In our first blog in this series, “Selling My Business, What Should I Expect,” we talked about what to expect in the sale process to a third party. If you haven’t read it, I’d suggest reading it to set the stage for this discussion on business valuation and how it fits into exit strategy. If you did read it, give it a quick reread: “Selling My Business, What Should I Expect?”.
Understanding Business Valuation – the Eye of the Buyer
When we start collaborating with clients, we ask them what they believe their company is worth. We hear many different things:
- “I don’t know,” which is great – honesty.
- We have a few clients who have a very realistic idea of what it’s worth.
- But then there are many who have an unrealistically elevated idea of the value of their company. “I have a great company. When I’m ready, I will just let people know it’s for sale and I will get the price I want because of the many years, plus the blood, sweat, and tears I put into it.” It’s understandable, they have spent years, even decades, working extremely hard. It should be unbelievably valuable. It may be, but a buyer is not purchasing blood, sweat, and tears. There is no blood, sweat, or tears on the balance sheet.
Whichever category you may fall into, let’s get real.
The elephant in the room: most business owners don’t understand business valuation in the way that they need to for a successful exit. It makes sense, most owners have been focusing on running their company and have not been through a sale before. Your business is likely worth less than you might want or need, and your assessment of its value is not the most important. Whose is? Your buyer. Value, or what we call transferable value, is what a buyer will pay at a particular point in time in a free market.
I am going to focus on value from this most important perspective. When selling your company, beauty really IS in the eye of the beholder – the buyer.
The most important thing you can do right now is to work with an exit strategist to understand how a buyer thinks, get an estimate of business value based on that perspective and work with your financial advisor on your personal financial plan to understand what you need from the sale. It is with this understanding that you will be able to make significant decisions, as necessary, to raise the value of your company and/or simply make it more sellable. With an understanding of the value and knowing what you really need, you can make an informed decision.
Not understanding value from the buyer’s perspective typically means you are not working to increase value and will end up extremely disappointed.
If your current business valuation fits into your financial plan, you can proceed to a sale.
If the value is not what you need or want, get to work!
Set out a plan for 1, 2, or more years for value creation. Warning: the older you are, the more this is a gamble. In your 30s? You can survive a few more up and down economic cycles. In your 60s, 70s, or 80s? Maybe not. Take a step back to consider whether you will put the extra time in to make a real difference as part of your exit strategy.
Along with value creation efforts, you need to consider sellability. You need to identify potentially significant problems – from a buyer’s perspective – that need fixing before a buyer will even consider a purchase. As is, buyers may simply walk on by – even if you have a fundamentally good business, good revenue, good profitability, and good cash flow.
If you decide to take the time, build out a plan and find the right advisors. You need a comprehensive approach to value creation and resolving sellability issues.
You Are Unique – Beware of Multiples
I am going to start with the headline and the bottom line: Your company is different from any other company in your industry. These differences run across revenue size, margins, your employee base, geography, history, partnership structure, technology infrastructure, and much more. Just because your competitor down the street has the same revenue and profitability as you do, it does not mean the value of the two companies is the same.
You may have heard about business valuation in terms of multiples for your industry. This is a wild simplification, and dangerous. Be careful when people use “multiples” as a shortcut for value.
Multiples work like this: you might hear that in your industry, the value of a company is worth X times the annual revenue. Let’s say you read that it is 1.5 times revenue. If your revenue is $5,000,000, the value would be $7,500,000. Or you may hear 5.5 times EBITDA (Earnings Before Interest, Taxes, Depreciation & Amortization – simplified, think about this as profit or operating margin with some adjustments.) If your EBITDA is $1,200,000, then the value would be $6,600,000. For different industries, the revenue or EBITDA multiple might be favored, depending on the business model and/or other factors.
Problems with Multiples
Averages are dangerous. One problem with this multiples approach is that when you hear that businesses in your industry are selling for 3 times (3X) revenue, it is an average of sales prices of transactions they could find and from all sizes of companies. Generally, with everything else being equal, the larger the company revenue, the higher the multiple will be. So, that multiple you hear is skewed higher because there were many companies larger than yours in the pool. Larger revenue companies will get higher multiples.
Old data. Multiples are calculated from past (even if recent) transactions, by definition, out of date. If you saw a multiple of 2X in February of 2020, would your company be worth more, or less, in March of 2020 after the Covid pandemic kept everyone at home? Timeframe, context, and the economic environment are critical components of value at a given point in time.
Internal Factors. Even if a direct competitor has the same revenue and profitability as yours, there are so many factors that may be different and result in vastly different business valuations. For example, if your machines are 15 years old and your competitor’s machines are one year old, your value may be lower. If their staff have been there for an average of eight years but yours have been with you for just an average of one year, a buyer will offer you less. There are so many issues outside of your financial statements that a buyer factors in when making an offer.
You. Are you still doing the payroll yourself? Doing payables? Doing all the sales? Delivering your services? Fixing the machines on the shop floor? Managing the website? If your business depends on you for most or all of these things, your business is not very valuable. If the competitor we just discussed has a dedicated team taking care of these things, a buyer will pay more for their company. The company’s dependence on the owner is usually the first question/concern of a buyer. (We will get into depth on what a buyer looks for and how to create value in my next article.)
Buyers Are Different. What is often not considered in a valuation is the fact that your company will be worth dramatically different values to distinct types of buyers and in different situations. For example, a competitor of a comparable size may be willing to pay a lot more than an individual who just left a corporate job. That individual will need everything and everybody in your company. But a competitor may not need your property or all your people, and therefore may be able to pay you a much higher price because she will be able to take out so many of your expenses. Simply put, if you provide all the same information about your company to ten potential buyers, you should expect to see a significant range of offers based on their particular situations. An estimate of value with an appropriate range may take this into account but build this into your strategy of where to focus efforts to identify buyers.
Valuations
The most in-depth business valuation is, at best, an estimate with dozens of assumptions. And it can have a truly short shelf life.
It is based on history, an assessment of the industry, many internal factors, and many variables from the economy around you. Even if you have an “accurate” value today, changes in the economy, changes in your business, changes in interest rates, supply chain problems, and more, can drastically impact value from one day to the next.
The economy in a down cycle likely means it is less valuable because you have fewer buyers with the resources to pay what you want. When interest rates are up, it becomes more expensive for a buyer to borrow to purchase your company, likely resulting in lower offers.
A business valuation will look forward, bringing in various data points, but they are guesses and assumptions, even if educated ones. You might ask if this is the case then why do it at all?
- Because you may need a valuation but understand what goes into it and why, as you collaborate with your advisory team on value.
- Because you and your advisors will need to agree upon an acceptable range of value as you enter into negotiations with buyers.
- Because you need a baseline to start from, especially if you’re working to build value. When working to build value over the next few years, you need to understand where you are today.
The Analogy of Your Home
Let’s step back and think about a big transaction you have probably been through – selling your home.
The house across the street was built at the same time, 15 years ago, and has the same floor plan. Since they were built, you finished the basement to include a bed/bath suite, tv room, and bar. You replaced the carpet with wood floors and completely rebuilt the kitchen. Your neighbor did none of this. They look the same from the outside. Are they worth the same because they look the same and are right across the street from each other? The answer is no. And there are dozens of other reasons why these home values would be quite different in the eyes of a buyer.
Let’s look at some numbers, considering the buyer perspective. Your real estate agent assesses your house in every way, looks for comparable homes that were recently sold, evaluating their attributes versus your home to calculate a value – a range of multiples. While they will list your home at a fixed price, let’s say $500,000, you wait with anticipation for multiple interested buyers to bid up that price.
Case #1: Imagine offers come in at $450,000, $475,000, $500,000, $515,000, and $525,000 all with the exact same terms and ready to close on the same date. These offers represent a range of 90% of your $500,000 value to 105% of that $500,000. You will likely take the $525,000 to the bank.
Case #2: Despite a listing at $500,000, the offers are for $440,000, $451,000, $460,000, $465,000, and $475,000. Again, all with identical terms. You accept the $475,000 offer.
What is your home worth? $475,000? $525,000? $500,000?
I would suggest that it is worth the highest offer, all other terms being equal. However thorough that valuation was in arriving at $500,000, considering similar recent sales and other factors, it is only an approximation as a baseline for negotiation. The true value comes down to the eye of the buyer and negotiation.
You may decide not to sell and gamble on the market getting better. Value would then be determined on that date, but the same principles would apply.
Applying this to Your Company
You may be saying to yourself, “I get it, but you are just talking about a $25,000, maybe $50,000 difference.” Ok, back to your life’s work – your company. Let’s say you determine with your advisors that $5,000,000 is a fair value. Let’s say the bottom offer is 10% below your $5,000,000 asking price – a decrease of $500,000! If the top offer is 5% above your asking price, you will be getting an extra $250,000.
Would anyone say, “well that’s only $550,000” or “only $250,000”??
One More Significant Component of Value
Regardless of the steps taken to get to the final value or purchase price, rarely will a seller get a check for the full amount at closing. There may be a partial loan note the buyer takes on that has payment terms: a schedule and interest. There be a consulting or salary component over a few years. Part of the sale price may depend on achieving certain revenue goals, with a potential decrease or increase in the final total sale price. There may be other elements of a final agreement that impact on the total dollars and when the seller receives them. The bottom line: the “sale price” may be significantly different from the total cash the seller eventually receives.
On a related note, you are not going to receive $5,000,000 on a $5,000,000 sale price, even if you are one of the rare sellers getting all cash at closing. From that $5,000,000, you will be paying taxes, your attorney, your CPA, your M&A advisor/broker, settling other debts, and more. Your advisory team is well worth it, don’t go without them, but make sure you have a good understanding of the net cash getting to your bank account.
The Bottom Line:
Understanding business valuation and what the buyer will pay for, and acting on these realities, is critical to optimizing your life’s work and ensuring that you have the resources to do whatever it is that you want to do for the rest of your life!
So, what to do?
- Do get an estimate of business value, if not a full-blown business valuation, just be sure to understand what it is and what it isn’t.
- Set a target date for your exit and set a target value, critical components of your exit strategy and succession planning.
- Get to work on value creation.
We are here to help – grab an hour with me to discuss: A complimentary hour with David
David Shavzin, Exit Strategist / M&A Advisor
Value Creation, Exit Strategy, Business Sales
Founder and President, The Value Track, Atlanta, Georgia
Co-Founder and Past President, Exit Planning Exchange Atlanta
770-329-5224 // david@GetOnTheValueTrack.com // LinkedIn
https://www.exitplanningexchange.com/wp-content/uploads/2024/06/calculator-3406960_1280.jpg