Knowing the real value of your business is essential to your future plans.
As a business owner, you’ve put in many long hours, days and nights to make your company as successful as possible. You’ve probably handled or managed every single aspect of the business, from finances to admin tasks and even manual labor. But how do you know how much all that hard work will pay off when you go to sell or transfer ownership of your business down the road, when you’re ready to retire?
The article below describes the many reasons why it is so important to have an accurate valuation of your business. At Flagship Financial, we want to help you understand that value so you can retire worry-free. Contact us today to schedule a free consultation.
When you sell a car, you’re not selling what it did for its owner in the past. You’re selling what it can do for its new owner in the future. The prospective owner will look under the hood, maybe get a mechanic to check it out. They will make sure everything is in order.
The same goes for a business. Problem is, when most business owners think of the value of their company, they’re stuck in the past, says Chuck Richards, CEO of CoreValue Software, a business consulting system. Many owners only look backward at past financial performance or estimate value based on rule of thumb.
The 2018 Business Owner Perspectives Study by Massachusetts Mutual Life Insurance Company (MassMutual) shows 70% of business owners think frequently or often about their business value. But they don’t always have an accurate sense of what that value is, or use the most effective methods to arrive at valuation. They rely on extrapolations from revenue or rule-of-thumb estimates based on competitors in their industry instead of consulting with professionals who can give them more accurate measurements.
That lack of accuracy can cause problems when it comes to selling their businesses, or otherwise extract value through a loan, buy-sell agreement, or transfer of the business to a management team or an owner’s heirs.
For example, Richards says, a manufacturing company generating $1 million in revenue may be considered to be worth $5 million under a model that only takes into account the company’s finances or the marketplace rule of thumb. But buyers are making the purchase based on the expectation of revenue they can generate once they own the business.
“The issue with that model is the assumption the person who acquires that business can also generate that $1 million,” Richards says. “People are buying it for its future income generating potential.”
Inaccurate valuations cause multiple problems
It’s not just a sale that can suffer if a business owner’s take on valuation is faulty. Many aspects of managing a business and living a business-owner lifestyle rely on a proper valuation, including:
Funding retirement: For most business owners, the most valuable thing they own is their business. Their retirement is built upon either a successful sale, or the continued success of business operations, which flow from the value of the business.
Funding a buy-sell agreement: Accurate valuation is crucial to making sure all parties in a buy-sell agreement are treated fairly.
Estimating estate tax obligations: An inaccurate valuation can leave you flat-footed when it comes to estate taxes.
Obtaining credit: While lenders look at such numbers as revenue and years in business, they also want an accurate sense of the value of your business.
Crafting a division of the estate: An inaccurate valuation of a business owner’s greatest asset can lead to ill-designed distribution of his or her estate among heirs.
John Warrillow, author of Built To Sell: Creating a Business That Can Thrive Without You and founder of The Value Builder System, says the trouble with using a rule of thumb, or a straight comparison with other companies in a given industry, is that it can wildly over- or undervalue a business.
“They are a blunt instrument,” he says. “They are not sophisticated enough.”
Warrillow says you can easily see the flaw in using rule-of-thumb comparable valuations when you look at specific companies. For example, Warrillow says, typically a company in the payroll industry can expect to trade at five to six times EBITDA. But a firm he works with had defined its niche so well – providing payroll services for nannies – that it sold for $54 million, 500 percent more than could have been expected using rule of thumb.
“She built out a highly-differentiated, niche product,” he says, noting a proper valuation put the owner in position to secure so much more in the sale of her company.
Faulty valuations can also put business owners in difficult later-life situations. For instance, an owner who overvalues his or her business could wind up taking a hit when it comes time to sell that business to fund retirement. An owner who undervalues their business could also leave heirs with unexpected estate tax bills.
Richards recalls a couple who wanted to sell their business. The business had assets of $1.3 million and revenue of $700,000 and the couple decided to value the business at what seemed like a low price, $1. 5 million. Trouble arose when they didn’t have any way to show that revenue would continue on its current path. Thirty-two prospects looked at the business, and none were willing to pay the asking price.
“It comes back to the ability to prove to a buyer that they can generate the same kind of income,” Richards says. Ultimately, that business sold for $2.4 million, but only after establishing the measurements and processes to put it on a solid revenue path for operating without the original owners.
Warrillow and Richards both advocate taking a more holistic look at a business than just rule of thumb or even revenue to determine valuation. Factors such as niche, whether the business can remain on track without its current owner, and potential market growth all play roles in valuation.
At the very least, hiring a business appraiser who will look at the major value drivers of a business can be money well spent. As a business owner, even if you’re not planning an immediate sale or other liquidity event, an accurate idea of valuation can give a sense of how your most important asset is doing in the marketplace.
“What’s the measure of a public company? Market cap. The same is true of a private business,” says Richards. “Your job as a CEO is to make it more valuable.”
Let us know what you think about this topic in the comments below. If you’re ready to schedule a consultation with us to find out what your business is worth, please click here!