Small to medium business owners often have no real idea of what makes up the value of their business when they come to sell. An area where there is often confusion is the impact that the tangible assets of the business, in most cases Stock + Plant & Equipment, have on the value quoted.

Most SME businesses in the NZ market will be valued by Business Brokers or owner’s accountants using a ‘Capitalisation of Future Maintainable Earnings’(FME) methodology or something similar. We assume that a SME is a business that offers a return on investment after an owner’s salary, in most cases has a management structure rather than the one man band type business.

Capitalisation of FME in simple terms involves the calculating of a net surplus figure for the business, quoted in most cases either as EBIT (Earnings Before Interest and Tax), EBITDA (Earnings Before Interest, Tax, Depreciation or Amortisation) or EBPITD (Earnings Before Proprietor’s Income, Interest, Tax and Depreciation) which is most often used for owner operator sized businesses. This figure is often based on an average of the last three years performance of the business for mature businesses and in some cases on the current year if the business is growing or declining.

A capitalisation rate or multiple is then set to reflect any positive or negative factors that have been identified, which could influence the businesses ability to earn that figure going forward. For example a SME with little risk could have a capitalisation rate somewhere in the range of 25-32% on EBIT or multiple of approx 3-4 times EBIT where a SME in the same industry which has risk could be somewhere in the range of 33-40% on EBIT or 2.5-3 times EBIT.

One of the assumptions utilising the Capitalisation methodology is that the value that is agreed to includes all of the tangible assets required to run the business in its current form. So all the normal stock requirements and all the normal Plant & Equipment required for the day to day operation of the business are included.

Now this is where things can get tricky because business owners everyday make decisions on the levels of the tangible assets of their business and these are often not reflective of what the business requires going forward.

The level of stock that a business holds at the point of valuation has nothing to do with setting the value of the business using the capitalisation methodology i.e.

Business A: EBIT $250,000 Cap Rate: 25% Value: $1 million

If Business’A’ currently has a stock holding of $500k or $1,2m it is still worth $1million utilising capitalisation methodology. So it is in a business owner’s best interest to keep their stock holding to an efficient but acceptable level. If the stock holding required for business ‘A’ to operate is $600k but there is only $500k on hand then the owner will have to either increase stock levels to the required level or have the sale price reduced accordingly.

The same can be said for the plant and equipment required to run the business. All the vehicles, fork hoists, computers, furniture etc. required to run the business day to day is included when using this valuation methodology.

There is no need for guess work here though for a purchaser. A good robust Due Diligence investigation utilising a good commercial accountant experienced in this type of transaction can accurately identify whether the levels of either stock or plant and equipment indicated on the Sale & Purchase agreement are at a level suitable for that transaction.

We also recommend though that the owner of any business that wishes to sell has an equally robust conversation with their accountant and/or business broker to identify what the true levels of each should be before the business hits the market. It is certainly better to have the business positioned correctly to all parties rather than having the business enter into a Due Diligence investigation, which incurs costs on both sides, and have the transaction fall over because of a perceived dishonest approach by owner, broker and accountant.

If you are thinking of selling your business and are unsure of where your business stands relating to any of this please feel free to contact Switch Business.