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Are your most prized people devaluing your business?

Every business has its stars. It may be the sales person who brings in more than the rest of the team put together, the client responsible for half your turnover, or perhaps it’s the supplier whose product or service underpins your entire business model.

When it comes to putting a value on a business, these people and relationships are extremely important. They drive sales and profitability, and because valuation price is usually a multiple of earnings, their “worth” makes up a large part of the goodwill in the company.

However, problems can arise when these people and relationships are unique or
irreplaceable. To the owner, it makes them even more valuable. But to a valuation specialist, their uniqueness is a liability – a source of risk that directly reduces business value.

This can come as a shock to owners, as most have never viewed their business from this perspective before. To get a true picture of what your business is worth, you need to view it as a valuation specialist would.

Areas to consider are customers, suppliers and employees. Over-reliance on one customer is an obvious risk. A less obvious one is when major accounts are all managed by one sales person. If that person left, how many clients would you keep and what would sales projections be like?

Likewise, the supply chain should be reviewed to remove over-reliance on any one provider. And contracts reviewed to find out if profits can be maintained if you switch suppliers. Alternatively, the risk may be internal – such as having only one person who can buy raw materials at preferential terms. Gross profit margins may be unsustainable if they left. The likelihood and impact of these risks will all be factored into a valuation.

Over reliance on key individuals can be harder to manage – particularly if that person happens to be the business owner. However, a strong management team, a comprehensive succession plan and well-documented processes can go a long way to reducing the risk. A valuation expert will assess the effect the person’s absence would have on the business. And how they calculate it will depend on the extent to which they can quantify the impact on sales or profits.

With a valuation based on earnings, the risk might be factored in by decreasing future cash flows. But if this cannot be accurately quantified, it may be factored in by simply lowering the multiple applied to current earnings. Regardless of which method is chosen, ensure the impact is not duplicated.

The circumstances of the valuation can also affect the price calculation. In a straightforward business sale, there is a coordinated transfer of strategic relationships over to the buyer. But in an estate valuation, the owner is deceased. Even if there is a succession plan in place, there is little chance for an orderly transition period.

The importance of key directors or shareholders in business valuation was highlighted in the recent First Tier Tribunal Spring Capital Limited v HMRC, which supported the view that goodwill is associated with individuals as well as the business.

Finally, if you cannot reduce the impact of a risk, you may be able to reduce the chances of it happening. For example, if you are over-reliant on one account manager, it may be impractical to transfer their key accounts to someone else. However, it may be possible to lessen the chance of them leaving by offering long-term incentives such as employee share options.

Entrepreneurs have a natural sense of what improves turnover or profit, but are often unaware of the risks that threaten to devalue everything they have worked for. To maximise the value of your business you need to do both.

Read and download the full Business Valuations update.

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David Stears - Menzies Accountant

Business Valuations Director

David Stears

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