Entrepreneur’s Wealth Digest
During last week’s edition of Entrepreneur's Wealth Digest, we briefly touched on the importance of an external business valuation when it comes to your exit strategy, no matter where you are in the life cycle of your business. In this blog, we will address the four key elements that most often drive equity value. More importantly, we will focus on the untapped potential of using business valuations as an important tool in your planning and how tracking business equity value well in advance of any sale adds significant value for owners.
Why go through the process if you are not looking to sell?
Unsurprisingly, the largest asset for many of our clients is tied into the equity value of their businesses and drives a majority of their cashflow. On average, we see the value of small businesses providing an upwards of 50-85% of total net worth on many of the personal balance sheets we review. As financial planners, our job is to mitigate risk and any large asset without a current and accurate valuation is a big concern. It is kind of like walking an obstacle course with a blindfold on. You may be able to find your way, but being able to see ahead will greatly decrease your chances of falling off.
Willful ignorance and hope are not viable strategies
Here is an example of what can happen when the actual value of an asset is unknown until you are ready to sell. Imagine someone who inherited a 1,000-acre parcel of raw land ten years ago. Their attorney told them it was worth $2.5M when they got it. The surrounding area has since grown into a bustling metropolitan area, and today they estimate that it is worth $3M, because that is what they want to sell it for when they retire. Fast forward another few years, and this person is ready to prepare for retirement and engage in the sale. They have their land formally appraised only to discover fuel storage tanks buried deep underground. After undergoing an expensive landfill cleanup to attract potential buyers, their net income on the sale of their property is $1M short of their original plan.
Let us now imagine a similar scenario, but instead of the land being overvalued, it was largely undervalued. That same 1,000-acre parcel of land appraises for $20M and this person realizes they missed out on the opportunity to retire ten years ago. Believe it or not, we hear stories like these all the time! We need to know what things are worth and what we can do to influence their value today and in the future. Without the right information, we cannot answer the question of how an individual’s assets are going to support their lifelong plans
Business valuations hold the keys to the most important asset on your personal balance sheet
The only way to accurately plan for your future is to make ongoing business valuation reviews a part of both your business planning and personal financial planning processes. In no way does a business valuation trigger a sale event. A business valuation is a tool that builds awareness, providing insight about the drivers behind your equity value and the ability to tailor your business according to the personal outcomes you and your family ultimately desire.
If you work with a Certified Public Accountant (CPA) or certified business valuation analyst who specializes in valuation, you will get more than just a single-line number. They will provide you with a full marketability assessment, digging deep into the unique field and market of your business. As a result, you will know how you would currently stack up in the eyes of a potential buyer. If you are more than three years out from an exit, you will have plenty of time to work areas of weakness or opportunity. If you are within the three-year mark, you will be able to mentally and emotionally prepare for the transaction to come.
A business valuation, while informative like a home appraisal, is so much more!
Before we dive into the key elements of a business valuation, let us consider the ways a home is appraised. In those 60-plus page documents, you will typically have a section on the selected comparable homes that the appraiser uses to create their appraised value. There will be attributes of the comparison homes and discussion of the elements that are similar and those that differ, such as lot size, square footage and condition. If a comparable house is in the same neighborhood, with the same dimensions and level of finishes, it likely compares closely with the valuation of the house being appraised.
When it comes to business valuations, the attributes differ significantly and are more varied than a real estate appraisal. The list includes revenue, earnings before interest/taxes/depreciation/amortization (EBITDA), intellectual property, key employees, agreements, contracts and more. Every small business valuation is unique and relies not only on what other similar businesses have sold for but also the elements that drive the value for your unique business.
Here are the four elements that drive most business valuations:
Profit comes first and drives most of your value. In the most basic sense, a potential buyer will look at how much profit your business produces, what their cost of capital is to acquire that profit and if the profit exceeds the cost of capital. When we think about small business valuation, the profit margin by industries can be massively varied from the low, single digits to perhaps as high as 40-50%. This element is also the most straightforward to understand when looking at how to increase your valuation. If you can drive more profit from your business while continuing to support long term health and growth, you will be able to create more value in the eyes of a buyer.
Revenue contributes significantly to your value because the size of the company is often measured by annual recurring revenue (ARR). In general, the larger the company as measured by ARR creates a pool of more experienced buyers with better access to capital. Revenue stability also decreases the risk profile of a transaction for many buyers. The larger your business is, the more attractive you are to larger buyers with more money to spend.
Intellectual property encompasses the elements that make your business highly unique and differentiated but does not have to rise to the level of patents and trade secrets to add value. Information about your customers, your suppliers and vendors, contracts and your brand are all elements of intellectual property. The better these are protected, the greater they will contribute to the value of your business. Trademarks, contracts and data security are things you can always work on strengthening and improving. A buyer will want to see these in good order as a part of any transaction.
Finally, the transferability of the business is a significant factor in valuation. This area may include the tactical elements of the transaction, such as whether a minority shareholder has the authority to block a sale or whether there is outstanding litigation related to the business. It also includes the strategic elements of the transfer. Is the seller’s name, image and likeness a key component of the brand? Are there a few key employees that are critical to ensuring the clients or customers remain with the business after closing? Businesses that are not tied to founders or a few key employees tend to transfer more easily without the requirement of the existing team to stay on for an extended period and thus drive more equity value in a sale.
In closing, our hope is this blog inspires action! Your business is your most important asset and engaging in consistent business valuation reviews allows you to treat it like the investment it is. Measure your business value regularly and incorporate the valuation information into your business and personal financial planning.
If you have a question, need a good valuation resource or simply want to talk through your financial planning, we are here to help.
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Disclosure: Jarrod Musick is an officer of Destiny Capital and Entrepreneur Aligned, a DBA of Destiny Capital. All opinions expressed by Jarrod are solely his own opinions and do not reflect the opinion of Destiny Capital or Entrepreneur Aligned. This article is for informational purposes only and should not be relied upon as a basis for investment decisions. We recommend consulting with your wealth advisor, CPA/tax advisor and/or attorney, as applicable to your situation, prior to implementing a new investment strategy.
About Jarrod: Jarrod was born into financial planning and solving financial problems. With his financial advisor father Steve telling stories about finance around the dinner table from an early age, the idea that everyone has a different financial situation was always there. After an early professional career spent in nonprofit and government, Jarrod came back to his roots helping people plan and invest in 2011. Since then, he has worked with individual clients, led internal teams and ultimately became partner and the CEO of Destiny Capital in 2017. With a passion for helping entrepreneurs change the world, Jarrod ultimately oversaw the creation of Entrepreneur Aligned in 2020. With both Destiny Capital and Entrepreneur Aligned, Jarrod leads teams that help people live lives of abundance where money is simply a tool to let everyone be a positive force for the world around them. When he isn’t working with the talented teams for EA and DC you can find him chasing his twins, wiley trout or a podium spot at an OCR race.