Keyboard question mark

Carl Reader, the author of The Startup Coach, looks at the important subject of how to value your business.

Valuing a business is a very complex and nuanced task, with no definitely “right” way of reaching a figure. In my Startup Coach group on Facebook, I was recently asked how a business should be valued, and it was acknowledged that the method of valuing a business is really not very scientific. Let’s explore this area a bit more in plain English.

Part 1 - the difficult “rule of thumb”

Unfortunately, most accountants, bankers and business advisers resort to a rather naive rule of thumb when considering the value of a business. It goes something along the lines of: multiply the average of the last three year’s profit by three. Using that formula, I’m going to buy Amazon for about a fiver. It’s not the best method; it doesn’t take into account a multitude of factors – the finance history, the state of the market and the economy, the reputation, any assets or debts…the list goes on.

Part 2 - so let’s apply a little more science to it

Adjust the weighting of the previous profits so that more recent performance is weighted higher than older performance. Find a comparable price/earnings ratio from the Financial Times, then arbitrarily half it, because that’s what we’ve always done. Then multiply this more complicated average by a more complicated multiple.

It’s slightly better and at least takes into account some realities and may be a rough approximation to start thinking about, but doesn’t address a fundamental point. I could still probably buy Amazon for a fiver.

Past performance is not an indicator of future results.

We’ve all heard this several times in relation to investments, and it’s of course something you and any buyer must keep in mind. What is a business purchase? Very simply, when a business is being bought, a purchaser is buying two things: its assets (the stuff the business owns, less what it owes) and the trade of the business. The valuation is therefore a combination of the two.

But how should you value the trade? Well, ultimately you need to place a value on tomorrow’s performance, today. Not easy, but fortunately there are a number of tools that can help you do this, such as discounted cash flows, internal rate of return, payback periods, etc. The description of each of these is beyond the plain English scope of this article, but broadly speaking, in order to value a business effectively, you need to be looking at the value of tomorrow’s profit, not yesterday’s. Get professional guidance to help you if you’re unsure.

And at the end of the day, of course, the biggest factor that will determine what your business is worth is how much a buyer is willing to pay. No matter what you value it as, or how you reach that number, they will do their own research to decide the price they’ll pay.

I cannot emphasise enough that an accurate estimate of the value of your business is essential. While it’s important to be confident, over-valuing can be very dangerous - you only need to see a couple of episodes of Dragon’s Den before you see just how a poor business valuation can affect an investor’s decision, so be careful!

To hear more from Carl follow him on Twitter @carlreader or join “The Startup Coach” group on Facebook