How to Assess Business Value

in Small- to Medium-Sized
Businesses

By James Price, BBM

Table of Contents
1. What are Business Maintainable Earnings? ........................................................... 4
The diesel engine analogy ........................................................................................ 4
Business Maintainable Earnings a practical example............................................ 5
2. How to calculate Business Maintainable Earnings .................................................. 6
What is Multiple of Earnings?.................................................................................. 7
3. Six key determinants of BME ................................................................................... 8
The challenge for owners ......................................................................................... 9
How to extract value along the way .......................................................................... 9
What does not determine Business Maintainable Earnings ................................... 10
4. Why information is critical in driving business value ..............................................11
10 key pieces of information to include in the sale process.................................... 12
Dont try to hide your skeletons ..............................................................................13
No one wants to pay for goodwill anymore ...........................................................13
5. What is your Point of Difference and Competitive Advantage? .............................14
What does Point of Difference and Competitive Advantage mean? .....................15
POD and Competitive Advantage practical examples ......................................... 15
Dont fall into the POD trap! ....................................................................................16

Disclaimer: The information contained in this eBook is general in nature

and should not be taken as personal, professional advice.

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How to Assess Business Value in

Small- to Medium-Sized Businesses
By James Price, BBM

In this eBook we take a look at How to Assess Business Value.

There are 3 key questions to ask when assessing the value of your
business:
1) What business maintainable earnings does the business generate?
2) How much meaningful information do you have on the businesss
performance and overall business model?
3) Whats the point of difference and competitive advantage in the
business?
Business Maintainable Earnings is a tricky concept, so well consider it first
and split it up over several chapters.

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1. What are Business Maintainable Earnings?

Business Maintainable Earnings (also called Sustainable Earnings) are often
the way the market values businesses, particularly small- to medium-sized
businesses.
Larger businesses traded on the stock exchange have a value attributed to
them day by day, minute by minute, in the share price. The share price
reflects the markets view of the ability of the business to generate
earnings into the future.
In this eBook were talking about businesses that are not traded on the stock
market, but were essentially measuring the same thing: Business
Maintainable Earnings, or the ability of the business to generate earnings into
the future.

The diesel engine analogy

Think of your business as a
diesel engine.
The fuel in your business/engine
is Business Maintainable
Earnings (BME).
If I buy your business/diesel
engine and I turn it on the day
you leave and just run it, how
long would it run for? How full is
the fuel tank when you hand the
business over to me?
How long will it run at its current capability before it needs intervention, such
as me having to go out and find new customers, invest in new equipment,
etc?
Essentially, thats the value that you as a business owner are building in your
business. You are putting fuel in your engine BME in your business that
will continue to appear beyond the transfer of the business to someone else.
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Business Maintainable Earnings a practical example

Business 1.
I am a sole operator running a lawn mowing business.
I have a lawn mower, a catcher and a ute.
I drive around and knock on peoples doors and say: Youre lawn looks long,
would you like me to mow it?
I mow it and I get paid for the work I do.
This business does not have significant BME because the minute I get sick
or decide to have a day off, I get no earnings.

Business 2.
I own a lawn mowing business that has a client base of 200 people.
It does maintenance work for large business and government installations.
It has contracts relating to that maintenance work that say: You will do my
lawn mowing for six months and we will pay you XYZ.
It has staff that assist in undertaking the work.
It generates a return over and above paying wages.
If I sold that business tomorrow the existing contracts for lawn mowing and
maintenance may represent a significant dollar amount and may run out over
time, regardless of me not being in the business.
This business does have BME and the market will consider those earnings in
valuing the business.

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2. How to calculate Business Maintainable Earnings

Business Maintainable Earnings dont appear on your tax accounts, your P&L
statements or balance sheet, and they typically dont appear on your
management accounts.
We often drive our management accounting systems to assist with our normal
tax requirements, but if youre really thinking about business value you need
to consider BME and you should be measuring it.
BME are calculated using the following formula:
Revenue
cost of goods sold
= Gross Profit
operating, finance and non-cash expenses
= Net Profit before Taxation
+ interest, depreciation, abnormal or non-business
expenses not related to the business
owners wages (including a reasonable marketrelated amount for owners working in the
business), non-business income or windfalls,
other abnormal income
= Business Maintainable Earnings

This formula gives you the basis for determining BME, or Adjusted Cash
Earnings, of the business. This calculation is often done on the previous
three years performance and then looking forward to at least the next 12
months.
As business owners looking to drive value in a business, the stronger and
more consistently you can build the picture of BME and show that it is robust,
the better your chances of driving greater value when looking to sell, all other
things being equal.
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What is Multiple of Earnings?

Business purchasers want to know: If I buy a business today, how long will it
take me to get my money back?
Remember, the purchaser doesnt want to pay for opportunity that they
create in the future. They only want to pay for what has been built up by you.
In the small- to medium-sized business market, purchasers are generally
looking from one, to four and a half years, to recover the money theyve
invested.
Multiple of Earnings is the term for how many years or months a purchaser
is prepared to wait before they recoup the value they paid the outgoing
business owner.
Imagine youre selling your business for $1m and Ive assessed it as having
an average BME, looking forward, of about $300,000 a year.
If I buy your business its going to take me three and a bit years to get my
money back.
That means Im paying a Multiple of Earnings of about 3.3.
The Multiple of Earnings is also a proxy for a purchaser allocating a risk
factor when considering their investment appetite. The lower the multiple,
the higher the risk.

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3. Six key determinants of BME

Business Maintainable Earnings are determined by a number of factors; here
are some of the major ones:
1) How much fuel is in the tank Does the business have contracts
and work in the pipeline, and are they transferable?
2) Business assets and management systems How does the
business manage its contracts and schedule its work to ensure there is
no break in the chain where customers are not serviced appropriately?
Does the business have sufficient plant and equipment and capability
to deliver and what is the utilisation rate?
3) Is it reliant on one person Even though there are contracts, does
the owner do the most of the work, or is the owner a co-ordinator and
there is an experienced 2-I-C and/or team to assist?
4) Does it have quality BME You could have two businesses each
with Business Maintainable Earnings of $500,000 a year. One business
has done $500,000 a year every year for the last five years, and is
projecting the same for next year. The second business did $500,000
this year, had a negative $200,000 the year before, a positive $150,000
the year before that, and the year before that they had a break even.
Clearly the former business has a greater ability to repeat performance
and consistently deliver BME.
5) What is the state of the market You may have very positive BME
that have grown steadily from $200,000 to $500,000 over the past few
years, but youre in a market that is suddenly becoming ultracompetitive. There is massive consolidation and big players are
entering the market, which will affect your ability to extract earnings into
the future.
6) How much cash does it generate We talked about Cash Flow in a
recent eBook. Cash earnings are important because they help fund the
business operating requirements and contribute to profits. If a business
generates positive cash earnings thats a good sign there is
sustainable value in the business.

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The challenge for owners

Its often challenging for business owners because they look at their
performance and say: Hold on, weve made this much money, so this
business must be worth X.
But the bottom line is a
smart purchaser isnt
looking in the rear vision
mirror when they buy a
business.
They will look in the rear
vision mirror to give them a
sense of how this business
has performed and then say
based on that history and
based on all these other
factors, how will BME track
in the future?
They dont consider what
they plan to do in the future to enhance the business, but instead assess what
you have left in the tank to run out and how it is going to run out in the future.
They will then base their price on their assessment of those future earnings.

How to extract value along the way

I often say to business owners: Dont just think that you get value out of a
business when you sell it or transfer it within your family. Value can be
extracted from a business in a number of ways.
Business owners who are focused on business value all the time not just
when they go to sell know this, because they know year by year how much
value theyre generating in the business.
And usually, a strongly performing business will allow the business owner to
extract value along the way.
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What does not determine Business Maintainable Earnings

The amount of borrowings, or the money youve invested in the
business, is not overly relevant to the price you ask when you go to sell.
So often I come across business owners who want to put a value on their
business which is largely linked to the size of their loan.
I can understand why thats important to an owner who wants to retire their
debt, but the market simply doesnt see it that way.
A purchaser will not look at the size of your loan when they look at the
business value they will look at the BME and what those BME might look
like in the future.

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4. Why information is critical in driving business

value
Youre not going to sell a business if you hide it under a bushel and youre not
going to have a confident purchaser willing to bid up strongly on your
business if you dont have solid, robust and transparent information to
support the performance of the business.
When a purchaser does due diligence on a business, among other things
theyre really looking to confirm:

the veracity of the Business Maintainable Earnings;

confirm the risks around shocks in those numbers and performance;

identify opportunities in the business;

understand how the business ticks what makes it do what it does;

understand the solidity of the business model i.e. the management

systems, the people, the customers, the contracts, the products and
services, the plant and equipment, and the supplier relationships.

The crisper and cleaner you can describe and present that information in the
business sale process, the more chance you have of actually driving
business value.
Remember, for a business person, information can reduce risk.

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10 key pieces of information to include in the sale process

1. What your Business Maintainable Earnings look like and what they
have looked like over the most recent 3 financial years, and whether
the business working capital and operations have been funded by
surplus cash earnings, or debt, or both.
2. What your pipeline looks like into the next 12 months.
3. A description of your client base and its diversity and any key contracts.
4. An explanation of your supplier relationships evidence of how you
secure your suppliers, particularly key suppliers that impact your ability
to service your customers.
5. A description of your staff, employees and their roles in the business,
including the owners role this could take the form of an
organisational chart, but should also detail the quality of your team.
6. An explanation of the market you operate in and why this business
delivers what its able to deliver.
7. At least the last two years tax accounts.
8. Profit and Loss statement and balance sheet.
9. Up-to-date list of plant and equipment and information about its
utilisation in the business.
10. Up-to-date documentation of any premises lease.
All of the above should be summarised into a professional document that
provides a credible commentary on the performance, track record and
future prospects for the business youve built.

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Dont try to hide your skeletons

Every business is different and they all have their skeletons even the bestperforming businesses.
Dont feel you need to hide those things; instead be transparent and open.
Sure, you can put a positive spin on things and you need to ensure the person
assisting you in marketing your business is able to do that effectively, but
dont try to hide the reality.
Credible, robust, transparent information is critical to allowing a
purchaser to get comfortable with the risk and opportunity theyre about
to take on in paying you a significant value for your business, particularly
when youre asking value for future or projected BME.

No one wants to pay for goodwill anymore

Goodwill is an intangible value associated with businesses.
Stock, plant and equipment, and other fixed assets are tangible items that can
be relatively easily valued on a market.
Goodwill is intangible; essentially it is the risk premium around how and what
BME will be delivered into the future.
I often hear people say no one wants to pay for goodwill anymore.
Let me assure readers, the market is willing to pay for goodwill, but theyll
only pay when they have confidence in the information that suggests
there is goodwill: a future flow of earnings beyond the current owner.

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5. What is your Point of Difference and

Competitive Advantage?
Point of Difference (POD) and Competitive Advantage are critical to ensuring
a business is saleable, but also that there is strong business value.
If Business Maintainable
Earnings are generated from
a business, often that is a
proxy for a POD.
In the chapter Six Key
Determinants of BME we
discussed the way changing
market circumstances can
impact the quality of earnings
into the future.
Competitive Advantage
occurs where businesses
have a POD that will protect
their earnings to some
extent into the future.
Examples of POD and Competitive Advantage:

Solid relationships of a long-term nature with customers or suppliers

A patent or exclusive distribution rights over a piece of technology

Exclusive distribution rights, for example, enable a potential purchaser to see

that for this particular product or service, the business has a market power
advantage.
Of course, that is only of value if the BME show there is value being
generated from it and forecast to be generated into the future.
Its one thing to have a patent or exclusive rights, but if theyre not
flowing through to value in terms of BME, then they wont be valued in
the sale process.
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What does Point of Difference and Competitive Advantage

mean?
First we will consider what POD and Competitive Advantage is not:

It is not being in business for 40 years

It is not having a well-known brand

It is not having a large turnover

It is not being located in a regional market where there are few

competitors

All those factors assist in driving business value, but POD and Competitive
Advantage is something a little more special than that.
Its about having the systems, processes, technology or differences that
others have to invest in and which will take time in order for them to catch
up to you.

POD and Competitive Advantage practical examples

Example 1.
I am a retailer operating in Sydneys Pitt Street. I am the only retailer
within a 10km radius selling a new mobile payment device. This is my
POD, but other retailers could start selling the device if they wanted to.
I then go to my supplier and negotiate three-year, exclusive distribution
rights for the Sydney market. I now have POD and Competitive
Advantage.

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Example 2.
Imagine a coastline of 4000km, but there is only a 1km stretch suitable
for the establishment of a deep water port to service large cargo ships.
The first business to build a port on that 1km of coastline and invest the
millions of dollars needed to establish facilities around the port, will
have a POD and a Competitive Advantage.
Right or wrong, it will be hard for other players to enter that market
quickly because:
1) they have to come up with hundreds of millions of dollars, and
2) there are limited sites available because there is only 1km
that has deep water.
So, everything else being equal, that business has a POD and
Competitive Advantage that is going to be hard to compete with and, if
its run well, will be able to secure BME.

Dont fall into the POD trap!

Make sure the product or service or other element that gives you Point of
Difference is actually a POD that people will value!
This is where understanding your customers and the market is vital to adding
business value.

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