662: Four Metrics That Reveal The Cash Value of Your Business

The number stunned me when I first heard it.  80% of a business owner's net worth is locked away in the asset of their business. Can you imagine 80% of your retirement dollars bottled up in one stock?   The cash flow of the business can often quell the desire for an owner to diversify their assets into anything beyond the business.  A business can be a high-return asset for sure… and with it, equally high risk. A standard question for any business owner to ask is, “How much is my business worth if I wanted to sell it?” The short answer is, “Whatever a buyer will pay for it!” There are ways to begin to have an educated idea on what your business would actually sell for on the open market.   Here are four metrics that you will need to know when getting prepared to understand a reasonable market valuation for your business. Before we lay out this framework be reminded that we are not financial or legal advisors and all such decisions should be consulted by financial and legal professionals.   First, all business owners must understand their wealth gap.  This is the gap between what the owner will “need” to live on if the cash flow from their business ended due to a sale. The majority of owners elect not to sell their business because of a lack of personal planning, or because they are not sure how they will continue to generate income.   You might have an owner sell a business for $5mm, and you think, “Wow!!!  That’s $5 million dollars!” It’s actually less than that once you consider taxes and other expenses and payoffs that usually occur in the event of a business sale.  Living off of the interest of what is left is usually not enough to cover the lifestyle of the owner prior to selling thus leaving the owner in need of an income-generating job…or starting another business, which is usually not in the desire of a recently exited owner. The wealth gap allows an owner to reasonably look at what they will need “in the bank” in order to live out the rest of their life at the lifestyle bar they have set for themselves.   As an owner, you will simply take the annual number that you wish to live on in future years and divide it by whatever reasonable rate of return you expect to gain on your invested wealth.   You will then ask your CPA for a net worth statement not including your business.  The delta between your non-business net worth and the large number on your calculator is your wealth gap.   Second, you will want to ask your CPA for a recasted set of financials showing your recasted EBITDA (earnings before interest, tax, depreciation, and ammortization).   Recasted financials will often include addbacks and adjustments.  Say you are paying yourself $150,000 in salary and when you sell the business, you nor the role you play will be needed.  In some cases, they will “addback” some or all of that salary to show as profit on the bottom line.  This scenario would likely increase the overall value of your business.   Recasted financials are good to look at anyway and most CPA’s would be willing and able to provide recasted financials.   These recasted financials would then be calculated with an “industry multiple”.  This multiple can theoretically “multiply” whatever number shows as your recasted EBITDA. If you have a Recasted EBITDA of $1,000,000, and an industry multiple of 2, then a cursory value of your business would be $2,000,000, or “2x’s EBITDA”. The fly in the ointment for many business owners is that the multiples of an industry or business or not controlled by owners, but instead by the private capital markets.   You can find a range of multiples for most industries on a variety of valuation databases.   The obvious question is then, “What affects my multiple and how can I be certain to be on the top end of the range of multiples for my industry?” The Exit Planning Institute has found that 80% of the value of a business is locked away in the intangibles of the business, what they call the “4C’s” or “Capitals”; human capital (people), customer capital (how broad or narrow your customer base is), structural capital (documented and trained systems and processes), and social capital (culture and brand). Put another, more succinct way, your product is not your product…your process is your product.  The following two metrics are likely to provide the private capital markets with a more appealing valuation multiple for a business.   Your business attractiveness score, and your personal financial readiness score. Your business attractiveness evaluates both objective and subjective business issues such as intellectual property, customer concentration, documented systems and processes, company documentation, and management issues among many other factors. Your personal financial readiness assesses your readiness regarding written personal plans, personal financial plans, advisory team members, and transition planning among other factors. Too many owners naively think, “Well, I’ll just sell the business when I’m ready to retire.”  That is far too simplistic for most and not very thoughtful to the hundreds or thousands of people who will be impacted by your transition. With a projected 80% of your potential net worth locked away in your business, you owe it to your family to think intentionally through the value and the future transition of your business.  You have built something worthy of legacy that others depend on, so make time to metrically and objectively think through your next steps. For help with understanding your business value and what life looks like post-transition, please reach out to a BOP team member at mybusinessonpurpose.com/contact.