Why every business owner should understand what drives business valuation

6 Minutes

In May 2024, Chris Paterson supported a free business seminar about preparing a business for sale. The area of business valuation spurred a lot of discussion. Reflecting on the importance of preparing a business for sale, because most businesses in their current state aren’t saleable, our latest article focuses on demystifying what drives business valuation.

If someone asked you “how much is your business worth?” you may have a rough idea, or perhaps a figure in mind that you would be happy to sell it for. Like all assets, a business is worth whatever you can persuade someone to pay for it. So, how do you persuade them to pay a premium price? For that, we need to look at two key elements of a valuation.
Buyers pay for the past, but they buy the future.

Buyers pay for the past, but they buy the future

If you had to summarise a business valuation in one sentence it is that buyers pay for the past, but they buy the future. The buyer is paying for two sides of the business:

• One side is the business built up to what it is today
• The other is what the business could generate in the future

Those two factors combined form a reasonable expectation of what the business is worth to start negotiating from. Investing time to prepare the business for a sale is what will give you the best valuation for these two elements.

Valuing the past

The valuation of past performance is usually a multiple of earnings that have been proven to be stable and repeatable over time. This is easier to quantity because you have historic records as evidence. To achieve a good valuation, you will need a track record of three years (at least) demonstrating how well the business has performed. Together with your accountant, you are looking to make the current business as commercially attractive as possible. In the years leading up the sale you may make strategic changes in order to support this such as reducing costs to make the business more profitable.

Valuing the future

The future prospects of the business are much more subjective. The multiple of earnings can increase depending on how desirable and convincing the future looks. To achieve the highest multiple of earnings, together with a robust track record of being highly profitable with great growth prospects, the business cannot be dependent on the current owner being active in the business. The management team must also be self-sufficient to run the business. Dependency on the MD and an inefficient management team are two common reasons why business aren’t saleable.

Combining the two – the multiplier effect

Though the past and future valuations of the business are two separate factors, they combine to create the business valuation. Investing time and focus to prepare both sides of the business will increase the overall value of the business because of the multiplier effect. Here’s an example:

Why preparation is key to securing a good business valuation

As part of the sales process, once a buyer has put an offer on the table, they will do their due diligence to formally evaluate the information they have been given. If things aren’t as good as they have been led to believe, then they will review (and most likely lower) their offer. This is why preparation is key.

Involving your accountant from the beginning will ensure you avoid any potential legal or financial issues that devalue the business further down the line. Due diligence involves thoroughly reviewing all aspects of your business, including financial statements, tax returns, legal agreements and contracts, and any outstanding debts or liabilities.

Planning to exit your business

Exiting a business via a sale is not something you just ‘do’. It needs a strategy behind it to be executed well and for you to achieve the value you want for the sale of your business. A strategy doesn’t happen overnight. In our experience a successful exit strategy will span 5-6 years when you add up the time to plan and diagnose areas to ‘fix’, the time to implement the solutions and get things right and then the three years of building that profitable track record.

At WoodWhite Accountants we help our clients to grow their businesses and to have a robust strategy in place ready for when they want to sell. Whether you plan to sell your business in the next five to ten years, or beyond that, working with our qualified and experienced team of accountants and tax advisors will prepare your business thoroughly for sale and help you secure the best price for it. Contact us on 0118 997 7100 for a confidential discussion about your business and your plans for the future.