW Corporate Finance, explains the difference between your business and equity valuation and the key reasons why every owner-manager needs to periodically find out the underlying value of their business interests.
Knowing the difference between business value and equity value
When it comes to carrying out a valuation, there are two distinct numbers; business value and equity value. Most owners are mainly interested in the equity worth. These numbers are two very different things, and this can be a confusing area within a valuation process.
To put that into context, you can value a business multiple times, looking at average historic earnings and other financial elements. That values the business but not the shares (equity), and the two values can be very different. It’s this lack of comprehension that can lead people to have a higher expectation of the value of their business.
The impact of debt in the company
Debt in the business has a huge effect on your equity value.
Imagine two identical businesses. Owner A puts in £1M on day one; Owner B puts in £100 and borrows a million from the bank. Both are making the same profits, with the same customers, in the same sector – but the equity is different.
To all intents and purposes, those businesses are worth the same. But the share value can’t be the same because one put in £1M and one put in £100.
The reason for this difference is what we call ‘indebtedness’ or debt in the company.
So, non-equity funding like bank loans, mortgages and asset finance will all reduce the business value down to what the shares are worth. So Owner A that put in £1M will have far more valuable shares than Owner B who only put in £100 and borrowed the rest.
Understanding the benefits of a valuation
We can help you drill down into your equity value more effectively when we know your business well, and when we have access to the financial detail.
The starting point for most trading businesses is to establish what we call the ‘normalised profit’. This starts by looking to identify any anomalies in the numbers. So, to use our example, let’s assume that Owner A takes out dividends every year, and Owner B takes a £200K salary.
Owner B’s profits are lower than Owner A’s because they have to account for the cost of their salary. But, actually, Owner A’s profits have to be normalised if they intend to sell the business. This normalisation process is easier when you have a drilled-down knowledge of the business, making it easier to identify anomalies and potential costs.
Possible elements to consider include:
- The need for new management – a new owner may want to hire a new management team to run the business and would have to pay them a salary at market rate – that payroll cost brings down your overall profit number.
- Legal fees and litigation – if there’s a litigation suit by a former member of staff, or a client sues, you’ll need to settle the legal case and cover any associated fees.
- Funding new equipment – if a piece of plant or machinery breaks, the owner will need finance to replace this, adding a debt to the balance sheet and lowering your profits.
It’s easy to see your company value in a relatively simplistic way. But, in reality, you’ve got to factor in the technical accounting elements around debt, normalisation, anomalies and multiples to calculate a realistic market value and equity value.
Surplus cash in the business
Another issue is surplus cash. Many owner-managers don’t take cash out of the business, because doing so triggers tax – instead, they store cash in the balance sheet.
Now, if you’ve got more cash in the bank than the business needs, that surplus cash is added to the equity value. So your equity value becomes your business value, plus your surplus assets, less any debt and borrowing.
The key here is to get the balance right between debt in the business, and surplus cash on the balance sheet. You need enough cash to keep trading, but must only take out an amount that doesn’t damage the business, or result in a huge personal tax bill for you as the owner.
Keeping debt low is also a logical thing from a credit rating point of view. The stronger the cash position on the balance sheet, the more likely creditors are to give you a positive rating. And customers who are looking to you as a supplier will also see a strong cash balance as a positive sign when looking at your public accounts.
You can’t you can’t hold too much cash, though, as this may damage your eligibility for entrepreneurs’ relief.
When do you need a business valuation?
There are likely to be times throughout the life of your business when carrying out a valuation will be a beneficial exercise, or even a necessary one.
For example, you will need a business valuation when:
- Planning to sell up and exit the company
- Planning your own retirement as the business owner
- When a shareholder retires and sells their shares
- Probate value is required due to the death of a shareholder
- A divorce settlement requires a value and payout
- There’s a falling out between 50/50 owners and shares need to be sold
- An enterprise management investment (EMI) options scheme is set up.
In all of these scenarios, having an accurate understanding of equity value and share worth will be critical. It’s important to understand the need for a highly detailed valuation, which takes into account the processes of normalisation and profit multiples etc.
Boosting value with a five-year plan
Time, emotion and money go into building up your business. But if you’re going to have a positive impact on the value of your company, you need a five-year plan to work to. With that plan in place, you can take proactive action to increase the value.
Key elements to include in your planning include:
- Taking out dividends to reduce the value of shareholder equity – by removing surplus cash from the business, you decrease the shareholder equity, but you’ll need sensible dividend planning to achieve the best results.
- Reducing debt in the business – the smaller the level of debt on the balance sheet, the more positive the equity value will look, as we’ve discussed.
- Using the most relevant multiple – there are softer things you can look at when opting for a valuation multiple, such as looking at the current economic situation or the supply and demand element in order to improve your multiple.
- Having the best accounting information – having an up-to-date accounting system in place will provide you with good financial data and business information, all of which helps to measure performance, profit numbers and financial position.
- Stepping back from the day-to-day business – the business can’t be dependent on you if you want to grow the value, so you need to work ON the business not IN it. If you want to scale up, you need a solid business idea, not a personality at the helm.
- Reducing dependency wherever possible – understanding how dependent your business is on certain customers and suppliers is an essential exercise. You don’t want all your eggs in one basket, so reducing dominant customers/suppliers reduces risk.
How we can help with your business valuation
We’ve had many years of experience in providing business valuations for a range of different owner-managed businesses. We know the market, we have the right network of specialists to call on and we can help you build a robust five-year business plan to deliver growth and additional value for your company.
Value is an ongoing process, with changes in the market and the business both affecting overall worth. But by continuing to measure your value, and working this number into your planning, you can take the best possible action to promote positive value in your company.
Talk to us about your business valuation or business planning needs.
Learn more about the business sale process here.
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