Valuing the smaller SME at sale

Valuing the smaller SME at sale

Studying the figures and knowledge of the company are necessary.

Accounting figures rarely reflect the business reality. It has nothing to do with bad intent, but often with tax optimization of the owner’s total assets. The buyer wants to acquire the company as a going concern, ready to operate, and separate from the owner’s assets. The buyer expects, for the first years after acquisition, at least the same profit generation with a market-based remuneration for the managing director and all other relevant costs to keep the company running.

Such analysis requires not only financial expertise but also sector-specific entrepreneurial knowledge. For most, buying or selling a company is not an everyday activity. Do your homework thoroughly and, if necessary, seek guidance to unlock the true operational value of the company. Personal decisions such as accelerated depreciation, excessive management fees, oversized company cars, unnecessary real estate, and not capitalizing software developments can unnecessarily reduce business profits. The opposite, where business profits are unlawfully high, can also occur—for example, management fees that are too low relative to the size of the company, understaffing, or necessary replacement investments being postponed in the years leading up to the sale. These are just a few of the many examples that can impact the value of a company. Often, the company’s activities are also spread across multiple entities. The business must therefore be viewed on a consolidated basis.

The timing of the sale is also important. If a machine manufacturer developed a new machine in the previous fiscal year but has not yet started selling it, that fiscal year will show a lower gross margin and less operating profit. In that view, the owner is better off waiting another year to sell the business until sales of the new machines start generating profit.

Searching for the reality behind the accounting figures
The value of a company is largely determined by the reality behind the accounting figures. These adjusted figures, reflecting reality, form the basis for the valuation of the company’s shares. Valuing companies is a discipline in itself, with many books already written about it. However, valuing a typical SME usually comes down to three methods: the earnings method based on multiples of EBITDA or EBIT, the adjusted net asset method, and the financing capacity of the acquisition amount. Describing each method in detail would go too far. It is still useful to highlight a few key points for each method.

A multiple of 12 times EBITDA does not apply to every company.
Multiples used in valuation are derived from studies of comparable transactions or sales. A common mistake is to rely too quickly on international tables for valuing a Belgian transaction and to adopt those values without adjustment. Just because a US publicly traded software group pays 12 times EBITDA for an English software company doesn’t mean the same applies to a Flemish software business with customers only in Belgium. For local transactions, it’s best to use local studies, such as those from Vlerick Business School, which publishes a yearly barometer linked to their buy-out academy.

Another interesting valuation exercise is the adjusted net asset method. For companies with depreciated buildings and other valuable assets on the balance sheet, such as transport, road construction, or construction-related businesses, it can be useful to recalculate equity based on the current market values of the assets on the balance sheet, even if this means it is lower than the book value. Important in this exercise is that deferred taxation is also taken into account.

Also consider the free cash flow of the company to be acquired.
And last but not least, the test of the financing feasibility of the acquisition price. It makes little sense to propose a valuation for a small SME that the buyer cannot finance because the free cash flow of the company to be acquired is insufficient. Available financial resources vary for each buyer. To be manageable for a management buy-in candidate, the acquisition amount should ideally be financeable with a 7-year loan and about 30% own funds.

Lieven Stas
Overnamepartners.be

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