The most common method of valuing a small to medium business is Enterprise Value (EV). Enterprise Value is generally based on a multiple of your earnings.
When investors and purchasers determine the Enterprise Value of a business they look at 3 things:
- Actual earnings/profit;
- Market factors (e.g. demand, industry regulation etc.); and
- Business Fitness (i.e. internal housekeeping).
Your ‘Business Fitness’ will influence the ‘multiple’ to be applied to your earnings when the business is valued. For example, a business earning $100,000 may be valued at $200,000 if the investor/purchaser is only willing to pay a 2 x multiple.
Alternatively, if the business is ‘fit’, an investor/purchaser may be willing to pay a higher multiple – for example, 5 x earnings ($500,000). Business Fitness plays a strong part in determining the value of your business.
By assessing your Business Fitness prior to seeking investment or a sale, you are likely to improve the overall EV.
How do you determine Business Fitness?
As we foreshadowed in our blog ‘Ten Things’, Business Fitness is based on the fundamental legal housekeeping requirements that every business must undertake:
- Business Structure – separating risk from assets;
- Partners & Key People – securing your business’ future without you;
- Branding & IP – creating value in your name;
- Credit Risk – ensuring you are paid on time every time;
- Compliance & Contracts – ensuring you have the necessary approvals and have documented your business relationships adequately;
- Warranties & Claims – limiting your exposure to warranty and liability claims.
If your business in ‘unfit’ as you approach a sale or investment you are more likely to experience:
- No investors/buyers;
- Lower EV;
- Payment is deferred and subject to key milestones being achieved;
- Obligations are imposed on key people. For example, a vendor may be asked to work in the business they have sold for a period after settlement.
We regularly undertake Business Fitness Tests for our clients who are considering investment/sale in the short-medium term.