For the purposes of Key Person [Keyman] Insurance - Part 3

In this third part of our Business Valuation series we look at valuing micro businesses.

Micro businesses form a large portion of small and medium-sized businesses.  There are more than 500,000 of them in Australia and in the main they employ less than five people and have a turnover o less than $500,000.

Valuing these businesses using traditional valuation approaches often produces an outcome that is inconsistent with market reality.

Valuation theory says that the true value of a business is the amount that would be agreed between an equally willing and informed buyer and seller.

Typically mico businesses have a value in the market but when valued using an earnings or cash-flow approach, they do not slow real value.

One of the key reasons for this is that many micro businesses will produce a good income for the owner-operator but they not produce a significant amount of profit after paying the owner a fair wage for their work.

The majority of earnings or cashflow valuation approaches assess value after allowing for all costs, including the fair costs of the owners if they are working in the business.

So after allowance for this, where there is little or no profit, the valuation will show limited business value.

Two valuation methodologies that could be more suited to micro businesses are the industry method and the cost-to-create approach.

The industry method seeks to model or reflect the market whereas the cost-to-create approach recognises the value of the tangible assets in the business and allows a premium for the cost of establishing the business.  These approaches tend to provide a more realistic assessment of business value.

In deciding on valuation methods, you must understand the purpose for which the valuation is being used.

Where someone is looking to buy a business and seeks advice on a fair price, the industry method or the cost-to-create one may be the most reliable methods to consider.  But if you are looking at the value for tax purposes, or valuation under  Family Law, these methods may not be appropriate.

There is a difference between value and price.  Some business owners who seek a valuation are really looking for a business appraisal rather than a valuation.

Over the last five years it has been common for price to trade at a premium to value.  Where you are looking for assessment of a market price being asked for a business, whilst the value is relevant it is not the key issue.  Too often this is ignored and it shows at its most extreme with micro businesses.

In a larger business, the impact of a valuation assumption may move the value across a 10-to-15 per cent range.  In a micro business, this spread can be the difference between recognising value and removing it.

Next week:  Taxation problems with valuations – what you need to avoid.

Part 4. Taxation Issues Concerning Business Valuation
We look at what taxation problems could arise with valuations and what you need to avoid. Go to Part 4

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• helping to establish a value on the business/practice;
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