Most SME owners who were planning on selling their business in early 2020 were forced to put their plans on ice when the pandemic hit.

Since then, while some businesses have struggled, others have flourished and may now be wondering if it’s time to capitalise on their success.

Selling a business in uncertain times comes with some challenges and it’s vital to get a realistic view on value as early as possible in any process. Most SME owners don’t like cost or complexity and are often put off valuing their business by the belief that valuation is costly and complex. The bottom line is that it doesn’t have to be and during uncertain times, it pays more than ever to keep things simple.

In pure financial terms, the value of any business is the present worth of its income streams. The most commonly used measure of income for SMEs is EBITDA (earnings before interest, tax, depreciation and amortisation). A company’s valuation is typically based on a multiple of its historic and/or future EBITDA. The reason for choosing EBITDA is that it is a reasonably reliable indicator of true income/cash flow generation.

Calculating EBITDA multiples

Once you have established your EBITDA, you then need to select the correct multiple of EBITDA for your business, which will give you a valuation. To do this you should review companies in your sector which trade on a public exchange and find out the range of EBITDA multiples at which they trade. Pomanda, the company information platform which I Chair, is another way to access this industry data quickly. Accountants and corporate finance specialists can advise further, but it’s worth getting a sense through your own research first. Once you have established a multiple range you can then apply this to your own business’s EBITDA to generate a valuation range for your company.

What you will typically find is that the multiple range is quite wide. So if for example, you have successfully researched the pink widget sector and established that your sector peers are trading at EBITDA multiples of 7-12x EBITDA, what should you do next? As a next step, it’s important to understand where in this valuation range your company sits and ideally how to get to the higher end. There are three key factors which will affect this:

The first key factor is the level of confidence you can provide in your EBITDA number. For historic numbers, you can help with this by being fully transparent about all your costs and provide clear justification for excluding any non-recurring expenses. In terms of your forecast EBITDA, the closer you are in your financial year to achieving this figure and the more on budget, then the greater credibility will be attached to your numbers. Be realistic in the context of how your business trades. If, for example, you are a retail operator and Christmas is a key part of your annual revenue generation, then any purchaser is going to want to see your numbers delivered over Christmas before attaching a high degree of confidence to your forecast EBITDA number.

The second key determinant of EBITDA is your growth rate. The faster an acquirer believes your company will grow, the higher the EBITDA multiple they will typically pay. So have a look at the growth rates of the companies you are comparing yourself with. If they are forecasting earnings growth of 10% per year and trading at EBITDA multiples of around 7x, and you are forecasting that you will grow at 15%, then you have a solid basis to argue that your EBITDA multiple should be higher.

The third determinant of EBITDA is your liquidity. In simple terms, if you are a publicly traded company and your shares can be easily bought and sold, then they are considered liquid. If, as is more likely for an SME, you are a private company, where there is no formal market for the company’s shares and probably restrictions in terms of who they can be sold to, then your shares are considered to be illiquid. In valuation terms an illiquidity discount is normally applied to the public market EBITDA multiple of around 20-30%. So if you find a company with a comparable growth rate which is trading at 10x EBITDA then you need to apply this multiple to achieve a realistic figure of say 7-8x EBITDA to your own business.

Calculating your Net Debt level

So having established that your pink widget company should be trading at a 7x multiple of its £2m EBITDA, you arrive at an Enterprise Value of your business of £14m. The final calculation you need to determine to arrive at the price an acquirer will pay for your shares or equity is the Net Debt level within the company. Net debt is broadly calculated as Short Term bank debt/finance leases plus Long Term bank debt/finance leases minus Cash and Cash equivalents. So if your Enterprise Value is £14m and your Net Debt is £1m, then your Equity Value will be £13m.

If you are lucky enough to be able to generate serious competition, then it is more than likely that an acquirer will be prepared to pay a premium to the value implied by your previous calculations. However, they are a good basis from which to start and there are many M&A processes which have failed due to a refusal to ground their valuation expectations on a sensible basis. Bidders can choose to bid up the price of your company if they perceive that it’s worth their while. But if you set the initial price too high, then you may scare them all off from the outset. Focus on keeping your process simple and your figures transparent and you will end up with a realistic view on valuation.

Read more:
How to value your SME business during uncertain times

For most businesses, navigating the perilous waters of Covid has been extremely stressful and taken up all their energy and focus over the past year.

Now recovery seems underway and strong growth is forecast for the UK, it’s a great time to think about how you are going to build value in your business in the months and years ahead.

‘Rome wasn’t built in a day’, the saying goes. But it’s also worthwhile making sure it’s Rome you’re building. Are you looking to develop a lifestyle business, which generates strong cash flow and guarantees you steady income for the next 10 years? Or do you want to create value through selling your business for the maximum capital gain in a few years’ time? Either way, you should keep your eyes focused on the value creation ‘dial’ on the basis that you’ll probably want to sell your business one day.

Whatever stage or sector of business you are in, there are several key financial indicators which it’s worth watching like a hawk if you want to make sure you’re steadily generating more and more value for your business, as you move towards your exit.

Gross Margin is a measurement which experienced investors always prize highly (your profits after the costs of your goods and services sold, divided by your revenues). Your Gross Margin will largely be determined by the industry you are in. Typically, this is likely to mean high percentages for technology businesses and low percentages for those in food retail, for example.

Either way, you should always try to compare your performance against your industry sector, and aim to improve your Gross Margin steadily year-on-year. Investors understand that Gross Margin is a key indicator of value in a business. It shows your relative bargaining power both in respect of your customers (the price you charge them for your goods/services) and suppliers (the price you pay for the cost of those goods/services).

A business that shows a higher gross margin is probably able to charge higher prices than its competitors and able to secure better deals from its suppliers. This is also a strong financial indicator of many important underlying value drivers such as strength of brand, quality of management and economies of scale.

Fixed and Variable Operating Costs are another highly valued measurement for those investors who have been around the block a few times. Your Fixed Costs are those costs that you need to incur to enable your business to function regardless of whether you are running at 10% or 100% of capacity.

Think property rental costs, rates, utilities, insurance, payroll and even senior employees on long notice periods. The lower these costs relative to your Variable Costs (salaries, marketing, packaging, sales commission) the more flexible a business you have.

The ability to run a business on a minimal Fixed Cost base will protect it in a downturn and was key to the survival of many businesses during Covid. It also offers you the potential to scale up rapidly if demand for your business’ goods and services increases quickly, since most Variable Costs can be switched on and off at very short notice. This could be a route to rapid value creation one day.

Cash Collection is another measure that was incredibly important for most companies during Covid and is a strong indicator of value. This comes down to making sure that your customers pay you on time.

Monitor your overall debtor days closely (the average number of days that it takes for your customers to pay you). But also monitor your 30 day, 60 day and 90+ day debtor levels and set targets for your finance team to improve these month on month, and reward them accordingly. Keep a close eye on potential bad debts, stay close to your customers and monitor their financial performance through credit checks and any other financial analysis you can get your hands on.

Effective and improving Cash Collection is a good indicator of a well run business, which understands its customers and has the commercial skills to enforce the payments of its bills. All strong indicators of value creation.

These are of course only a few of many important drivers of value creation. However, if you can show steady improvement in all these financial indicators year-on-year, then you can be confident that you are generating value in your business. What’s more, when you come one day to sell your business, there will also be a clear and strong value growth story for your purchaser to buy into.

Read more:
Building value in your business post Covid: which financial indicators should you focus on?