Got Value?

"Got Value?" The Importance of Measuring and Understanding Business Value

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.

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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