What is Your Business Worth?

I have noted that there have been several high profile hospitality sales in the last couple of months. In case you are thinking that it might be time to sell your business, it might be interesting for you to note how the value of a business is established. I am only considering the value of a business itself, and not any real estate that may be part of the transaction.

We essentially look at three distinct issues when we are valuing a food and beverage-based hospitality business, whether it is a hotel, restaurant or café. Those issues are:

Profit history for the previous three years.

We start valuing a food and beverage business from the beginning point that the average business has a base valuation of two times net profit. In plain language this simple formula means that if you purchase a business on this multiple, given consistent performance it should take two years to pay itself off.

This multiple is adjusted up or down according to the circumstances of the two other issues that are considered immediately below:

Manageability i.e. is the business under employed management or is a skilled owner required to operate the business?

If the business is managed as a typical small business: i.e. by a ‘benevolent dictator’, without management structure and systems it can prove extremely difficult to sell and is not worth much. The Laws of supply and demand kick-in here; at any time there are probably 10,000 of these businesses for sale in Australia and there are likely to be only a small number of potential purchasers. This is a typical ‘buyers’ market’.

I have often found that small business owners have an inflated view of the value of their business and place it on the market and an extremely ambitious selling price, often at the recommendation of a ethically challenged business broker. This inevitably means that they end-up spending serious money continually advertising a business which does not sell until the price comes down substantially, often several years later.

I have encountered a number of hospitality business owners who have owned a business for many years which is now in decline and presents as old fashioned and tired. They have considered the sale of their business to be their superannuation payout and have optimistically asked us to sell it at 8 – 10 times what we calculate it is worth. They often value their fixtures and fittings as an addition to the sale price, whereas we would consider them as ‘tools of trade’ at their mostly fully depreciated value.

If a fit-out is shiny and new it may add some value to the sale, but this is rare in the sale of established businesses and is more common in new businesses that have failed. In the case of a failed business there is no profit and only a recent fit-out to sell, which may realise a quarter of its set-up cost.

Generally speaking, a well-established business that can be purchased as an investment and which does not require a constant presence of a skilled owner, is worth much more than a business which is not able to sustain itself without the owner’s constant care and attention, because it can be purchased by an investor, as distinct from an operator. Here the Laws of Supply and Demand reverse. At any one time in Australia there may be 300 of these for sale and potentially thousands of MasterChef and My Kitchen Rules viewers who fancy owning a restaurant or other hospitality business. We would add a further one times multiple of EBIT to the base valuation to establish the value of a business which could be purchased as a passive investment.

Potential for growth of revenue and profit into the foreseeable future

If the new business owner had a reasonable opportunity to substantially grow the business and increase its profit in the near future, by either an increase in customer numbers, or an increase in customer average spend, we would consider that there was a good potential upside for that new owner, and we would add to the basic multiple on the assumption that an operator could still pay the business off within a small number of years from the increase in profit that they had yielded from growth in the business.

We would normally add a further one times multiple if we assessed that the business had a strong potential for substantial growth that could be easily achieved, given an average set of management skills.

Summary

If you want to maximise the sale price of your business, you need to think well ahead and forgo the extraction of profits in the early days until you have set up a proper management structure and systems, so you don’t have to be there. This may take several years. If you don’t do this the penalty is being locked into a prison of long working hours and low sale price when you want to get out.