SME owners may be called upon to estimate the worth of their business for any number of financial, legal and business reasons, including occasions when they’re attempting to secure grants, benefits, loans or investment. But how do they go about it – and are their valuations accurate? Often not, according to top accountancy association the UK200 Group.
Skewed Data
The problem lies, says the UK200 Group, in the data SME owners may use to produce their valuation. They may use an index such as the BDO Private Company Price Index, which shows the 
average Enterprise Value to EBITDA (EV/EBITDA) ratios of larger businesses with publicly available financial data.
Until a valuation is carried out by a team of qualified accountants, no business owner can be sure what their company is worth. They may be tempted to estimate the value of their firm using an index such as the BDO Private Company Price Index, which shows the average EV/EBITDA ratios (Enterprise Value to Earnings Before Interest, Tax, Depreciation and Amortisation) of larger businesses, whose financials are publicly available.
While this is a more comprehensive calculation than price to earnings (P/E), it’s not always translatable to smaller businesses – and using indices such as the BDO may lead small business owners to over-estimate the worth of their business, warns the UK200 Group. For instance, the BDO’s most recent data shows an EV/EBITDA ratio of 10.0, meaning that an SME owner with annual profits of £1million might use this figure to value their business at £10million.
By contrast, the UK200 Group’s own SME Valuation Index, based on its knowledge of and data from smaller companies, indicates that an SME with profits of £1million should be valued at around £5.6million – suggesting a significant discrepancy that could have a noticeable impact on business planning and finances.
“Not Simply a Case of Scaling Up or Down”
Simon Blake, Chairman of the UK200Group’s Corporate Finance Panel, explained why valuations of smaller business must be done differently.
“Small businesses behave differently to large ones in a number of ways, so it is not simply a case of scaling up or down. In smaller companies, there is a greater level of entrepreneurial impact on the data that is used to create a valuation. Small business owners may put costs through the business that a large corporate would not.”
“Another consideration is funding. A typical bank will lend around 2 to 2.5 times EBITDA, at typically 50 or 60% loan-to-value. Because of this, the EV/EBITDA ratio of smaller firms will remain at 5 or 6. Larger businesses are able to command greater debt leverage and therefore greater debt funding.”
Mr Blake said it is too early to say what affect the UK’s proposed Brexit has had on business valuations, as the SME Valuation Index is based on real life transactions that have already occurred uses only valuations stemming from real transactions, which can take many months to go through, but that overseas interest and purchase prices for UK businesses seems to be healthy.
“My experience of 2016 is that we saw plenty of strategic buyers coming from places such as the US, paying a little more – in sterling – than they would have because of the depreciation of sterling against the dollar. Although sterling now seems to have stabilised, this theme of increased interest from overseas companies is one that we do expect to continue in 2017.”
As for small business owners wanting to improve the valuation of their companies – what can they do?
“A key factor in a company’s EV/EBITDA ratio is the strength of its income stream,” says Simon Blake, who cites Microsoft as an example of a company who have wisely moved from selling one-off packages to subscription-style sales.
“Microsoft has created a much more strongly-recurring, sticky revenue, which makes it much more valuable than a company that can’t predict its orders and takes orders for February in January but doesn’t know what it’ll sell in March.
“Companies with a subscription-based income have a much higher Enterprise Value to EBITDA ratio, so tech companies often have much higher multiples than, say, a retail business which is solely reliant on its brand to pull in customers.”