New data from business adviser association the UK200Group shows that indices such as the BDO Private Company Price Index, which shows the average Enterprise Value to EBITDA (EV/EBITDA) ratios of larger businesses, may lead the owners of small businesses to over-value their enterprises.
With most distributors being in the small to medium enterprise (SME) category, this could be something for their management to ponder.
The UK200Group’s members provide accountancy and law services to over 150,000 SME clients. The BDO’s most recent data shows an EV/EBITDA ratio of 10.0. By this measure, an SME owner with annual profits of £1m might assume that their business could be sold for £10m.
The association has compiled the SME Valuation Index, a set of data that shows that the mean EV/EBITDA ratio of a smaller company valued by its members was 5.6m in 2016.
By this measure, the SME owner whose profits are £1m should revise their valuation figure to £5.6m. This discrepancy of £4.4m could be significant to exit plans, business strategy and investment.
Simon Blake, chairman of the UK200Group’s Corporate Finance Panel, explains the factors that mean small businesses have lower EV/EBITDA ratios: “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. For example, at a firm I have valued, the owner was taking his senior management on trips around Europe to celebrate business achievements. Those costs would not be incurred in a larger corporate firm in a similar industry. Because they are non-recurring costs and are unusual, these trips have taken £50,000 off the firm’s annual profits, potentially reducing the valuation of the business based on the 10x multiple above by £500,000 erroneously.
“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.”
But has Brexit affected valuations in the SME community? According to Blake: “I think that it’s too early to say. The SME Valuation Index uses only valuations stemming from real transactions, which can take many months to go through.
“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.”