Business valuation, explained: how a small business is valued

The profit on a small business's financial statements is rarely the profit a buyer would earn. Owners pay themselves in different ways: a low salary and large dividends, family members on the payroll, a vehicle or phone through the business, or nothing at all for the hours they work. Once-off events, such as a large insurance payout or a legal bill, distort a single year.

Normalising the earnings means adjusting for these so you see what the business earns under a new owner. Some adjustments add to profit, such as personal expenses that will stop. Others reduce it, such as the market cost of a manager to replace the owner's unpaid hours.

Each add-back should be backed by a document. If a seller claims large add-backs that the records cannot support, that is a finding in itself, and it belongs in the negotiation.

Two businesses with the same profit can be worth very different amounts. The difference is how much a buyer can rely on that profit continuing after the sale.

Owner-dependency is usually the biggest factor in a small business. If the owner prices every job, holds every key customer relationship and is the only person who can run the operation, a buyer is paying for something that may leave with the seller. Customer concentration works the same way: when a few customers make up most of the revenue, losing one changes everything.

Records, systems and staff work in the other direction. Clean books, written processes and a team that can run the work without the owner all make earnings more dependable, and dependable earnings are worth more.

• Owner-dependency in pricing, sales, operations and relationships
• Customer concentration and the strength of contracts
• Quality and completeness of the financial records
• Debtors: how much is owed and how old it is
• Staff, systems and SOPs that let the business run without the owner
• Tax and statutory compliance, including any outstanding returns

Before agreeing a price, ask for enough to test the story the seller is telling. Three years of financial statements are a start, but they need to be compared with bank statements to confirm the money actually moved the way the statements say.

Ask for a debtors ageing report, the list of top customers by revenue, staff contracts, lease agreements and an asset register with the condition of major items. Check the tax and company position too: a current tax compliance status, CIPC annual returns that are up to date, and, for employers, a Compensation Fund letter of good standing.

Involve your attorney and accountant for the legal and tax structure of the deal. The valuation tells you what the business is worth; they make sure what you sign matches what you think you are buying.

• Three years of financial statements and the latest management accounts
• Bank statements for the same period
• Debtors and creditors ageing reports
• Revenue by customer for the last two years
• Asset register, vehicle list and condition of major equipment
• Staff contracts, leases and key supplier or customer agreements
• Tax compliance status and CIPC annual return history

Some warning signs are common enough to look for every time. Revenue that jumps in the year before a sale deserves questions. So does profit that only appears once large add-backs are applied, or financial statements that cannot be matched to the bank.

Watch for a debtors book full of old invoices that are unlikely to be paid, cash takings with no clear record, and a business where key assets are owned personally by the seller rather than by the company. None of these automatically kills a deal, but each one changes what you should pay or what you should ask the seller to guarantee.

This is a decision-support valuation for buyers, sellers, partners and owners. It is built to help you decide and negotiate, with the reasoning set out so you can test it.

It is not a formal valuation for court proceedings, a divorce settlement, SARS or a regulatory filing. Where one of those is needed, I will tell you, and you will need an appropriately accredited valuer. The confidence of any valuation also depends on the records behind it: where a seller's records are incomplete, I say so and show how much that uncertainty affects the range.