After years spent pouring their life’s work into building a business, an owner invariably forms a perception of its worth. Yet, this perception often differs from the view of the market. Owner’s opinions of their business value can be influenced by inherent biases, flawed valuation methodologies, and factors lurking beyond their control. As a business owner, understanding the underlying drivers of genuine, market validated value in your enterprise empowers informed decisions. Whether the plan is a near term sale or a sale transaction in the distant future, proactively identifying and adopting the right strategies and activating the optimal value creation levers will result in the maximization of value and the accomplishment of owner overall financial objectives.
The Pitfalls of Subjective Valuation
Valuing a business based on the emotional reasoning of its owner is a common pitfall that tends to underplay the significance of sound financial practices and market dynamics. An owner’s rationale might echo sentiments like, “My business consistently generates revenues, affording me $500K annually; therefore, I would only consider parting with it if I could secure a sum equivalent to a decade’s worth of distributions.” However, if the business generates net operating profits of $500K annually, prospective investors typically consider paying no more than 4x to 7x that amount. The delta between an owner’s expectations and the market’s potential can be considerable and is based on a number of financial and non-financial metrics.
Owners often seek valuations from CPAs or similar entities for purposes such as insurance, estate planning, or internal events. Typically, a CPA employs a Discounted Cash Flow (“DCF”) valuation methodology, which entails estimating future cash flows, determining discount rates, and approximating current value of that cash flow. This requires a lot of estimates and can lead to substantial overestimation or underestimation of a business’s potential sale value. Consequently, prospective buyers and investors scrutinize various financial and non-financial facets to gauge a business’s readiness to exit and the price they are willing to offer.
Understanding Enterprise Value and Equity Value as a Seller
It is pivotal for sellers to distinguish between Enterprise Value and Equity Value. In the lead-up to a potential transaction, the focus should primarily be on Equity Value.
Enterprise Value, encompassing Market Capitalization, Debt, and the subtraction of Cash and Cash Equivalents, provides an overview of the business’s total potential sale price.
Conversely, Equity Value (Equity Value = Purchase Price – Transaction Costs – Debt and Liabilities +/- Escrows/Contingent Payments) evaluates the company’s asset value and outstanding obligations, reflecting what shareholders stand to gain from the sale once all commitments are settled.
While business owners frequently focus on Enterprise Value, many elements contributing to it are beyond their immediate control. In preparation for a sale, decisions that enhance Equity Value, such as reducing outstanding liabilities, can yield considerable financial benefits to the selling shareholders, even in the context of a relatively modest Enterprise Value transaction. Moreover, several levers can be adjusted to favorably impact both Enterprise Value and Equity Value.
Financial and Non-Financial Variables that can be Adjusted to Increase Value
Pay attention to your EBITDA, Earnings before interest, taxes, depreciation, and amortization expenses. This is a critical number used in valuing companies. All of your expenses impact it as well as under realized income opportunities. Discussion of several common adjustments follows.
You can learn how you compare to your competitors and best in class by benchmarking your performance to a peer group. This will tell you what the top valued companies look like financially and give you a picture of operational areas where you may lag. With this information you can take a deeper look internally for potential improvement.
Financial factors in valuation serve as indicators of your business’s capacity to generate revenue efficiently. For instance, if your benchmarking shows a gross profit margin below the industry, that may signal excessive Cost of Goods Sold or Cost of Sales, suggesting operational or supplier agreement issues. Identifying and addressing these financial issues lays the groundwork for actions that if implemented will enhance your valuation and equity position.
Another common area of adjustment is various personal expenses (e.g., personal vehicles, entertainment, vacations labeled as business travel) that owners sometime charge to their companies. These expenses translate into add-backs to Operating Income, increasing EBITDA (a fundamental figure in determining Enterprise Value) that potential buyers scrutinize in your Income Statement. It’s important to recognize that personal expenses, along with the actual salaries drawn by owner-operators, constitute overall owner compensation that new owners need not incur, and so they add it back in their analysis.
Debt incurred by the business is approached similarly. Interest expenses and non-cash charges like depreciation and amortization featured on the income statement stem from past financing decisions. Consequently, these amounts are added back, acknowledging that new owners might employ different capital structures or face dissimilar borrowing costs.
Financial valuation also encompasses practices such as owners owning facilities separate from the business’s assets while leasing them to the business, sometimes at above-market rates. Moreover, the absence of a salary or a below-market salary for the current owner who periodically extracts cash distributions from the business factors into the purchase equation. Prospective buyers must consider the costs associated with hiring someone to manage the business and securing facilities for its operation. Consequently, these elements influence the determination of Enterprise Value, with normalized EBITDA (actual EBITDA after all the add backs and adjustments) serving as the foundation for applying the market multiple.
Non-financial factors play an equally vital role in shaping business value. Potential buyers and investors delve into a multitude of questions, including:
- Is there an experienced management team, and do they have a path to ownership?
- Does the customer base exhibit diversification, or is it overly reliant on a few key clients?
- Is the product or service geographically constrained, subject to local economic trends?
- Are there readily available substitutes, intensifying pricing pressures and competition?
- Does the business grapple with high employee turnover, signaling potential operational, managerial, or compliance concerns?
The financial and non-financial factors highlighted here represent only a slice of the comprehensive criteria that prospective buyers and investors employ to gauge your business’s value. Collaborating with a fractional CFO, possessing extensive experience in all facets of business value drivers, can help an owner objectively look at the business through the lens of an investor, and identify and execute on areas of improvement that can be made resulting in a higher exit value.
Making Decisions that Elevate Equity Value and Business Value
While business owners may understandably develop a subjective view of their business’s value, it is imperative to recognize that prospective capital providers and purchasers approach valuation with objectivity. They evaluate your business based on a wide-ranging set of financial and non-financial factors that collectively paint a portrait of its financial sustainability, risk profile, uniqueness, and management, and assess the ease with which these attributes can be replicated under new ownership. When business owners understand these factors, they can leverage them to make informed decisions that not only enhance business value but also result in a satisfying and optimized financial exit.
Take the time to take a look. You will likely be amazed at the difference modifications in your present operations can make in your value.
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Engaging in a conversation with an experienced CFO who has guided business owners in maximizing their business value and navigating successful sales and transitions can be transformative. Request a complimentary consultation today. With over 27 years of experience partnering with more than 5,000 businesses, we are eager to share our knowledge and expertise with you.