When is it time to hang it up? Assuming we are mentally prepared and know what we need to retire, the question of how much the business is worth comes into play, as that is a major part of the assets of most business owners -- for many of us have little retirement assets outside of the business.
Get printers together and ask them how they value their business and you will find many methods. Problem is, as Zig Ziglar says, it’s “stinking thinking.” That’s because we don’t get to make the rules about how our businesses are valued.
No, bankers make the rules or, more broadly, the financial community based on principles of finance.
Why them and not us? They have the money to loan to the buyers of our businesses. So, regardless of how we view it, bankers are going to put their money where they choose, so it’s their rules that matter, not ours.
It is in our best interest to know how values are determined. Knowing that, we have a shot at improving our performance before we put the business up for sale.
There are two main methods of valuing a business: parts and earnings.
Businesses can always be valued in parts. That’s mainly assigning values to equipment, inventory, customer list, and so forth to arrive at a total value or selling price. This is the way many businesses with less than $100,000 a year of owner’s discretionary income are valued.
What’s owner’s discretionary income? That’s generally sales minus direct materials minus wages paid to others minus overhead and adjusted for expenses that the next owner might not have to bear (country club dues, Porsche delivery truck, etc.). However, there are guidelines on what’s acceptable and not acceptable, which we will discuss in a future article on the “normalization” of expenses.
The best way to get maximum value for the business is to have significant earnings and base the value on those earnings.
A simple example is the bank account. Work backwards: For simplicity, assume interest of 10 percent is being paid (we wish) and you earn $100,000 a year. What’s the bank account worth? Well, $100,000 / 0.10 = $1,000,000.
Don’t get excited though. Active investments (running a business) are always discounted when compared to passive investments (bank accounts). Why? Duh. One doesn’t need do anything to earn the money from a bank account while a lot of work is required to get the same return from a business.
In my experience, an active investment would be worth somewhere between 25 percent and 50 percent of the passive investment depending on the probability of maintaining earnings. But where your value falls on the 25 percent to 50 percent scale depends upon a number of other factors.
If the business has outdated and/or worn equipment then that would decrease the business’ value on the range because the probability of maintaining earnings without additional investment would be less. Likewise, a business in a market that is shrinking would be discounted more than a business in a fast-growing market.
A business with a hot and growing product line would be valued more than one with an old and tired one. And a business with long-term employees who were expected to retire within three years would also be worth less.
So, the range is what results from these various factors -- and the specific value is where equipment, market, and other conditions come into play using a capitalization of earnings method.
That’s why it’s important to have a vibrant business; be increasing your sales and earnings to maximize value. If you’re not, depending on your time horizon, you may have time to fix it. If you don’t, not all is lost; it’s just that you’ll receive a lower value.
What I’m describing here is a capitalization of earnings method. There are more earning-based methods such as multiples of EBITDA (Earnings Before Interest Depreciation and Amortization), a multiple of cash flow, or some sort of multiple of earnings.
We’ll do a deeper dive into valuation methods in future installments. For now, understand that we owners don’t get to determine how businesses are valued and the two main methods are: parts and earnings.
So, while we may come up with logic behind our value, just don’t expect someone else to use that method. They’ll use financial methods similar to the bankers for it’s their money they are putting into the deal.
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