February 2024
It seems to make total sense that, if two businesses in the same industry doing the same kind of work for the same kind of clients, both businesses might be treated similarly. What if both businesses have roughly the same number of employees along with similar sales and similar earnings? It stands to reason that if your friend sold his or her business for 10 times (10x) earnings, that you should be able to do the same. In fact, in your opinion, you might be able to get more because your business is better – right?
The problem with this back-of-the-napkin analysis is that this approach overlooks so many factors and drivers of how a business is really valued and gives owners a false sense of reality. Businesses are valued on both quantitative and qualitative factors. In the scenario presented above, only the numbers, or quantitative factors, were presented to assume the value of the friend’s business might be similar.
Although businesses sell within a range of value, which is typically referenced as either a multiple of sales or earnings, owners cannot control the endpoints of the range of value. For example, subject to market conditions, a business in a certain industry could be valued from 3x to 10x its earnings, while businesses in other industries or markets with higher growth rates, stronger demand, better demographics, etc., might trade from 6x to 15x earnings. An owner with a business in the first industry can’t change the endpoints of the range of value from 3x to 10x up to 6x to 15x, just because they want more value. The owner has the ability to control whether their business value is at the bottom or top end of the range of value.
Companies that are less risky and appear to have superior qualities will be more attractive to a buyer so they will likely sell at the higher end of the range compared to those with more risk. Factors that impact risk include client concentration, lack of key management, weak revenue trends, or poor management systems.
In our example, while both companies might have similar financial quantitative results, a few key differences in qualitative factors of value might be: 1) the level of client concentration, 2) the strength of the management team, 3) the employee culture,4) the market perception and brand image, 5) the potential regulatory or litigation risk, and 6) the development of processes and workflows. These are huge factors when valuing a company that can be masked if not properly evaluated.
Perhaps or perhaps not. While strong revenue and earnings are critical to the attractiveness of a potential buyer, it does not end there. What is more important to a potential buyer is the certainty of those future earnings and the transferability of that income stream from the current owner and management team to the new buyer. The certainty refers to the repeatability of the earnings into the future since companies are typically valued based on their future cash flows.
One aspect of transferability refers to the likelihood that the clients (and therefore the revenue) are sticky enough to stay with the company even if the ownership changes hands and the prior owner is no longer in the picture. This is one of the central risks a buyer is trying to evaluate during the due diligence process. The higher the perceived risk, the more of a discount the buyer will assign to the purchase value of the business.
The solution is to focus on decentralizing the client relationships to others in the organization beyond the owner. This is simply good business strategy to mitigate key-person risk and allows the owner to focus on the strategic initiatives of the company. This decentralization helps the buyer to see the business as a true enterprise.
Additionally, ensuring the business has adequate diversification among clients is critical. If you lose one key client, it could shut down the business. In many cases, this can be anon-starter for many buyers. While each industry and business are unique, a good rule of thumb is that no single client should be more than 10% of the total revenue.
Beyond the sales and client relationships, if all decisions related to processes, operations, finance, and marketing are run through the owner, there is a significant problem. This is not a business enterprise that is readily transferable to a third-party buyer. Ideally, the owner has developed the structural capital, human capital, and social capital of the business to make the business a true enterprise. If not, it is simply a “lifestyle business” or a glorified job that cannot be transferred to a buyer.
An acid test to consider – Can you step away from the business for 30days or more?
Would it run effectively without you? Is there a management team that can run the business and execute without your daily or weekly oversight? If not, and your end goal is to be able to have an effective sale, now is the time to start mapping out a way to make this happen over the coming years.
Naturally it makes sense that the owner’s focus should be on the business when developing a business succession or exit strategy. For most owners, the business is their single biggest asset. Because owning and running a business takes so much time, it is always at the forefront of their minds. Often, owners are overwhelmed by the day-to-day grind of managing the business, dealing with one fire drill after another. The idea of selling or transitioning out of the business can be deeply emotional and is typically not acknowledged until it is too late. Because of this, it is easy to push off the estate planning, tax analysis, and cash flow planning that are part of a properly coordinated and thorough exit plan.
The implication of only focusing on the business is that the owner is not recognizing the domino effect that the sale has on all the other areas of their life. Their personal financial affairs, family, or legacy cannot be forgotten in the process of running a business. For so many owners, their identity and purpose are tied to the business. Exit planning helps remove the tie to the business in preparation for the third phase of life.
Consider that for many owners, they are drawing a good income stream from the business. Without taking the time to develop a thorough cash flow plan that truly calibrates what their lifestyle needs and wants are both today and in the future, they run the risk of treating the business like an ATM machine while they are actively working in the business. Over time, “lifestyle creep” is not uncommon – a bigger house, nicer cars, more toys. The effect is that they continue to work harder and harder to support their lifestyle without any real visibility on what the end goal is. When it does come time to consider a transition out of the business(whether voluntarily or involuntarily due to factors beyond the owner’s control), they may find themselves backed into a corner. I’m not suggesting that business owners shouldn’t enjoy the fruits of their efforts and enjoy their lives. However, visibility is critical to maintaining a healthy balance between enjoying today and planning for the future.
Unless the owner is an experienced investor, there can oftentimes be a psychological transition period between drawing income from a business that the owner is actively managing and involved with on a day-to-day basis and moving to a more passive role by relying on a portfolio of investments like stocks, bonds, real estate, etc., to support the owner after the business is gone. It is critical that owners have a realistic understanding of how the capital markets work, what their portfolio can reasonably produce in predictable income, and whether it is sufficient to meet their needs.
Lastly, for most advanced estate-planning techniques and tax-planning strategies to be effective, they need to be planned for and executed prior to the disposition of the business. Saving on taxes and securing their legacy is oftentimes an important goal for many owners. By punting this part of the process until after the sale, they are missing out on maximizing their opportunities.
Business owners often believe that the same entrepreneurial skills responsible for their business success will effortlessly translate into a seamless and successful exit from their business.
The reality is that the entrepreneurial strengths of the business owner that propelled their business to success in the first place can become challenges during the exit-planning process. For instance, the independent, problem-solving, risk-taking business owner who created the business may not be the best party for exit planning decisions that dramatically affect the long-term success of the family.
Exit planning is the number one private business challenge of our time, according to Christopher M. Snider in his book, Walking to Destiny: 11 Actions an Owner MUST Take to Rapidly Grow Value & Unlock Wealth. Despite its critical importance, many business owners overlook exit planning for seemingly more urgent matters. As exit planning becomes an increasingly urgent matter, business owners find themselves faced with an unfamiliar and time-consuming challenge. A common sentiment becomes “I don’t know how.” A stark reality underscores this dilemma – only 20% to 30% of businesses reaching the market will successfully sell (Walking to Destiny),with many leaving substantial money on the table due to lack of readiness.
It is crucial to acknowledge that navigating the exit process demands a distinct set of skills and considerations. Recognizing this complexity, business owners can benefit from the guidance of a team of exit-planning professionals. These professionals provide a structured framework, leveraging their understanding of the complex exit landscape to assist business owners in making well-informed decisions and ensuring a smooth and successful transition.
Consider the case where a business owner's independent risk-taking inclination leads to a hurried decision to sell before optimizing the business’s value without the support of specialized exit-planning professionals. Instead of surrendering to the impulse to sell quickly, a team of exit-planning professionals will advocate for a comprehensive evaluation of the business’s current state and potential areas of improvement. The exit-planning professionals help uncover the emotional aspects of the decision as well as operational efficiency, financial management, customer retention, and market positioning. By carefully assessing these factors, along with many more, they can find opportunities for growth, cost reduction, and other measures that could significantly raise the business’s value. This thorough analysis ensures that the owner does not settle for a suboptimal exit option and maximizes the potential success from the transition or transaction.
Recognizing and addressing the natural entrepreneurial mindset is pivotal for a successful exit. Collaborating with exit-planning professionals can convert innate entrepreneurial skills into a well-executed exit plan that is both timely and rewarding, ultimately benefiting the business owner and optimizing their future life beyond the business.
Some business owners mistakenly believe that engaging a single advisor for their exit planning is a more cost-effective and efficient approach compared to assembling a team of specialized advisors.
In reality, using only one professional overlooks the intricate nature of exit planning, which involves multiple complex elements like financial analysis, legal considerations, tax planning, and strategic decision-making, not to mention the personal and emotional issues with employees and family members. There is no single individual that can be fundamentally competent in all of these highly critical areas. Relying on a solo advisor will lead to oversights and missed opportunities, compromising the overall effectiveness of the exit strategy.
Engaging a team of qualified professionals is an investment that yields both tangible and intangible rewards. Business advisors optimize the transferrable value, insurance and legal experts mitigate risks, tax professionals navigate complex tax regulations, financial planners guide the use of proceeds, and an exit-planning professional can coordinate all efforts to benefit the business owner.
While the upfront dollars of multiple advisors may seem like costs, the long-term benefits of such an investment significantly outweigh the perceived initial savings of using one advisor. Pushing forward with a transaction without investigating the pros and cons of each of the many professionals that normally deal with the operating business seems silly when planning for an exit or transition of the business.
Imagine a scenario where the business owner assembles a team of specialized exit-planning professionals, each well-versed in the various nuances of their individual fields. This multidisciplinary team collaborates to conduct a comprehensive analysis of the many potential aspects of the various options to the exit strategy. They identify potential pre-transaction steps with estate planning, review allocations of assets and important deal points to reduce tax liabilities, explore available exemptions, and strategically structure the transaction to optimize the owner’s long-term family goals. Ultimately, the team of specialized professionals act as a safeguard against unforeseen setbacks, preserving the business owner’s wealth and maximizing the net proceeds from the exit. Utilizing a team of exit-planning professionals ensures thorough understanding and mitigation of the many implications of transferring a business while preserving the business owner’s wealth.
Every business, owner, and exit plan is different. Ranges of value and transferability of each business vary, personal financial planning cannot be put off until after the exit, and each entrepreneur needs to rely on a team of exit-planning professionals to achieve the greatest success.
It is critical for an owner to develop a “Moving Towards” mindset when developing a succession strategy rather than an “Away From” mindset. Business owners may sell or transition the business because they are burned out, tired, or are forced to because of an adverse condition – they are moving away from the business because it is no longer “safe.” Clearly, this situation is because the owner is trying to avoid a bad situation. It is challenging to create a positive future when coming from a place of negativity.
Humans are innately creative beings. When we are inspired to work towards something, we are creating and intrinsically motivated. This is the “Moving Towards” mindset – the right mindset. We are then much more open to possibilities and willing to do the hard work exit planning requires.
Exit planning is an investment of time, energy, and resources now for a greater return later.
I removed the paragraph just before because it was repeating the concepts from the second paragraph in this section.
