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Valuing A Small Business

How should you value a small business with a volatile history and unpredictable future?

Valuing A Small Business

Valuing your business can be a lot of fun when negotiating an equity investment to springboard growth or structuring a lucrative exit strategy that will assure your financial freedom. However, there are many scenarios (e.g. forced buyouts due to owner deadlocks) where getting your business valued may be decidedly less glamorous but no less necessary.

Many conventional valuation practices are based on large companies, so applying them to a small enterprise is challenging. SMEs are risky, volatile and unpredictable. Their valuation can vary by an order of magnitude depending on your methodology: valuations based on historical performance tend to be overly-conservative, while those based on future potential risk excessive optimism.

So what's the solution?

#1 Clarify the context

The purpose of a valuation ought to inform its calculation. Equity investors are motivated by a share of the upside, so it's reasonable to prioritise future returns. By contrast, if a disgruntled partner wants to sever ties as quickly as possible, it makes more sense to focus on current financial position and recent trends.

#2 Normalise the data

SMEs tend to be highly dependent on owners who don't come from strong management backgrounds, which is reflected in their financials. Irregular income and discretionary expenditure are common, particularly when personal and business affairs get conflated. Adjustments must be made to account for these otherwise any valuation will be biased towards the owners' personal idiosyncrasies.

#3 Establish a range

Relying on a single number is foolhardy because every valuation methodology has its own pros and cons. Performing multiple valuations will confirm over-arching trends and provide a range for framing negotiations. For example, if liquidation, net asset and normalised EBITDA valuations all yield a range of R1.2m - R2.4m, then it's hard to defend a value of R200k or R20m.