What your business-owner clients should know about valuation and performance
by David FeinMr. Fein is the co-founder of ValuSource, a leading producer of business valuation data and software for professional valuators, business brokers and financial advisors. Visit www.valusource.
Part I in a three-part series on business valuation and exit strategy.
Life happens and being prepared is the key to survival. Ensuring that your business owner clients are prepared for anything the future might throw at them is no different and is crucial for protecting their families and their businesses, which is probably their most valuable asset.
The first step in preparing your business owner clients is to help them determine the value of their business. From there, the owner can determine the best way forward: improve efficiency in the business to create more income, free time, and a better quality of life; exit the business by leaving the business to an heir, or selling the business to an outside buyer, key employee or business partner. The valuation should ideally also include a business performance score, that will enable you and your business owner clients to make better decisions for any of these outcomes and will ultimately help ensure the owner maximizes their financial resources in the short term, long term, and retirement.
ValuSource surveyed business brokers and found that most business owners overestimate the value of their business by between 50% and 200%. Business owners overestimating value by this much is a serious issue and one that, as a financial professional, you are in a unique position to help them address. Not understanding both current and potential future value puts the owner at risk because it provides a false sense of security and can result in poor financial, insurance and retirement planning and operational decision making.
Business Performance Directly Impacts Business Value
Up until now, most business owners have been completely in the dark about the actual value of their business and how its performance beyond sales and cash flow directly affects its value. They had no way of knowing about their business’ value unless they commissioned a formal valuation which is costly, or they enlisted the help of a business broker when it came time to sell their business. Hiring a business consultant to analyze business performance is not only costly but simply isn’t typically on the owner’s radar because they are unaware of how general business performance outside of their financials directly impacts the strength and value of the company. Many business owners feel their business is doing well enough, unaware that it could be performing significantly better and be worth much more money.
Understanding business value for exit planning
Research clearly shows most business owners don’t know that better performing businesses with the same sales and cash flow sell for 300 to 400% MORE than their more poorly performing business peers. Business owners don’t understand the link between their “business performance”, their business’ value, and the quality of their lives. They work too much, have too much stress and feel they aren’t making enough money – there is a solution to all three of these issues, and it starts with a business valuation and performance score report.
Value = Cash Flow / Risk
The formula for business value is expected ongoing cash flow divided by risk. The ongoing cash flow is something all business owners understand. However, ongoing risk is very much overlooked and misunderstood.
This is why it’s a common misconception amongst business owners that the value of their business is determined mostly by sales and cash flow, but the truth is that business value is much more than simply the P&L, it’s related to the overall risk of the sales and cash flow continuing in the future. There are more than a dozen value drivers (or killers) that impact risk and most business owners usually only focus on a few.
The four major killers of value are:
- lack of a defined marketing and sale process,
- lack of recurring revenue
- lack of innovation
- over-reliance on the business owner to drive sales and operations
Learning more about value drivers and specific areas of improvement means you could help your clients dramatically improve their business performance, and ultimately its value, by implementing small improvement strategies and finding ways to increase business effectiveness.
Formal vs. Ballpark Valuation
The value of a business can be determined in a variety of ways and figuring out what type of business valuation your client needs comes down to what they ultimately plan to do with it.
A formal business valuation carried out by a certified valuation professional is a requirement when it comes to any situation where a precise and defendable value is required. These situations include litigation, IRS/taxes, divorce and granting stock options, among others. A certified valuator will typically spend over 30 hours, use multiple valuation approaches, and incorporate multiple valuation databases. The entire process follows accepted valuation standards with hundreds of steps and typically costs between $4,000 – $20,000. This is much like a specialist physician who treats serious illnesses.
A ballpark valuation is designed to give you and your business owner client an estimate of the value of their business, which is all that’s needed for financial, insurance, retirement, buy-sell and succession planning because it provides a quick and reasonable estimate of value. Think of it as going to your primary care doctor for a blood pressure check – no need to see a cardiologist!
The Single Best Indicator of What a Business Could Sell for is What Similar Businesses Have Sold For
Much like the Multiple Listing Service (MLS)® used in real estate, using comparable business sales is one way to provide business owners with a ballpark estimate or range of what other businesses in their industry have already sold for. There are several different online business valuation applications including ValuSource’s Online Business Valuation, which stands out amongst the various applications because it provides both a value and business performance score. Once you have your client’s business valuation along with a business performance score in hand, you are ready to start helping them with a coordinated financial, insurance, retirement and/or exit strategy.
Business Exit Strategies
Once you know what your client’s business will likely sell for and you have a good understanding of how it is performing, you and your client can start discussing ways to improve its performance and directly increase its value through discovering what is holding the business back and applying best practice business decision making to enhance operations to ultimately improve performance.
Now you can talk with the owner to discuss options which include:
- Improve Performance and Value –by improving operations and becoming more efficient, owners can earn more money, work less and reduce their stress. When this happens, many owners choose to stay involved in their business and not exit at all.
- Finding a Successor – this could be a family member or a trusted employee. This approach works well if your client would like to have an influence over the future of the business and wants to keep things simple.
- Partner or Management Buyout – this option involves a business partner or a group of managers pooling resources to buy the owner out, either completely or partially.
- Selling the Business to a Third Party – this is where the value and performance of the company are paramount. The data on sold businesses shows that buyers will pay the most for businesses that are best performers and growing and buyers will pay much less for a business that is performing poorly, even if the sales and cash flow is the same.
Choosing the Right Strategy for Your Client and Their Business
There isn’t a one-size-fits-all approach to help with the planning of the future of your client’s business. Ultimately it will come down to your client’s objectives and their timelines.
Business Owners who want to take a step back but continue ownership will need to be coachable and adaptable to outside advice on improving operations and efficiencies in the business. Done properly, the rewards of improved sales and cash flow, more free time and less stress can be a life changing event for your client.
Those owners looking to sell to an outside investor will need to consider business performance and market conditions and find a broker to assist them in selling the business. But having an estimate of the value and a performance score will put both you and them in a solid position to begin the selling process. Even if they plan to retire in 10 years or longer, you can help them start thinking today about implementing best practices and business improvement strategies.
Less Stress, More Income and Peace of Mind
No matter which direction your business owner client chooses, you’re the “Quarterback” of the overall planning team. You’ve firmly placed yourself in the role of Trusted Advisor by providing tremendous value and clarity to your client in an area where it’s very hard for them to get answers – business value and business performance.
Helping your business owner clients understand their business value and performance is a great first step to improving your client’s peace of mind and ensuring that they and their families are well taken care of. Business value and business performance is crucial information necessary to securing their financial future and maximizing the years of hard work and sacrifices they have made to get their business where it is today. It will help them sleep better at night, reduce their stress levels and provide them with more income and, most importantly, time to do the things they love, like spending time with family. Helping your clients with business value and performance issues will help you strengthen your position as one of their most trusted advisors.
For a FREE demo and 15-Day trial of Online Business Valuation, send and email to Kevin Stockton: [email protected]