More often than not, a business’s value is calculated using a general, strictly mathematical rule of thumb, but it’s not that simple.
For example, some people think all you have to do is multiply income by three, four or five. If you stop there, you could be in for trouble. Chances are high the buyer pays too much or the seller does not get a fair value for the shares or assets sold. Moreover, there is a significant tax risk in the context of a business transfer between related parties.
A business’s value and risk level
Consider for example, two barber shops located on the same street. They generate the same profit and have the same yield. So why should one of them be worth more than the other?
The primary reason is the individual risk of the two businesses. In fact, it is a business’s risk level that determines the multiple used to calculate its value as a going concern. For a risk of 20%, a multiple of 5 is used to calculate earnings (1 divided by 20%).
Even if it is only to be well prepared for a business purchase or acquisition, it’s important to qualify, justify and document the business risk appropriately. This will have a significant impact on the value of your company.
Identifying the risk level
For an entrepreneur, knowing the risk level and how to reduce it can significantly increase the business’s value. This does not even involve increasing sales!
There are numerous risk factors. The main ones include:
• presence of successors and key employees;
• degree of dependence on certain customers and suppliers.
There are over a hundred risk factors to consider, some of which are industry specific.
Whether you’re a seller or a buyer, assessing business risk is a key component in calculating the business’s value.
If you’ve ever watched Dragon’s Den, you’ve probably noticed that the Dragons ask a lot of questions. They’re trying to assess the business risk and find an appropriate multiple based on a number of qualitative factors.
Avoiding valuation errors
Calculating a business’s risk premium is the most difficult step that requires specialized expertise. If you don’t have a Dragon’s financial skills, consider calling on a professional with business valuation expertise.
And if you hear someone use a general rule like “My business is worth three times income” or “it’s worth $X per customer”, don’t hesitate to pass on this article!