The financial value of a business, in terms of a single monetary figure, is only known with certainty on the day it is sold. At that point, assuming a willing buyer and willing seller, the value of the business is the price it changed hands for.
It is useful at many times, and for many reasons, to estimate the value of business. Just with the valuation of a property or other physical asset, an expert can give an opinion on the value. This opinion can be helpful but is always subject to disagreement by other experts (or HMRC) and may be different from the final sale price.
Valuations may be needed when:
- A sale is envisaged or sought
- A purchase of a business is being considered
- Shares are to be issued to an employee
- An objective is to grow a business and progress needs to be monitored
- Shares are to be sold or transferred and there are tax consequences
- Legal issues including divorce and disputes
- Obtaining finance.
The theory of valuation, more so than any other subject in accounting, is complex yet often overly simplified. The following notes are extremely brief and are given as an overview about valuation, not as a guide on how to value a business.
The principle is to estimate how much a willing buyer and willing seller would exchange the business for. This is usually a function of how much the potential buyer would profit from the business after they have bought it.
For a business to have any value, in terms of being sold, it must first be capable of being owned and operated by an investor. Being self employed does not necessarily mean you have a saleable business. A surgeon for example may operate very profitably on a self employed basis, but it is difficult to envisage how he or she could sell their “business” to a third party. The requirement for the personal skills of the owner to create income usually means there is no saleable business.
The next requirement is for economic profits, or at least potential profits. An investor will not buy a business that has no prospect of profits. The profits have to be available to the investor. Economic profits are basically the taxable profits adjusted to reflect a position of outsider ownership. Economic profits are after deducting commercial salaries for all workers (including the current owners), commercial rents and interest payments on all debts. If you are considering the value of your business, the first thing to consider is whether there are (or at least will be in future) economic profits.
Business valuation models use the value of economic profits to estimate the value of business. Different formula are used in different valuation theories. The basic idea is to divide the economic profits by the rate of return required by the investor. The rate of return can depend on many factors including the current economy and interest rates, the risk, the sector, growth prospects and investors circumstances.
Other methods of valuation look at turnover (especially for takeovers by competitors); dividend history (useful for part sales) and asset values (property companies).
We have carried out many business valuations. Each includes detailed analysis and discussions and results in a four to six page report on the valuation. We have a good acceptance rate with HMRC and understand the issues that HMRC tend to raise.