Blog | This Way Out Group
Sell your company while things are going really well.
Makes sense. Sounds straightforward enough.
In this context, ‘well’ is a metric of success that will make ideal buyers take notice. What would make your ideal buyer/acquirer take notice? It could be any and all of the following:
- Number of users on your ‘app’
- Viral growth
- New channels you are opening
- Market monopoly opportunity
- Recurring revenue streams
- Happy customers
- Caliber of channel partners
- Growing diverse client base
- Penetration of the marketplace
- Operational excellence
- Strong leadership
- Strong corporate culture
- Achieving revenue, profit margin,
and growth goals
- Measurable value drivers
- Strong forecasts
- Reduced risk
- Maximizing value
- Do you run your business on metrics that can be measured or do you run your business from personal experience?
- Do you hit your goals for the business? Is your business a showplace to be proud of?
- What more could you do so that your ideal buyer starts to take interest in your business?
Timing an External Sales Process
So when is the right time to consider selling the business? When should you launch an external sale process?
First, get clear on your exit criteria. If you don’t know your criteria that would make you say yes to a deal, start there. It’s time for thoughtful consideration of your exit criteria, dreams and goals in terms of:
Second, monetize what you built. To sell well, you should secure:
- the business
- your team
- your family and
- your finances
before starting the transaction process.
Third, determine the best timing before committing to the transaction process.
- What’s the best timing for you personally – 3 years from now, or 3 decades from now?
- What’s the best timing for the business – is it already a turnkey operation, do you have a successor groomed, is the business at or approaching its peak?
- What’s happening in your market – is the market expanding, is it consolidating, are there opportunities your company is in a position to leverage?
Changes and Challenges
Pay attention to personal and family factors, which impact us all. Any number of changes and challenges from retirement, health, or family obligations can compel a sale, even if, those same challenges (e.g., conflicts, litigation, shareholder diversity, disability, etc.) can reduce the value of the business or make the business un-saleable!
You Can’t Sell Well In A Vacuum
In addition to attracting your ideal buyer/acquirer, you also must prepare:
- your company
- your team
- your family and
- your finances
or you won’t be in a position to sell well.
That preparation, planning and forethought takes time, commitment, focus and resources to position your business to sell well. That’s time you can’t be tied to day-to-day operations of the business. It’s imperative that your team can shine hitting your numbers independent of you at the helm. It’s time you need to focus on the strategic imperatives of an ideal transaction and your successful transition.
To Sell Well, Surround Yourself With A Team
It takes a team of experts around you to get all the pieces done and done right. You want all-star specialists around you. Do not accept ‘dabblers’ in any role on that team. Check out the whitepaper: How to Manage a Gaggle of Advisors to Build Your All-Star Exit Team.
The lead-time investment in pre-transaction/pre-transition planning will pay handsome dividends when you sell well to your ideal buyer/acquirer.
Business owners get lots of support, training, and direction on starting and growing their business. They engage a business attorney and an accountant from the outset. Along the way, they may hear a question or suggestion about how they will cash out the business they built.
But the idea that exit planning and the lead-time to maximize the value of their business could take years is unfathomable for most owners in the lower middle market.
It’s unfathomable, because:
- No one told them how long the process takes, the range of advisors they and their buyer will call in to assess the sale-ability of their ‘baby’, or its value.
- No one prepared them for the gauntlet of demands in the transaction process
- They never knew they’d have to reveal so much about the inner workings of their business – their secret sauce, as well as their personal takings from the business.
- The [costly] expenses they have avoided along the way are now mandatory to demonstrate the business is a turn-key operation that can run successfully under new ownership
- They did not need all these different experts while running the business, why should they need any more help to sell the business, after all it’s it as simple and straight-forward as selling a house isn’t it?
- They’ve been operating the business successfully for decades, generating a healthy income and lifestyle, so why would anything need to change for someone else to buy them out?
The shock of what that valuation could look like if they fast-track a transaction process, vs. the potentially greater valuation if they extend planning time, (to better prepare the business from a few weeks to even a few years), can put a big wrinkle in their retirement plans.
Just a few of the incentives of extended exit planning:
- Better prepared companies command higher valuations and higher multiples
- Extended Lead-time can showcase increased growth, reduced risk, improved quality of operations, stronger forecasts, etc.
- A Planning Phase of 3-5 years gives an owner time to prepare:
- The business
- Financials [personal and business]
- Owner’s future plans
- Reduce advisor and transaction costs
- Leverage the business to the strongest terms in the seller’s interest
- Ensure the owner gets a successful transaction the first time
- Clarify, address and focus the owner on their reinvention
Without an exit plan as a framework for every decision you make, owners end up working harder, not smarter for the lifetime of their business. Starting years before an intended exit date to prepare and plan for your ideal transaction and transition will position you, the owner to:
- Increase business value to increase transaction value
- Reduce risk
- Command higher multiples
- Grow revenues and profit margins
- Make the business buyer ready and buyer attractive
- Minimize the tax burden you will incur
- Plan and test your reinvention
- Ensure you don’t sabotage the deal once it’s made
- Surround yourself with an all-star team of advisors
Transaction Value increases with the length of time invested in early exit planning.
Most business owners assume that selling their business is a sprint to the finish-line, but the reality is it is more like a marathon. Whether you are prepared for it or believe it or not; it takes a long time to sell a business – if you want to command full value.
The sound of the starter gun sends adrenaline flowing as you leap forward out of the blocks. Within five seconds you’re at top speed and within a dozen your eye is searching for the next hand. Then you feel the baton become weightless in your grasp and your brain tells you the pain is over. You start an easy jog and you smile, knowing that you did your best and that now the heavy lifting is on someone else’s shoulders.
That’s probably how most people think of starting and selling a business: as something akin to a 4 x 4 100 meter relay race. You start from scratch, build something valuable, measuring time in months instead of years, and sprint into the waiting arms of Google (or Apple or Facebook) as they obligingly acquire your business for millions. When they hand over the check and you’ll ride off into the sunset. After all, that’s how it worked for the guys who started Nest and WhatsApp and many others – right?
Unfortunately, the process of selling your business looks more like a grueling 100-mile ultra-marathon than a 100-meter sprint. It takes years, a lot of planning and a lot of preparation to ensure you can make a clean break from your company – which means it pays to start planning sooner rather than later. Here’s how to backdate your successful transaction and transition to a reinvention to get started.
Step 1: Pick your sell-by date
The first step is to figure out when you want to be completely out of your business. This is the day you walk out of the building and never come back. Maybe you have a dream to sail around the world with your kids while they’re young. Perhaps you want to start an orphanage in Bolivia or a vineyard in Tuscany.
Whatever your goal, the first step is writing down when you want out, identifying why that date is important to you, as well as what you will do after you sell, with whom, and why.
Step 2: Estimate the length of your earn out
When you sell your business, chances are good that you will get paid in two or more stages. You’ll get the first check when the deal closes and the second at some point in the future — if you hit certain goals set by the buyer. The length of your so-called earn out will depend on the kind of business you’re in.
Earn outs these days average two – three years. If you’re in a professional services business, your earn out could be as long as five years. If you’re in a manufacturing or technology business, you might get away with a one-year transition period.
Estimate: + 1-5 years
Step 3: Calculate the length of the sale process
The next step is to figure out how long it will take you to negotiate the sale of your company. This process involves hiring an intermediary (a mergers and acquisitions professional, investment banker or business broker), putting together a marketing package for your business, shopping it to potential acquirers, hosting management meetings, negotiating letters of intent, and then going through a 60 to 90-day due diligence period. From the day you hire an intermediary to the day the wire transfer hits your account, the entire process usually takes six to 12 months. To be safe, budget one year.
Estimate: + 1 year
Step 4: Create your strategy-stable operating window
Next you need to budget some time to operate your business without making any major strategic changes. An acquirer is going to want to see how your business has been performing under its current strategy so they can accurately predict how it will perform under their ownership. Ideally, you are in a position to give them three years of operating results during which you didn’t make any major changes to your business model, financial structure or ownership.
If you have been running your business over the last three years without making any strategic shifts, you won’t need to budget any time here. On the other hand, if you plan on making some major strategic changes to prepare your business for sale, add three years from the time you make the changes. These could include such things as: a new accounting software package; a clean financials; or changes in cashflow, risk tolerance, operational quality, pricing, cost structure, market channels, etc.
Estimate: + 3 years (after changes implemented)
Figuring out when to sell
The final step is to figure out when you need to start the process. Let’s say:
- You want to be in Tuscany by age 50, your sell-by date.
- You budget for a three-year earn out, which means you need to close the deal by age 47.
- Subtract one year from that date to account for the length of time it takes to negotiate a deal, so now you need to hire your intermediary and commit to the sale process by age 46.
- If you’re still tweaking your business model – e.g., experimenting with different target markets, channels and models; you will need to lock in on one strategy by age 43 so that an acquirer can see three years of operating results.
It certainly would be nice to make a clean, crisp break from your business after an all-out sprint, but for the vast majority of businesses, the process of selling a company is a squishy, multi-year trek to reduce risk and maximize value. The sooner you start, the better.
So if you wanted to command full value and be out by age 50, and you’re 45 or 47 now, you may have to delay that sell-by date or tie down operations right now, and get started planning earlier rather than later.
How do you know when it’s time for a transition? Is it a transition or a transaction or both? Is it your conscious decision, or are things so out of control in your business, you are at a distinct disadvantage? How do you know?
In your business, deciding it’s time for a transition can be colored by a myriad of issues, events, or individuals. A transition can take years to explore, refine and execute.
Strategically planning each step will keep you in control. In contrast, having no plan will take away all your control and leave key decisions up to others.
Take a moment to read the following statements. Do you AGREE or DISAGREE with each statement?
- The business is running well, but I’m bored.
- There’s more to life than running this business, I want to do something different.
- That burning desire to compete isn’t there anymore. I may be “burnt out.”
- I thought all along that my children would take over the business. Now they’ve found other ventures they want to pursue. I don’t know what’s next.
- I’ve been approached by a competitor, I want to know what he’ll pay for my business but I don’t want to ‘give away the store’.
- The market for companies like mine is hot. It may be a good time to sell, but I’m not ready.
- I/my spouse had a health scare. I hope it’s not too late to ‘smell the roses’.
- I’ve been working in my business so long I really don’t know what it would be worth to anyone else.
- I’m tired and drag myself to work most days.
- I don’t know if I can afford my lifestyle if I let go of the business now.
- I can’t sleep at night because I feel like I’m being held hostage to my business.
- My company is starting to lose market share, revenue and/or profits. It’s a trend I don’t know how to fix.
- Most of my wealth is illiquid tied up in the business. I want to diversify by taking some chips off the table.
- We never drafted any contingency agreements. Now family and partnership relationship issues are emotionally draining me and putting the business at risk.
- When I leave my business, I want it to be on my terms and from a position of strength.
How many of these statements describe you right now?
If you AGREE with 0-2
Your company is not facing an imminent transition.
If you AGREE with 3
You would benefit from a frank conversation with a specialist about your transition timeline
If you AGREE with 7-10
Call for a free consultation now, before one more issue arises to derail the business or your transition opportunities
If you AGREE with 10-15
You needed to start transition planning years ago. We can get you back on track and in control. Call today.
David Kong in his Fortune.com commentary: Best Western CEO: Why you should never get promoted too quickly, stated:
“When we’re young, especially in our 20s, no one is thinking about retirement. But everyone’s career comes to an end, at some point. So it’s never too early to start focusing on your legacy. We should think about how we want to be remembered not just in our company, or our industry, but in our family and amongst our friends.”
It can take a lifetime to build a legacy or it can be galvanized overnight. The challenge is to consciously choose what you want to be remembered for. If we abdicate this opportunity, others will decide what our legacy will be or if it (meaning us) is even remembered.
If you value how you will be remembered, what do you want it to be?
There are two sides to legacy
On the qualitative side, your legacy preserves what you stand for personally and in your business:
The challenge is that most business owners are so busy operating their business that these larger parameters which have long term impact get sidelined or neglected.
On the fiscal quantitative side, your legacy will depend on a number of extremely personal decisions:
• How much money do you need for personal financial freedom?
• What lifestyle are you planning for beyond the business?
• How much money do you want to be able to pass on to family to secure their future for generations?
• What philanthropic commitments do you aspire to make in your lifetime or as bequests?
Your answers to these questions depend on many factors. In some ways the financial decisions are easier than the qualitative ones!
Starting now, take time to reflect:
• Are you having a positive and lasting impact on your team or customers?
• Do your actions inspire the people around you?
• Have you made a transformational impact on the company you built? On your industry? Or the people you care the most about?
• How do you want them to value that experience?
In building your legacy and providing security for your dynasty, it’s imperative that your plans ensure you do not outlive your money. You do not want your legacy clouded or tarnished by inadequate planning for your own lifetime.
Your business and personal legacy plans take time to define, test and execute. It does not come together overnight, or in the midst of the intense transaction process. Rather, it takes contemplation and preparation over the years leading up to that transaction and transition.
The planning for your reinvention, legacy and dynasty should be established before you let go/cash out of your business. To focus on your legacy, integrate your reinvention planning with your exit planning to achieve your ideal qualitative and quantitative outcome.
Your legacy is about your journeys, your values and the truly lasting and positive impact you make. What will yours be?
The Owner’s Journey, a newly released study commissioned by US Trust, at the Eugene Lang Entrepreneurship Center at Columbia Business School, assessed and measured experiences and lessons from eight entrepreneurs who successfully sold or transferred their businesses to family members.
This whitepaper explores how founders or their successors created financial value in their businesses and prepared them for ownership change. Below are just a few of the early planning takeaways you can glean from their experience and apply today.
The stories of the entrepreneurs showcased provide rich insight to a wide range of exit options that worked for them:
- Transferring ownership from father to daughter
- Transferring ownership from a couple to their children
- Selling to a strategic buyer
- Selling a dental practice to a strategic buyer
- Selling to a financial buyer
Introducing the report, Keith T. Banks, President of US Trust, Bank of America Private Wealth Management stated:
“The most successful transitions require entrepreneurs to orchestrate finely tuned exits……Taking the time to initiate the planning process early is often neglected…. Without this planning, ‘business owners are often forced to exit on other people’s terms.’”
Early Planning for a Transfer of Ownership
Two-thirds of business owners who responded to the 2014 US Trust Insights on Wealth and Worth Survey do not have a formal succession plan. And for those who do have plans, many never ‘get around to’ implementing them.
With the greatly increased inventory of small businesses for sale (e.g. businesses listed on www.bizbuysell.com ) multiples for smaller businesses have been eroding. Smaller sellers are now lucky to receive only 1-2 times earnings equal to only couple years of the income they have been taking out of the business.
In the middle market, sales were robust in 2014 and are expected to be the same in 2015.
Exit Strategy Options for Owners of Privately Held Companies
For the purposes of this whitepaper, they considered these six exit options:
- Going Public
- Transfer of Ownership to employees management or partners
- Transfer ownership to family members
- Transfer ownership to financial or strategic buyers
The first two are acknowledged as being unappealing options. The last two are recognized as the most plausible options.
Other Insights from The Owner’s Journey
- Not all businesses are saleable. Even long-standing, successful businesses will face challenges if they are not been deliberately managed for sale.
- One family said: You must do the best you can to protect your assets, to protect your family. If nothing is done, one is leaving one’s situation to chance, the government and God.
- One owner was so passionate about his mission and building the company that he had little thought for anything else. He never pondered the endgame.
- Before one puts a business up for sale, one should streamline business processes and audit all costs and contracts.
- Be as firm and detailed as possible in your letter of intent. It is the time to list everything that is important to you … The purchase agreement then easily flows from the letter of intent.
- Find out how other deals were structured. Know your bottom line position. And don’t be afraid to ask for much more than your advisors recommend.
- [My favorite] Start working with professionals years before you want to sell. Have a valuation done years before selling. Learn what you can do to make your company more valuable.
- Unexpected things, both challenging and fortune, will happen. The trick is to be prepared for both.
Tips from experience
These entrepreneurs shared their hard-won advice on numerous topics. Every tip in the table of ‘Tips from experience’ is a golden nugget owners should take to heart. This advice is from the study participants, not advisors. Here are just the categories they cover:
- Selecting advisors
- Understanding the real value of your business
- Selling a company is complex and can take time
- An owner cannot always count on his/her children as the exit plan
- When events move quickly
“The unknowability of the future bedevils every decision maker, not just those selling a business…. Planning can sometimes be difficult and time consuming, but it’s the best tool we have. And the earlier it is started, the greater the likelihood of a favorable outcome.”
The last point I want to highlight is not part of the study itself but what the advisors ‘caught’ along the way:
“Our advisors…were hearing a consistent and passionate message that early planning and enhanced education about exit options and the exit process were in great need.”
That’s our mission at This Way Out Group LLC. That need is growing daily. We help owners start planning early to give them greater exit options, choices and control; we prepare them for and guide them through the exit process (it’s not just an event). Call for a free consultation.
Advisors and buyers speak in a language most business owners have never heard before. Their term, ‘a liquidity event’ is a euphemism for many transaction options.
In financial terms, a liquidity event can be the merger, purchase or sale of an enterprise or even an entrepreneur’s Initial Public Offering. For established lower middle market business owners, a liquidity event is any exit strategy that converts ownership equity into cash for owners and investors.
Regardless of what type of exit transaction you choose to pursue, it is advisable to prepare well for that liquidity event. That preparation entails maximizing enterprise value now. It is essential to start early to produce and prove the maximum value your business should command in a liquidity event.
Preparing for the Transaction
Timing is Everything
You want to be in a position take advantage of any trends and growth opportunities in your market. This can also mean being open to recapitalizing the business, not just cashing out.
Lifestyle and Personal Goals
Business success offers a lifestyle and standard of living that are comfortable. Defining your personal goals, criteria, pursuits beyond the business takes time and often entails planning ahead. Without a clear plan for your reinvention, even if it’s the right time or right opportunity, you may not be ready to take that step.
The terms of a deal are unique to every buyer/seller agreement. But unlike selling a house, there are strings attached to the deal you sign at closing for your business. Those commitments or responsibilities can impinge or constrain your transition plans. For example, the successful integration of your company, your team into the buyer’s organization or culture may require your assistance for months before the transaction as well as more time and involvement after the transaction itself.
The time to plan and prepare your retirement/reinvention financial requirements is long before the liquidity event, in parallel to preparing you and the business for this transaction and transition. For example, pre-transaction (before any type of liquidity event) establish your:
- Retirement goals and ensure they are engaging you and compelling you forward beyond the business
- Gifting plans and execute them
- Preparations for letting go – owners are often surprised how hard this is to do
Identify your potential suitors, or types of potential buyers/acquirers – at least 2, preferably 5 years ahead of your target date in order to be in a position to maximize value throughout the company:
- Strategic Buyers – they could be customers, distributors, vendors, even your management team.
- Financial Buyers – Financial buyers will look first at your cashflow, growth, management team, risks of ownership, fit in their portfolio, and any transition issues/difficulties they could face
- Industry Relationships and Associations can be great sources to explore the right fit, the best fit to achieve your goals for the company, your team, your timeline and your financial future.
Your Management Team
- Objectively assess the depth of your team, their tenure and experience, and their (not your own) customer relationships. – In a liquidity event, the buyer or investor wants to know that the company can thrive even more, without you at the helm, with a strong committed leadership team.
- Strategic Suitors and Financial Suitors will look at your management team differently. One will value their contributions through the transaction and integration. The other will be depending on them to perpetuate your success and growth well beyond the transaction.
- Buyers and acquirers expect that you have many legal elements current and in place to ensure your team will stay with the business including:
- Non-compete agreements
- Non-solicitation agreements
- Employment Agreement – that doesn’t expire for a number of years
- Transaction Compensation – These are financial incentives for them to stay (stock options, phantom stock, bonuses, a percentage of the transaction itself, etc.
If a liquidity event appeals to you and if your objective in that liquidity event is to maximize value to command the highest multiples, start planning now. It takes time to get ‘all your ducks in a row’. And since timing is everything, if you aren’t always preparing to maximize enterprise value, you could miss the window of opportunity when a liquidity event does appear.
If your company is growing, it will have a tendency to continue to grow because you’re doing things right. Conversely, a company that is going backwards or shrinking has a tendency to continue to go backwards or shrink until acted upon by an outside force or you choose to make a change.
When we read about the concept of business growth in the top business periodicals, they always reference the multi-national corporations. That context isn’t relevant to small and medium size businesses. For you, business growth requires individual effectiveness.
In your business, you hold the office of president or CEO of the corporation, and you’re responsible for its success or failure. You and the members of your team are invested in your corporation, and it’s your responsibility to see that the value of the business continues to increase in the years ahead.
Growth vs. Death
All responsible company officers know that unless the company is growing, it’s showing the first signs of death. As the head of your corporation (be it 1, 50 or 500 people), you must realize that this applies to you as well.
However, because you are also a person, you have a tremendous advantage over even the largest corporation. In a large multi-national corporation, can it double its production in a single day? Of course not. Can it double its sales in a single day? Of course not. It might like to, but its growth options can be gated by the complexities of such a large organization. Yet an individual person can double, triple, quadruple his/her effectiveness in a month or less. As a smaller business, you can implement flexibility, control and responsiveness to get immediate results which is very difficult for corporate giants to do.
Can you grow and improve as a person at least 10% a year? Of course you can. In fact, experts estimate a person can increase his or her effectiveness anywhere from 50% to 100% and more within 30 days. Now apply that to each person in your entire business.
History is filled with people who exceeded their previous performance to an almost unbelievable extent (artists, athletes, musicians, orators, military and political leaders, not to mention the corporate rags to riches stories).
Cost of Wasting an Hour
Think about it. If you waste even an hour of productive time every work day, it adds up to 250 hours a year. If you had an employee who wasted that much time, would you keep him on the payroll or fire him?
What is your time worth per hour [the burdened hourly rate it costs the company]?
If your salary is $150,000 and your burdened hourly rate is 1.5 then your hourly cost to the company is $108 (assuming a straight 40 hours/week).
Multiply this by 250 and you can see what you’re throwing away. $108 x 250hrs/yr = $27,000/yr.
The effect is compounded when you tally the cost for each member of your team.
If even 5 people (at $50,000 salary) waste an hour a day, that’s $36/hr x 5 = $180/day x 250 hrs/yr = $45,072/yr.
Salaries are sunk costs. That’s $72,000 you can’t recoup and you have nothing to show for it.
What can you do now to improve the effectiveness of every member of your team, to get better results/person? How would that improve your bottom-line?
Here’s the challenge from Earl Nightengale:
“How much are you worth right now, today, as a corporation? What’s your value today, to yourself, your family, your company? If you were an outside investor, a stranger [e.g., a potential acquirer], would you invest in this corporation?”
Effectiveness, Performance, Productivity
Business growth requires individual effectiveness from the entire team. Wasted time equals lost opportunities and a direct reduction in net profits to your business that can be measured daily. Measure these three factors: effectiveness, performance, and productivity, to track the value each individual on your team contributes to your corporate growth.
Business valuation goes beyond simple mathematics.
To get some idea of what your business might be worth, consider these three business valuation methods.
Your business is likely your largest asset so it’s normal to want to know what it is worth. The problem is: business valuation is a “subjective science.”
The Science Part
The science part is what people go to school to learn: you can get an MBA or a degree in finance, or you can learn the theory behind business valuation and earn professional credentials as a business valuation professional.
The Subjective Part
The subjective part is that every buyer’s circumstances are different, and therefore two buyers could see the same set of company financials and other value drivers and offer vastly different amounts to buy the same business.
Below we’ll look at the basic science and math behind the most common business valuation techniques. Keep in mind that there will always be exceptions, outliers that fall well outside of these frameworks. These are strategic sales, where a business is valued based on what it is worth in the acquirer’s hands. These strategic acquisitions, however, represent the minority of acquisitions, so use the three methods below to triangulate around a realistic value for your company:
Assets-based Valuation Method
The most basic way to value a business is to consider the value of its hard assets minus its debts. Imagine a landscaping company with trucks and gardening equipment. These hard assets have value, which can be calculated by estimating the resale value of your equipment.
This valuation method often renders the lowest value for your company because it assumes your company does not have any “Good Will.” In accountant speak, “Good Will” has nothing to do with how much people like your company; Good Will is defined as the difference between your company’s market value (what someone is willing to pay for it) and the value of your net assets (assets minus liabilities).
Typically, companies have at least some Good Will, so in most cases you get a higher valuation by using one of the other two methods.
Discounted Cash Flow Valuation Method
In this method, the acquirer is estimating what your future stream of cash flow is worth to them today. They start by trying to figure out how much profit you expect to make in the next few years. The more stable and predictable your cash flows, the more years of future cash they will consider.
Once the buyer has an estimate of how much profit you’re likely to make in the foreseeable future, and what your business will be worth when they want to sell it in the future, the buyer will apply a “discount rate” that takes into consideration the time value of money. The discount rate is determined by the acquirer’s cost of capital and how risky they perceive your business to be.
Rather than getting hung up on the math behind the discounted cash flow valuation technique, it’s better to understand the drivers of your value when you use this method. These value drivers are: 1) how much profit your business is expected to make in the future; and 2) how reliable those estimates are.
Note that business valuation techniques are either/or and not a combination. For example, if you are using Discounted Cash Flow, the hard assets of the company are assumed to be integral to the generation of the profit the acquirer is buying and therefore not included in the calculation of your company’s value.
A money-losing bed and breakfast sitting on a $2 million piece of land is going to be better off using the Asset-based valuation method; whereas a professional services firm that expects to earn $500,000 in profit next year, but has little in the way of hard assets, will garner a higher valuation using the Discounted Cash Flow method or the Comparables technique described below.
Comparables Valuation Method
Another common valuation technique is to look at the value of comparable companies that have sold recently or for whom their value is public. For example:
- Accounting firms typically trade at one times gross recurring fees.
- Home and office security companies trade at about two times monitoring revenue,
Most security company owners know the Comparables technique because they are often getting approached by private equity firms rolling up small security firms to sell theirs. Typically you can find out what companies in your industry are selling for by asking around at your annual industry conference.
The problem with using the Comparables methodology is that it often leads owners to make an apples-to-bananas comparison. For example, a small medical device manufacturer might think that, because GE is trading for 20 times last year’s earnings on the New York Stock Exchange, they too are worth 20 times last year’s profit. However, in one study of more than 13,000 businesses, it’s clear that a small medical device manufacturer is likely to trade closer to five times pre-tax profit, not 20 times.
Small companies are deeply discounted when compared to their Fortune 500 counterparts, so comparing your company with a Fortune 500 giant will typically lead to disappointment.
Finally, the worst part about selling your business is that you don’t get to decide which methodology the acquirer chooses. An acquirer will do the math on what your business is worth to them behind closed doors. They may decide your business is strategic, in which case back up the Brinks truck because you’re about to get handsomely rewarded for your company. But in most cases, an acquirer will use one of these three techniques to come up with an offer to buy your business.
Curious to see what your business might be worth? Get a free valuation here.