A common issue encountered by business owners and entrepreneurs of every stripe is the value of their business. While it’s common in the land of startups and venture capital to create valuations of an idea, followed by funding rounds over the years that progressively measure and estimate the value of a business enterprise for future funding rounds until the business is inevitably acquired, goes public, or simply belly up- it’s much less common for the closely held bootstrapped businesses of the small town entrepreneur to go through a valuation process. In fact, it’s so uncommon, that over ninety percent of small businesses close down after the owner retires or dies; and what a waste that is!
The survival of any small business is far from assured. Whether they survive the almost 50% failure rate of the first year or the 15% survival rate of the first five years, any business that can say it has been around for decades is not only a survivor, but a valuable asset. So this week, we’re talking about business valuation, how to value a business, common mistakes business owners make, and increasing the value of the business.
Business Valuation – The Sum of its Parts And?
The first thing to understand is that a business valuation is about understanding what someone would pay to own your business, or a part of your business, which means that the business can be more valuable than the sum of its parts. This means that a business’ value is not only the accumulated balance sheet of the assets minus the liabilities of the business, but also a representation of the good will, reputation, and relationships that the business has created. For example, in Longmont, the Pumphouse, a famous local landmark restaurant and brewery, recently began the process of becoming an employee-owned co-op. This means that the employees of the Pumphouse have the opportunity to purchase shares of the business from the original owners progressively over the years until the entire business is owned by its working members. However, this raises a question: How do you decide what it will sell for? The building itself is nicely made, they have thousands of dollars in kitchen and brewing equipment, not to mention thousands more dollars in tables, chairs, glasses, and so on. Yet, quite importantly, the value of the pumphouse cannot be replicated solely in its material components. If another business came in today using the same exact furniture and equipment, it undoubtedly would not benefit from the reputation and good will of decades of good food and good service that the pumphouse has built up over the years.
Another even more extreme example might be MY Wealth Planners® itself. It was recently valued at $1.26 million dollars by a specialized financial planning appraisal firm. To be clear, we’re not sitting on $1.26 million dollars in furniture, computers, or intellectual property. Rather, the systems and processes we’ve developed to serve our clients well, and in turn, to have clients whom we serve and are paid to serve, have created over a million dollars of goodwill, such that another financial planning firm would pay well over a million dollars to obtain such systems and client relationships. Yet, this valuation is not simply a multiple of revenue or profit, but a reflection of numerous factors that influence the overall value of the firm. In turn, the valuation can increase or decrease in the future as those factors change, reflecting not only changes in revenue and profitability but the scope of services provided and whom they’re provided for.
How to Value a Business
So the question arises: how does one value a business? This turns out to be a unique question for almost every type of business, as each business will have special factors that influence not only its basic book value, but also how much will be paid and how much will be paid for it. There are some common rules of thumb that get thrown about for an extremely rough estimate. For example, valuing businesses with purely transactional relationships such as a retail store at 25% of annual sales plus the value of inventory and equipment, or valuing businesses with subscriptions and ongoing retainers at 1x-2 of annual sales or 10x of profit if the business is profitable. Ultimately, while these are useful for doing some scratch paper estimates of value, these are not reliable means of determining what a business would sell for.
There are business brokers who can provide a rough estimate of value for a business. These organizations play a role akin to that of a sell-side real estate agent: providing a sticker price for the business, listing the business for sale, and trying to find a buyer for the business. In return, they receive a percentage of the sale price. It’s noteworthy that there are some issues with relying on a business broker for valuation: First and foremost, the majority of business brokers are generalists and not specialists, so their valuation methodologies may be somewhat blunt compared to the unique nature of your business, such as valuing all service-based businesses one way and all transactional businesses another. Secondly, the business brokers are going to be paid upon completion of a sale. This can create a somewhat neutral push-pull around the valuation of the business, in that while their compensation will reflect the value of the sale and they thus have an incentive to value a business at a higher valuation, they also won’t get paid if the business doesn’t sell, and thus have an incentive to keep the price affordable for a buyer.
The more substantial and accurate means of valuing a business is to work with a certified business appraiser, whose sole business is business valuation for both transactional purposes but also for work in estates, audits, and for tax purposes (other important occasions that can raise the necessity of knowing what a business is worth.) Simply put, high quality business appraisers aren’t cheap and you shouldn’t engage with one without good or significant reason. But if you are interested in creating a co-op approach for your business to have internal succession, or are looking to sell a portion of the business to a potential partner, or to simply establish value for succession planning, then these are the appropriate professionals to engage.
Common Mistakes
The most material mistakes in business valuation have to do with a simple question: what is there to buy? A business that is functionally the operation of a solopreneur is going to struggle to be sold. For example, a very successful real estate agent might have enormous business value in their work, earning hundreds of thousands or even millions of dollars in commissions annually, but if they do not have a team that can carry services beyond their participation or systems in place for the acquisition of clients and serving those clients, then the value of that business drops to zero, because with the retirement of the agent so too goes all the value.
Another issue that can occur in the sale of a business is what is previously an advantage: being poor on paper. Often business owners will combine personal and business expenses for items such as car mileage, cell phones, or other mixed-use items into their business financials. While this can create the tax-effective appearance of having lower profits than would otherwise be subject to taxes, this is a no-nonsense declaration of profitability to a potential buyer, and one that you can’t easily change without admitting to some “light tax fraud” as Jeffrey Tambor might put it. It thus behooves a business owner to get serious about showing the profitability of their business before a sale, and while that will come with an additional tax bill, there’s a world of difference between trying to sell a business that appears to barely be breaking even and showing one with significant profit margins.
Last in our incomplete list is the value of continuity, and this is where the major difference in multiples comes in between transactional and subscription-based businesses. Businesses that make all of their revenue by selling products or on one-off transactions will struggle to attain a high business valuation unless they can show that there is an incredibly strong marketing mechanism to drive regular and repeated transactions. In turn, businesses with long-term contracts for repeat and continuing business are much more valuable. While it might not seem to a pest control business that there’s much of a difference between charging $300 to spray for bugs and charging $25/month to spray for bugs every year, the difference in value can be 4-12x, simply because there’s no expectation of repeat business in the first model, while the second model suggests business will continue unless otherwise canceled.
Increasing the Value of the Business
The natural answer to this is: Make it more profitable, but if it were only so easy! While growing the revenues and profits of a business is a natural answer to growing the value of a business, there are other mechanisms at play. Some easy examples:
First, find a way to create or increase recurring revenue. Every repeating dollar in a business is going to carry more value than a historical transactional dollar. Ways to produce this in predominantly transactional businesses can be to create membership programs or loyalty programs that demonstrate repeated transactions with the same customers. In the case of service businesses, monthly subscriptions or recurring retainer projects can be a way to take an hourly tax or law practice in the direction of showing recurring revenue (though this may not function appropriately in all versions of all service businesses.)
Secondly, consider internal succession. While an external buyer can offer a juicy premium for a well-established business, this often reflects a circumstance in which too little planning has been done too late. For a business owner who has at least five years, and preferably closer to ten years before they want to exit the business, performing a valuation and creating an internal succession plan or stock purchase plan can not only extend the valuation and liquidation of an ownership interest out over several years, but it can also create greater employee loyalty and engagement in a business where ownership is possible. The opportunity is thus a twofold occasion: Not only can the business grow more valuable by showing the longevity of the employees within the firm, but they in turn can be incentivized to help create greater value in the business, with both the motivation to see it be more profitable and the responsibility not to waste the firm’s resource’s so easily.
Third and finally (for now), pay close attention to where the business’ revenue comes from. A business that has grown substantially in customers and clients is a strong business, but a business that efficiently targets and markets to its ideal customers and shows a strategy and track record for doing so is going to show a potential buyer a stronger future for the business they’re looking to acquire, and in turn, command a greater premium than a business that has grown well despite a lack of focused planning around how it will grow.