What are the risks asks Rob Cameron, Adviser.
One of the biggest risks when purchasing a new business is the risk of overpaying. Once you’ve overpaid for a business, it’s very hard to turn it into a good deal and your financial returns can be decimated. Because of this, it’s critical to get some good advice on a sound market valuation.
In many small business transactions, valuation is assessed on two (2) key factors:
- Business maintainable earnings (BME)
- Capitalisation rate (or multiple)
The business value is then determined by multiplying the BME by the capitalisation rate.
The BME is essentially the profit the business will reliably make over the next couple of years if you stepped into the business and didn’t change anything. It’s critical to assess as accurately as you can. It’s important to not factor in improved profits from changes you will make – you are valuing the business on today’s performance, not future promises, hopes or even improvements you know you can make.
The capitalisation rate is based on a broad assessment of risk. The riskier the business, the lower the value, and vice-versa. Understanding all the elements of risk and, importantly, how you can mitigate them, is one of the key parts of a successful business transaction.
It’s worth noting that business valuation is part art (subjective assessment), part science (or more accurately, mathematics). In this regard, it pays to draw information from a range of sources and ensure you speak to people who understand business valuations in detail.
If you’re considering the purchase of a business make sure you get the best assessment of value that you can. Discuss with a trusted business advisor with sound experience and a track record in business purchases and valuations