As owners begin to think about selling their businesses, the first question they have is: “How much is my business worth?” They may have a vague idea of what they think it should be worth, but don’t usually have any tangible numbers to base it on. And more often than not, it’s unrealistically high in comparison to what a buyer would pay.
This disconnect between the owners’ perception of business value and that of potential buyers is very common. Owners spend years devoting themselves to their businesses, investing personal and financial resources, and often sacrificing precious time. Their business is usually the most valuable and important asset they own. However, a potential buyer’s perspective of business value is generally quite different.
Let’s look at what constitutes business value, where the divergence of perceived value occurs, and how business owners can increase their business value and make it more attractive to prospective buyers.
What Constitutes Business Value?
Determining business value is not an exact science. There are various methods of calculating value, depending on specific circumstances, which we won’t go into here. But basically, business value is a prophecy of future cash flows for the prospective buyer, whether the business is sold to an internal or external party. And, buyers don’t want to purchase businesses that are unlikely to generate cash.
Publicly held companies have a definitive value, on any given day, based on their stock price. Privately held companies have a range of values, on any given day, due to a variety of factors. Value can vary because of the type of prospective buyer, as well as its cash flow, risk profile, and quality of the business. If the purchase by a particular buyer will automatically generate higher business profits or “synergies,” that buyer can afford to pay more for the business. Thus, the value of the business is higher.
3 Common Mistakes Owners Make that Decrease Business Value
While growing their businesses, many owners make financial and operational mistakes that are actually decreasing value.
Focusing on tax minimization – In an effort to reduce income taxes, owners will often purposely drive down profits. One way owners do this is by running it as a “lifestyle” business. Paying for homes, vehicles, memberships, etc. through the business reduces profits, thereby reducing taxes. This is penny-wise and pound-foolish. While it may reduce taxes (typically 30% to 40% of profits), it also drives down the value of the business. Every dollar of business profit will be recouped multiple times over in a sale.
Be sure to work with an experienced accountant who can advise you on tax planning with the sale of the business in mind. See also: Have You Saved Enough to Sell Your Business?
Driving revenue rather than margins – People often assume that simply increasing revenues will increase business value, but this isn’t necessarily true. Gross profit margin — the percentage of revenue you retain after accounting for costs of goods sold — and net profits have more impact on the value of a business.
One key strategy for increasing value is to add recurring revenue streams to your business. See: How Recurring Revenue Increases Business Value. Studies show that businesses with recurring revenue sell at much higher multiples than those that don’t.
Ignoring business risk – Potential buyers are seeking quality businesses that are scalable, transferable, and have little risk. And, the price they are willing to pay is largely a reflection of their perception of risk in your business. The higher the risk, the lower the multiple; the lower the risk, the higher the multiple. Common types of business risk include environmental, product and service liability, technological, and employment.
It’s critical for business owners to identify and quantify business risks and find ways to mitigate them. See also: Avoid These 7 Mistakes When Selling Your Business.
Steps to Increase the Value of Your Business
As we’ve discussed, the question of business value isn’t an easy one to answer. And, no matter what the numbers are currently, it’s more than likely that you’ll want to increase them. Here are some steps you can take:
Perform a detailed review of the business well in advance of considering any type of transaction. We recommend that you work with an objective advisor such as a business broker/intermediary or a reputable business appraiser to complete this review. This is usually an eye-opening and informative experience for an owner. It generally results in an approximate business value and provides you with a starting point from which to make improvements.
Invest in key employees who can help you propel your business to the next level. Buyers don’t want to buy businesses that are dependent on their owners. They seek businesses who have well-trained staff and well-documented processes and procedures.
Develop a written strategic plan with your team’s involvement that will serve as a roadmap for you to follow to propel business growth, correct any issues, and increase business value long before you engage potential buyers.
Taking the steps above is great starting place for you to begin to increase business value and improve your chances of selling, whether it’s internally or externally.