One of the biggest small business risks can often start with the owner! In our many years of working with business owners, it’s not uncommon to hear the following:

“My customers will be with me until the day I die”.

“My business is my identity”.

“My business is my superannuation”.

If you agree with these sentiments, it is likely that your business is overly reliant on you.

You might ask, so what?

A business that relies heavily on its owner is not as valuable as a business that is not reliant on its owner. When we talk about small business risks, many business owners don’t understand the risks of key person reliance and how it can significantly impact the value of their business.

Compare the following valuation scenario of the same business when key person reliance is reduced or minimised:

Business Key Person Reliant Same Business not Key Person Reliant
Business Profit $200,000 $200,000
Business Valuation Multiple 3.05 3.5
Business Value $610,000 $700,000
Value Improvement $90,000
Improvement % 14.75%

 

Buyers will pay a higher price for a business that can be easily integrated into their current business or smoothly transitioned to a new principal. They will want some comfort that the business’ key customers and staff will stay with the business once the current owner departs.


What can you do to reduce the small business risks of key person reliance?

There are many different business and risk management strategies business owners can implement to reduce or minimise key person reliance.

The table below provides some suggested examples:

 

STRATEGIES ACTION
Business  

 

1. Business Systems: introduce systems into your business. For example, a good quality stock management system will reduce reliance on the owner’s product and services knowledge.
2. Client Relationship Management: establish customer relationship management protocols so staff can manage key customer relationships.
3. Management Succession: invest in the professional development of your key staff so they can eventually share in part ownership (succession planning) of the business.
Risk Management   The very nature of some businesses means it is difficult if not impossible to reduce or remove key person reliance. A specialist surgeon is an example of an occupation that will always be key person reliant. In this case where key person reliance cannot be removed or reduced the purchase of business insurance is considered an effective risk management strategy.

 

Start assessing the impact of key person dependency on your business by requesting a business valuation from your accountant. Your accountant is best positioned to provide advice on key person reliance, business valuation and business and risk management strategies to reduce, remove or minimise the risk from key person reliance.

The team at MGI South Queensland can help you with all aspects of improving your business valuation as well as business succession and exit planning strategies and business benchmarking for business growth. Give us a call on 07 3002 4800 or book a consultation online today.

Disclaimer: this information is of a general nature and should not be viewed as representing financial advice. Readers of this information are encouraged to seek further advice if they are unclear as to the meaning of anything contained in this article. MGI accepts no responsibility for any loss suffered as a result of any party using or relying on this article.

If you are considering selling your business, either now or in the future, it’s important that you understand how to value a business for sale.

The challenge for many small business owners is that emotions often play a big part in their assessment. And that’s often for good reason: a passion for whatever it is that the business makes or does, a commitment to the industry sector, or a happy way of working.

But business owners can sometimes allow their emotional investment in the organisation to cloud their financial judgement.

It’s a useful exercise to weigh up your business as just another investment that needs to make a return on capital. After all, if capital wasn’t in your business it could be invested elsewhere.


So just how to value a business for sale based on rate of return on capital?

Known as the Capital Asset Pricing Model, you begin with determining a ‘risk-free rate’.

Generally you take a 10-year government bond rate (currently about 3.5 per cent) as a surrogate for a risk-free rate.

So, if you’d say your business is more risky than a risk-free rate, you’d need to achieve a rate of return higher than 3.5 per cent.

Then, if you were to invest in a broad portfolio of publicly-traded blue chip stocks, you could expect a return of between 6-8 per cent above the risk-free rate, which would be about 10-10.5 per cent (assuming a risk-free rate of 3.5 per cent and an average portfolio return of 7 per cent).

The rate of return of an owner of one business in one industry in one city, that’s not publicly traded, should be significantly higher than that so you’ll need to calculate how much more risky your business is compared with a broad portfolio of blue chip stocks.

While there are endless measurements and calculations that can be made when looking at how to value a business for sale, it’s not necessary to get “too pedantic”.

Pick a figure that’s the appropriate benchmark for your business. Let’s say it’s 20 per cent. So if you’re actually getting 2 per cent, you know you’ve got some serious work to do to improve the value of your business.


Why is this a better measurement of my business performance?

Most business owners can tell you the dollar profit they’ve made. Often they’ll say: ‘That’s a 10 per cent return’, and when you quiz them further and ask 10 per cent on what? They’ll say, ‘On my sales’.

So they might have had sales of $10 million at a profit of $1 million but that’s just one part of the equation – the profit and loss – not the balance sheet.

Every business is fundamentally the same. It’s a pot of money made up of equity funding (your own money you’ve invested) and debt funding (money you have borrowed from the bank, bank overdraft, lease equipment etc).

Then you give your customers credit terms (accounts receivable/debtors), you invariably have stock you invest that money in (you’ll get credit terms from your suppliers, so you’ve got to take off creditors); you may have some plant and equipment that you need; and you may have bought some goodwill. That’s your pot of money.

So when looking at how to value a business for sale, what you need to be measuring your profit against is that pot of money, not your sales. You don’t say I made $1 million in profit and $10 million in sales therefore it’s 10 per cent. That’s the wrong thing to look at.

Some of our clients are achieving a return on capital of as much as 90 per cent.

When a business owner understands the concept of the pot of money and they can see that if they reduce the size of their pot – in other words, the amount of capital invested in the business – and keep their profit the same, then the return on their capital goes up.


How do I value my business?

The valuation multitude that someone will pay to purchase your business is dependent on risk i.e. how likely is it that your business will continue to produce the same level of revenue and profit in the years to come. The following comes into play when assessing this risk:

  • the industry type associated risk
  • dependency on the business owner i.e. are there the systems and processes in place for the business to operate without involvement of the owner
  • dependency on a small number of major clients

Generally a prospective buyer will pay between 1.5 and 3 times the return on capital.


What can you do today to increase the value of your business?

The first step is to understand your current return on capital and then to come up with a plan to improve this. The second step is to address any risks in your business that might act as a deterrent to prospective buyers.

MGI South Queensland has a team of experts ready to help you understand how to value a business for sale. Contact our business valuation services team in Brisbane or the Gold Coast for assistance today or download our business valuation guide to get a head start.

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