What is Value?
Business is a relationship in which people exchange value. A good business definition of value is: the regard that something is held to deserve; the importance, worth, or usefulness of something.
In a barter economy, I would give you something that was useful and important to you in exchange for something useful and important to me.
A “value-added person” tries to add value to the lives of other people by giving something they need or want without regard for what might be received in return. Therefore, he does not go to a friend’s home or to a business meeting empty handed. In business, the most powerful gifts are intangible, such as information, knowledge, or useful introductions to other people.
In truth, you usually do receive something in return for being a value-added person. You might receive inner satisfaction at having helped to enrich the life of another, albeit it a small way. But you also receive “good will” from the other person. They will generally be more inclined to welcome your future visits, return your phone calls or emails, listen to your ideas, and share their knowledge and insights with you. However, if your gifts prove defective, your information inaccurate, your knowledge faulty, or your introductions fruitless, your counterparts likely would hold a diminished appreciation for the benefits of association with you. So, in the realm of business relationships, there is a sort of barter system in play.
Most human beings today do not live in a barter economy. We live in an economic system that uses money to exchange goods and services. “Monetary value” is the value in currency that a person, a business, or the market places on a resource, product, or service.
The Value of a Business
The subject of value arises constantly as Go Beyond LLC works to help the owners of privately-held small and midsize businesses prepare themselves and their companies for what will be the biggest exchange of value in most of their lives.
For the vast majority of them, nearly 80 percent of their net worth is locked inside a very illiquid asset, their company. According to the Exit Planning Institute’s (EPI) nationwide State of Owner Readiness survey, 56 percent of lower middle market business owners claimed to have a good idea of what their business was worth, yet only 18 percent had had a formal valuation in the past two years. This despite the fact that 76% stated a desire to exit their business within 10 years.
The EPI also found that 65.9 percent of business owners had completed no formal education related to transitioning their business. Go Beyond offers a five-month workshop series for business owners based on the EPI’s Value Maturity Model and closely follows the EPI’s Owner Roundtable series. The rest of this article will cover the broad strokes of measuring the value of your business so that you can take actions and create policies to protect, grow, harvest, and manage that value.
Most people who start a business do so with the idea of maybe selling it or passing it on somehow to employees or family. But they spend so much time just trying to keep the doors open that, even if Exit is part of their overall plan, it is usually relegated to the back burner. They think in terms of revenue and income, but hardly ever think in terms of the Open Market Value of their business. The odds are not in a business owners favor, according to the EPI about 80 percent of lower middle market businesses ($5million to $100 million annual revenue) that go on the market never sell. That doesn’t include those businesses whose owners are forced by circumstances to exit prematurely. The odds are event worse for businesses with less than $5 million annual revenue. Those that do sell, do so for much less than their owners imagined.
According to Walk Away Wealthy: The Entrepreneur’s Exit Planning Playbook (Mark Tepper, 2014), “If you want to defy the odds, there’s an essential strategy you must follow that will dramatically improve your chances of a successful sale: Put a strong exit plan in place.” Exit Planning requires a different kind of mindset. You have to think of your business as an investment and make decisions that will maximize the Open Market Value of your business.
Fundamentals of Business Valuation
The first step in maximizing Open Market Value is to understand the fundamentals of business valuation. Let’s operationalize our terms. We are talking about Open Market Value, but you may have heard a similar term: Fair Market Value (FMV), which is used in courts of law, means price a company would likely sell for in a transaction between a hypothetical will buyer and seller, each with perfect knowledge relevant to the sale and neither experiencing coercion. Fair market valuations are expensive to get and are not all that relevant in open market transactions.
Open Market Value (also known as Strategic Value or Enterprise Value) is a function of earnings, growth, and risk. Our simple valuation formula is OMV = EBITDA x Multiple.
Earnings is represented by re-casted earnings before income tax, depreciation, and amortization (EBITDA). Re-casted EBITDA means that the person doing the valuation recalculates the financial statements by adding back extraordinary onetime expenses or owner perquisites that would not be considered normal operational expenses. This is accomplished to arrive at the “real” number that more closely approximates cash flow from business operations, which often is quite different from number reported on tax returns.
Risk and the potential for future growth are both represented by the EBITDA Multiple. As Tepper explains in Walk Away Wealthy, a good way to understand the Multiple is as the reciprocal of the buyer’s required return on investment (also known as Cost of Capital) at the perceived level of risk. For example, if the required ROI is 33%, that can be expressed as 1/3. The reciprocal gives a Multiple of 3. Whereas for a similar but less risky business, the required ROI might be 20%, which could be written as 1/5. The reciprocal of which gives a multiple of 5. If both had an EBITDA of $500,000 the first company, would sell for $1.5 million, but the second company – the less risky investment – would sell for $2.5 million.
Range of Multiples
Historically, lower middle market businesses sell at between 4 and 7 times EBITDA. However, in today’s market with so much investment capital looking to be deployed, those with businesses that are at or near best-in-class are getting multiple between 8 and 10, even 11 is not unheard of. Small businesses below $5 million annual revenue, have typically sold at multiples of 2 or 3. However, many get less than 1 times EBITDA. Multiples are lower because the smaller the business the greater the risk. Tepper helpfully points out there is a sweet spot, where higher multiples become more common place. That threshold is marked by $5 million in annual revenue and $500,000 in EBITDA. So, if you are at $3.5 million in revenue with a 10% EBITDA margin, it may well be worth your while to push to the $5 million annual revenue mark while maintain your profit margin. Likewise, if you have already arrived at $5 million revenue, but you EBITDA lags at about $300,000. It might be a good idea to hunt for efficiencies to get you to $500,000 EBITDA.
However, concentrating solely on revenue and earnings would be misguided. Taking those actions and enacting those policies that increase your multiple is the surer path to improved OMV. Chris Snider explains in Walking to Destiny: 11 Actions An Owner MUST Take to Grow Value & Unlock Wealth that the income statements account for only 1 or 2 times EBITDA during the valuation process. The remainder of the Multiple comes from the intangibles of the business. These are the value drivers. In Your Exit Map: Navigating the Boomer Bust, John Dini lists four categories of value drivers: finance, operations, revenue/profit trends, and planning. Chris Snider, in Walking to Destiny, also lists for kinds of value drivers. He calls them the Four C’s: human capital, customer capital, structural capital, and social capital. If you break both sets down to their constituent parts, Snider’s drivers include all the elements of Dini’s driver and are more inclusive of factors that influence OMV. Go Beyond teaches the Four C’s.
- Human Capital consists of all your policies and procedures for attracting, vetting, hiring, onboarding, developing, motivating, and retaining top talent.
- Customer Capital consist for your customer relationships, how much your company is an integral part of customer success, the contractual nature of those relationships, do these customers provide consistent recurring revenue, and whether business is spread across enough customers so that the loss of one or two would not be devastating to the business.
- Structural Capital consists of your infrastructure, technology, systems, processes, and procedures that capture the knowledge assets within the company, converting mental processes and decisions into company property that is transferrable. It also includes your legal business structure and financial processes.
- Social Capital consists of your corporate culture (value, norms, ways of treating people inside and outside the company), your brand, the way your teams work, the rhythm of daily operations, communications, the management system, strategic planning, goal setting, etc.
Concentrate on improving these value drivers and you will improve sales and create efficiencies that also positively affect the financials of the business. Commit yourself to relentless execution over a period of 3 to 5 years, and you can double or triple the OMV for your business. Even if you don’t have that much time, money, or energy to spend on getting the business ready for market, paying attention to the factors we’ve addressed will help you improve your chances of successfully transitioning ownership of your business.
If you want to learn more, sign up for the Elim Group beginning on March 28th or contact us for a free one-hour consultation.
Go beyond what the world expects.