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August 2005 Got Value?
The importance of
measuring and understanding business value
It is inevitable that all business owners will at
some time part with their business. For some, it will come as a result of years
of planning for their departure and continually managing the business to
maximize its ultimate value at the time of sale or transfer.
For others, this event will come abruptly, for
reasons ranging from sudden health problems that force the owner to exit the
business prematurely to an unexpected offer to buy their business from an
interested third party.
When the latter occurs, many business owners are
faced with probably the most important financial decision in their lives and are
frankly unprepared for such a life-changing decision. While most owners
sacrifice significant time, sweat and money to build up their businesses, many
do not invest sufficient resources to understanding the value that they are (or
are not) creating. Further, if the owner has never had the value of their
business determined by a knowledgeable professional, the owner may be left at a
disadvantage if faced with an unanticipated offer and not obtain a fair deal for
their life’s work.
This issue illustrates the importance of pre-exit
planning and the periodic monitoring of the value of a business. Whether a sale
is imminent or is not anticipated for several years, it is crucial that owners
consult with outside professionals (valuation advisors, attorneys and
accountants) experienced in valuation and exit planning strategies.
For many business owners, the business represents
the owner’s most valuable investment, whose eventual value will significantly
impact the comfort of their retirement or other future endeavors. Owners of
privately held businesses do not have the luxury of an observable publicly
traded stock price to measure and monitor the value of their business. Because
expectations and reality can be quite different for many owners, it is important
that business owners not only measure the value of their business periodically,
but that they understand the value gap between what they believe their business
is worth and the current value of the business. Through the understanding of
this value gap and the value drivers of a business, owners can better plan for
their eventual exit of their business and meet their financial goals.
Misunderstood value
Many business owners significantly overestimate the value of their business. For
these owners, it is difficult to accept that their years of hard work and
sacrifice have not been kindly rewarded through the appreciation of business
value. While these owners are usually highly knowledgeable of the day-to-day
operations of their business, their problem generally results from a lack of
understanding of all of the value drivers of their business and how their
business would be perceived in the marketplace. Other times, a business owner
may not be aware of just how valuable their business is, especially to a
motivated buyer looking to buy into the business, market or industry in which
the business is involved. In these cases, the real benefit to the owner of
understanding the value of the business is the avoidance of “leaving money on
the table,” and this value can be quite high.
Value drivers
There are many internal factors that impact the
value of any business, but the most common factors generally include the level
and consistency of profitability and cash flow, the growth rate of revenues, and
management depth and expertise.
External factors also have a significant impact on
the value of a business, which makes it even more crucial to periodically
measure the value of a business based on the current economic environment,
industry trends and business acquisition activity. This is easily illustrated in
an example where the value of a business is considered in two consecutive years.
Assume that, in a given year, the earnings before
interest, taxes, depreciation and amortization (EBITDA) of a company equal $2
million, and similar businesses are transacting at a multiple of seven times
EBITDA, implying a business value of $14 million ($2 million x 7 = $14 million).
Next, assume that, in the following year, the
business has achieved strong growth in EBITDA to $2.5 million, but acquisition
activity has cooled and transaction multiples for similar businesses have
declined to five times EBITDA, implying a decrease in business value to $12.5
million ($2.5 million x 5 = $12.5 million). It can be seen in this example that,
while the business owner has successfully managed the growth in cash flow of the
business (a value-enhancing action), the increase in the value of the business
from the increase in cash flow is more than offset by the decrease in the
multiple of cash flows being paid in the marketplace. This example illustrates
the importance of not only understanding the value and value drivers of a
business, but also understanding the overall market for a business and how
changes in the market can affect value.
Obtaining an initial valuation, updated
periodically for changes in the business as well as the current economic and
industry environments, provides the owner of a privately held business with the
feedback necessary to understand and monitor the value of their investment and
the ability to better react in a changing market environment.
Never too early
In conclusion, it is never too early to begin
planning for the eventual sale or transfer of a business. It is important to
understand that the value of a business is not static, nor is the value of a
single business the same to all investors.
Owners can better understand the value drivers that
impact their business and improve the likelihood of receiving a fair
consideration upon eventual sale by consulting with outside professionals
experienced in business valuation and the sale of businesses.
Next to the decision to go into business to begin
with, the decision to invest in an exit planning strategy relating to their
business may be the best business decision an owner ever made.
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