BRETT: Welcome to The Charleston Entrepreneur Podcast.
BRETT: My radical idea is that personal finance should be…personal.
BRETT: Ultimately, the human element in each of us is what makes up personal finance. We are all business owners doing the best we can to make the right decisions about our personal lives with the information we have.
BRETT: In this podcast it is my goal to give you everything I have to make you successful. I want you to live your most fulfilled life, and I know you can.
BRETT: In today’s episode, I’m focusing on the benefits of a business valuation when determining the value of what is typically the business owner’s largest asset – their interest in their business.
BRETT: In order to have a successful Exit Plan, the result has to be that you the business owner exits your business with enough money to meet your future needs.
BRETT: Now there are many reasons why you as owner may want to exit your current company; retirement, you want to try something different, or simply wanting more time for family and friends.
BRETT: But one of the first steps in any Exit Plan is getting an accurate estimate of your company’s value.
BRETT: In this podcast episode, I’m going to discuss some important considerations to think about before deciding on whether or not a business valuation is right for you. These thoughts range from proper timing of your sale or the business’s current financial position and outlook. The goal in discussing these topics is to help listeners better understand what would be most valuable and helpful for them.
BRETT: As an Exit Planner, an initial step in working with business owner clients is to quantify the value of all their assets as well as their financial needs following their sale or transfer.
BRETT: Once each of these has been quantified, with the business owner we can then determine whether there is a gap between the two. And if a gap exists, well then, our next step is to create a plan to close that gap.
BRETT: But assessing this gap is crucial in creating a successful Exit Plan. Today I’d like to focus on one aspect of assessing the gap: the benefits of a business valuation.
BRETT: It is common to hear business owners tell me what they think their business is worth. It’s also very common to hear that what a business owner thought their business was worth…is much, much different than what a buyer is willing to pay.
BRETT: So any uncertainty about the value of your business can drastically increase your chances that a gap could arise when you want to exit and leave you as business owner without the money you needed – sometimes by hundreds and thousands of dollars per year in lost retirement savings.
BRETT: But by having a quality business valuation, you can improve the probability of a successful exit, since the gap can be identified, and you have time to plan how best to close that gap before it becomes one of those “dreaded surprises.”
BRETT: In addition to that, by having a business valuation prepared, you’re going to be much more consistent with an approach any possible buyer will take.
BRETT: Therefore, completion of a business valuation years before you plan to exit your business can be an excellent practice to run, to experience the due diligence process that a potential buyer would typically complete.
BRETT: Also, a business valuation will provide you with benchmarks that can help you during the years prior to your planned exit date in identifying opportunities for increasing the value of your business.
BRETT: And my experience is that creating these benchmarks, driven from your current business valuation, is huge at this early stage of the process in developing a plan to address a gap.
BRETT: So let’s dive into the advantages and disadvantages, of the two most common valuation methods.
BRETT: The first is really, nothing more than a rule of thumb.
BRETT: As I just mentioned, I bet you have a general idea of what your business may be worth, in your industry.
BRETT: In its simplest form, the most common method is basing your business’ value on a multiple of your revenue or Earnings Before Interest Taxes Depreciation Amortization (EBITDA).
BRETT: What this means is if your industry has a common multiple, you’d take the multiple and simply apply it to your revenue or EBITDA.
BRETT: For example, the common multiple in my industry of financial services is 1.5x to 2x revenue. This means an advisory firm with revenue of $2 million has a value ranging from $3 million to $4 million.
BRETT: But what if your industry doesn’t have a common multiple? What if your business is a franchise? The valuation multiple in franchising can vary by industry, but the most common multiples are proprietary.
BRETT: Or what if you run an event planning or staffing company and there’s no prevalent standard for valuing these types of businesses? When this happens it would be best to work with a professional, like a valuation specialist, CPA, or Exit Planner to help you find the best methodology to use in order to come up with a fair valuation.
BRETT: Using a multiple of revenue or cash flow is pretty easy, isn’t it. But it really is nothing more than a rule of thumb and that’s why it’s so easy. The problem with rules of thumb is that they tend to be self-supporting.
BRETT: What I mean by that is these multiples which people are using today, well they come from past transactions that may have been based on the same rule of thumb.
BRETT: While these rules of thumb are simple to apply, we need to use caution with the results. When you see a valuation range with an average of two times the revenue, it doesn’t mean that your business is worth exactly twice as much. The value will always depend on how competitive your industry is and what type of company you own.
BRETT: Also, not all companies in the same industry are created equal. Consider two insurance agencies each with $2 million of revenue.
BRETT: One has a high level of cash flow and the other has a low level of cash flow. Do they both have a value ranging from $3 million to $4 million?
BRETT: Where either of those insurance agencies falls into that range is impossible to know without a deeper analysis that benchmarks the insurance agency to other comparable insurance agencies.
BRETT: So next we have the Income approach.
BRETT: To get beyond a rule of thumb, what usually happens next in an effort to be more precise, is your trusted advisors will benchmark the most common indicator, income. Because this approach considers a company’s ability to create cash flow and estimates that value on that cash flow.
BRETT: Using cash flows can be estimated by using a historical review, looking backwards, of the company’s financial performance.
BRETT: For example, if the company has an average cash flow of $100,000 for each year over the past five years and there are no significant changes in its operations or business plan, then it will likely have a similar future.
BRETT: You can also use projections of future cash flow (often referred to as the discount cash flow method), looking forward, in conjunction to confirm the reasonableness of the business value when using an income approach.
BRETT: What I like about using an income approach is that you’re using real performance of the company. The income helps you identify how the company operates; considers its strengths, weaknesses, opportunities, and dangers; and will use these figures relative to benchmarks.
BRETT: So using cash flow is amazingly important because it’s a very reliable and accurate way to measure the key aspects of your company. And this in turn can greatly assist with closing the gap between your assets and your financial needs following the sale of your business.
BRETT: Using an income approach will identify opportunities for you to improve your company’s cash flows and/or reduce the risk of each of those cash flows. Either of which will lead to an increase in your business’ value.
BRETT: Although there’s more technicality to it than I’ve mentioned in this episode, those really are the two main approaches to a business valuation, rule of thumb and income approach.
BRETT: Applying the rule of thumb will provide an approximate estimate but gives little information regarding improving the cash flow of your company.
BRETT: Use of the income approach will give you a value conclusion using an approach consistent with that of a potential buyer. And it will provide comparisons to benchmarks that may help you identify opportunities to increase the value of your business during the years prior to your planned exit date.
BRETT: If you’re considering selling your business, you have to be realistic in that any legitimate potential buyer is going to do their due diligence. They will be looking to confirm that cash flows are sustainable after you leave the business and that those cash flows are not subject to other risks, like concentrations on a few customers or suppliers.
BRETT: So by your having a thorough valuation completed years before you want to exit, is an excellent practice to experience; (1) for the due diligence any buyer would typically complete and (2) you now have the information you need to increase the value of your business over time.
BRETT: Both of which will reduce your risk of having any gap in your exit process. You exit your business with the financial resources you need to meet your needs following the exit.
BRETT: To wrap this up, it’s important to understand the value of your business and how that impacts you. I hope this podcast episode has helped answer some questions for you about a valuation when determining the worth of what might be your largest asset – the interest in your business.
BRETT: Thanks for tuning in today everybody. As always, visit our website oakcapitaladvisor.com for more information, and request a Free Retirement Assessment to get started on your retirement planning journey. And check out the show notes for more resources that can help you succeed. Until next time.
BRETT: Have a great day!