What’s Your Business Worth? Part 1

Into the Dragons’ Den came a chap with a proposition to sell us 5% of his business for £20,000.  I checked that he understood what that meant in terms of his current valuation of his business.  He was well aware that it valued the business at £400,000.  To be honest some people who come in have not done the simple calculation of working out that figure.  If, in this case, 5% of the business is worth £20,000 then the whole business is worth 20 times that.  The revenues of the business were £7,500 in the past year and the profits zero so can that valuation possibly be right?

Funnily enough it might be. 

So how do you value a business?  I’m going to tackle this topic in three blogs starting from this one that concerns start-up companies and small businesses that have been trading for a while.  We’ll get to quoted companies in the next blog and finish off by looking at how to get your company to have the highest possible value, preferably just before you sell all or part of it.

To understand how to value a business, start from thinking about what your house is worth and how you know that.  You can value it in various ways, ask an estate agent, find out what a similar house in a similar location was sold for recently by asking the buyer or the seller or go to a site like www.houseprices.co.uk and get a record of the house transactions in your neighbourhood.  But you can’t be sure can you?  The fact of the matter is that you do not know the exact value of your house until you have not only put it on the market at a price you think sensible but also sold it. 

That’s what market value means – the price that someone has agreed to pay for a house, a sofa, a car or, of course, a business.  So it’s really the buyer who decides what a business is worth.

So how do investors go about it?  Think first about how an investor makes a return on their investment.  They can take a salary as a non-executive director; but that could be counter-productive as it reduces both profits and cash: that limits business growth.

They could take the money out as dividends.  Over the medium term that might give them the return they are looking for.  In order to pay a dividend a company needs two things, first profits over and above its overheads and taxes and secondly the cash to pay it.  More likely the small company investor looks to sell the business for many times the amount they invested to someone who thinks that they can make profits grow even more and that their return could come from dividends.  To make a big profit on selling a business you need two things.  Firstly a huge growth in volume: it’s called scalability.  Investors look for the point at which the business will really take off in terms of sales and then profit.

That’s why the business with sales of only £7,500 might be worth £400,000; but the entrepreneur will have his work cut out to prove it.  He has to make us believe that profit growth is close and very rapid, like an ice hockey stick.

The value of a small or medium sized business is governed by its current profits and its potential to grow those profits into the future