I have dedicated the past few weeks to the comparison of some of the largest companies in the world. In the next two weeks I will go back to talk about small businesses in a two-parts article on business valuation.
Among the emails that I have received from the readers recently, two of them stood out for their opposite nature. One of them was from Sultan, who wrote me to share his negative experience of having sold his business too cheap.
The other one was from Jen, who was asking me why nobody seemed interested in buying her company. I sense that the topic of small businesses valuation is always sensitive and interesting to discuss.
Given that there is not a “one size fit all” in this field, the principle that I will share in this article are to be taken as simple guidelines, and certainly not the only rules of the game.
Let us start with Sultan’s claim. My first question to him was: “What makes you say that you sold the business too cheap?”
His answer made me feel that his perceptions were in the way. He said that the new owner is making a lot of money... more than Sultan used to do when he owned the business. For as much as truth might hurt, a simple explanation could be that the new owner is just better at running the business.
Perhaps Sultan was not optimising costs and his profits were not maximised. That is certainly a possibility. Regardless of the reason, Sultan could have factored in his inability to maximise profits as part of the sales price. We will back to this in a minute.
Jen, on the other hand, seems to valuate her business too much. When I asked her how much is her yearly net income, she replied by stating the amount of sales per month.
Such number alone is useless in a proper business valuation. No smart investor would commit on a “sales per month” figure without context.
In fact, when I asked a few more questions on how Jen is managing the business, it became clear that in her case too, she is not factoring in costs and she is taking profits out of context.
So, both Sultan and Jen are experiencing the same issue, but with different outcomes. Because Sultan was not able to quantify his lack of profit maximisation, he ended up “selling cheap”.
Because Jen is not rationalising costs, she cannot find a buyer for her business.
My suspect is that both of them are not familiar with the concept of Add -backs. These are — to put it simply — costs that are currently affecting the business, but they might not occur in the future. In other words, these are costs that are applicable to Sultan and not to Jen, but the new owner might or might not have.
The usual method for a valuation is to take the yearly sales, and subtract the Operation Expenses and the Cost of Goods Sold. By doing so we reach the Net Income. This amount is a first indicator of the business valuation, but it is not all we need to know to correctly valuate.
Next week we will see how this amount without context could render highly inaccurate valuation. (The columnist is a member of the International Press Association]
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