It may not seem vital to know the value of your business until it’s time to sell. However, by then, it’s too late. There’s nothing you can do if it’s not worth what you expected.
“Typically, a closely held business is the largest asset owners have, perhaps 60 to 80 percent of their net worth.
Unfortunately, many just guess at the value and guess wrong. Then their retirement is significantly different than what they expected,” says Tim McDaniel, CPA/ABV, ASA, CBA, a principal with Rea & Associates.
Smart Business spoke with McDaniel about determining the value of a business and steps owners can take to help it grow.
How is the value of a business determined?
There are a few different approaches an evaluator will use to value a business, but in most cases, the most effective way is an income approach. In this approach, the valuator uses the mindset of an investor to project the company’s future cash flow and determine how much risk is associated with it.
All valuations are really a forecast. Historical trends are reviewed to predict future cash flows, but the valuator will also interview management to understand what the company’s future looks like.
Should owners always know what the business is worth?
People will spend a lot of time with an investment manager trying to grow a stock portfolio that may be only 10 to 20 percent of their net worth and ignore their largest asset, their business. In order to treat the business as an investment, the first step is to know the value.
Next, set goals — how much should the value grow annually and where do you want it to be when you exit — and implement a plan to reach them. There are three major factors that impact the value of a business:
- Increase expected future cash flow.
- Decrease risks associated with your business.
- Increase the future growth rate.
Develop a plan addressing how to positively impact these three areas. Too often business owners don’t develop a plan — they work in their business, not on their business. Between keeping customers happy, ensuring employees are doing their jobs and maintaining quality control, it’s easy to get caught up in the day to day.
It’s rare when an owner treats the business as an investment and has an annual or biannual valuation. One owner recently thought his business was worth five times its actual value because his CPA told him the value was one times gross revenue, which is completely erroneous. That may be how a CPA firm is valued, but there’s a lot more involved in valuations than a simple multiplier, and it takes years to develop the necessary skills. The unfortunate part is that some people have been living with the assumption that they will retire as millionaires, but come to find they might not be able to retire.
What are the best ways to exit a business?
Exit strategy depends on the individual. If you want the highest dollar amount, sell to a synergistic buyer — a bigger company in the same industry. The downside is that some of your long-term employees might lose their jobs. Another way is to sell to a financial buyer or employee stock ownership plan where the business may continue to run in a similar fashion. Many owners prefer to keep businesses in the family and give stock to children. If that’s the case, make sure your retirement is funded and you gift stock when the value is down. Another strategy that’s gaining popularity is retaining the business and hiring a professional management team to run it so you can significantly reduce your role.
It’s important to develop exit plans early. If you want to retain the business, it takes time to develop a good management team. If you want to sell, you want to sell when cash flows are highest. If you want to gift it to your children, they have to be ready. No matter which way you proceed, it’s a long process.
Tim McDaniel, CPA/ABV, ASA, CBA, is a Principal at Rea & Associates. Reach him at (614) 889-8725 or firstname.lastname@example.org.
More on this subject can be found in Tim’s new book, “Know and Grow the Value of Your Business: An Owner’s Guide to Retiring Rich.” Learn more here.
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