Whether you’re looking to buy or sell a business, you’ll have a vested interest in knowing whether the valuation is fair.
There are business brokers who specialise in valuing and marketing businesses. However, it’s always helpful for you to have some understanding of the factors on which the valuation will be based. These will vary depending on the type of business but we set out below some general factors.
Key factors affecting the valuation of a Business
Businesses operate from a wide range of different premises. The nature and condition of those premises can have a significant effect on the valuation of the business. Factors that will be taken into consideration include:
Freehold, Leasehold or Licence to Occupy?
Freehold property gives business owners exclusive occupation of the premises, offering long-term security together with the potential to alter and/or extend the premises to accommodate the growing needs of the business.
As such, freehold premises significantly enhance the overall valuation of the business. Banks will generally lend buyers up to 75% of the purchase price for the business when there is an associated freehold property. This is opposed to less than 50% when the premises are leasehold. This makes the business a more attractive proposition for a wider pool of potential buyers.
Leasehold properties limit tenants’ occupation and use of the premises for a specific period of time. The value attributed to a leasehold property will, therefore, depend very much on the terms of the lease.
For example, a lease that only has 3 years left to run, contains onerous rent review provisions, extensive repair and maintenance obligations and an uncooperative or troublesome landlord, will have the effect of reducing the overall value of the business. A lease that has more than 25yrs of its term remaining will be valued more positively, particularly if the business is in a good location.
Finally, some businesses occupy premises under a more restrictive Licence to Occupy; often small businesses. Such licences are, typically, granted on a rolling 12 month basis and
restrict the licensee’s use to a particular area of a property and for a specific use. It’s also usual for either party to have the right to terminate the licence on giving very short notice.
The temporary and restrictive nature of a licence to occupy will significantly reduce the overall value of a business.
Fixtures, fittings and equipment
A business’ inventory of assets can run into many pages. Identifying what’s included in the sale and establishing a current value is an important part of assessing the overall valuation of the business.
Ultimately, the operating capacity of the business will be dictated by the physical constraints of the premises and if there is scope to extend.
Depending on the type of business location maybe a key consideration in valuing the business. The success of a business may be closely tied with the demographics of the immediate area and the number and location of competitors.
Good access to premises is also key to attracting new customers, as is easy and adequate car parking.
Modern, purpose-built day premises will achieve a higher valuation than businesses occupying older premises that have been adapted for the purpose and which may have a cumbersome layout and/or require significant and costly ongoing maintenance and repair.
Ultimately, the valuation of a business will come down to the cold, hard figures: it will not reflect the blood, sweat and tears that have gone into creating and growing it. This can be a bitter pill to swallow for some sellers of businesses.
Factors taken into account will include:
The key factor to determine the value of the business will be an assessment of its profitability. Many sellers will wax lyrical about the amazing potential for future growth but,
when it comes to arriving at a valuation, little heed is normally paid to their enthusiasm. Potential is just that.
Instead, profitability is normally calculated by taking a weighted average of the business’s earnings before interest and tax (EBIT) from the last 3yrs of accounts and then applying a multiplier to that value. The multiplier applied by an independent valuer will depend on market forces at the time of sale. It may be in the region of 1.25 to 2.5 it is for example a nursery business where the premises are leasehold, or 4.25 to 6.25 where the premises are freehold. The multiplier will also depend on the type of business.
Using children’s nurseries as an example, larger nurseries offer greater capacity and should also benefit from operational economies of scale. However, the physical operating capacity of the nursery premises won’t always translate to consistent occupancy rates. A children’s nursery business that is poorly managed, marketed or operated – or which has location or access issues – may have low occupancy rates.
Reputation is a key factor in valuing a business and forms part of the ‘goodwill’ of the business.
Brand identity, customer base, customer satisfaction and employee satisfaction all contribute to the reputation of the business and will be considered when assessing the value of the goodwill.
How many employees are there, what are their qualifications and what are their terms and conditions of employment? This will impact both on the success of the business and on the overheads of the business.
Does the business, for some reason, have difficulties retaining a full complement of staff? Whilst businesses on the Isle of Man face recruitment challenges, a business with a particularly high turnover of staff is likely to be hiding other issues.
How many other businesses are there and where are they based? What is their reputation and what kind of set up and rates do they offer?
If there is direct competition from a successful rival, do the demographics of the business’s catchment area provide a sufficient pool of prospective customers to maintain a healthy income stream?
Will the seller agree to the inclusion of a non-compete clause in the sale contract?
Circumstances of sale
Occasionally, a seller’s personal circumstances can affect a valuation. For example, if the seller is in poor health, a quick sale may be more important than achieving a full price.
A final word on how to value a business…
Whilst all of the factors listed above are relevant to establishing a fair value for a business, the most important point to realise is that a business is only worth as much as a buyer is willing to pay – and a bank is willing to lend!
Bear in mind, also, that much of the detail required to establish whether the figures stack up won’t be uncovered until after an offer is made and the buyer, with an advocate’s help, gets responses to pre-contract enquiries (a process known as ‘due diligence’).
The outcome of due diligence – and the warranties and indemnities that the seller is prepared to give in response – may also affect the agreed final price.
We are advocates who specialise in working with business buyers and sellers in the Isle of Man. The sooner we become involved in the process of helping you to buy or sell your business the more likely it is that your purchase will be successful. Please either call us now on 01624 665522 or complete our free online enquiry form and we will be in touch as soon as we can.
Our full contact details can be found on our Contact Us page.
Lorcan is the Head of Business at Quinn Legal
Click his photo below to find out more!