Part 2 of a 3 part series published in the Big Sky Business Journal.
The other day a business owner asked me, "How can I be confident that I will have a valuable and sellable business when the time comes for me to leave my business?"
All business owners have reason to ask Jim's question, because a transfer of ownership is inevitable. The timing and the ideal buyer for each business will vary, but the certainty of a sale at some point is unavoidable.
For most entrepreneurs, their business is their most valuable asset, the place they spend most waking hours, and a primary part of their identity. One of Jim's fears in a potential ownership transfer is failing to capture the full value from his two decades of building a business. Jim is part of the majority of business owners that do not have an exit or succession plan – 85% according to M&A Today magazine. With careful planning in advance of a sale, Jim can gain confidence in the success of his future ownership transfer.
There are many options to transition out of a business, including selling to a third-party, selling to management, structuring an employee stock ownership plan (ESOP), transferring to children, liquidating the assets, or leaving the business to the owner's estate. Each exit path has unique benefits and shortcomings, including tax, legal, valuation and operational implications.
Jim should sit down with his advisors to review his options and form an exit plan. It is never too early to start planning. Even though Jim doesn't plan to sell and retire for about 5 years, we all know that life is uncertain. Having a good plan in place will help a business survive the unexpected health or other crisis. Astute business owners are always ready to sell and are never forced to sell.
Jim told me that he would be on the first flight to Hawaii after he sells the company. While I understand his desire, especially since he has been working 60-70 hour weeks for many years, his company is not ready to have him step away suddenly. He has not built a capable management team that can run the operations. Any buyer would negotiate for him to work for a transition period to assure the operations do not fall apart. We both agreed that one of his top priorities would be to develop a management team that can replace many of his duties. One practical way to test the company's management strength is to ask, "How long Jim can go on vacation without calling into the office?"
As Jim and I talked, it became clear that Jim knows what he will do with his time after the sale. He plans to start a new business with fewer employees and volunteer for a couple of non-profit organizations. Many business sellers have found themselves unfulfilled when they wake up on Monday morning and no longer have a company to manage. Personal planning is an important part of the ownership transition plan.
I told Jim the story of a recent client who wanted to sell their company and planned to reinvest the proceeds in income producing assets. However, after they started the sale process, they concluded that passive investments would not produce enough income to make a sale worthwhile. This scenario can be avoided with a personal financial plan guided by a trusted financial advisor or wealth manager.
Jim asked me what buyers are looking for in today's market. Of course, this is the ideal question. To be successful at selling anything, we should think like the buyer and sell what the buyers want to buy. An entrepreneur or investor who can write a large check to purchase a business will be savvy. A business must be well positioned in order to attract the best buyers and achieve a maximum price.
Businesses often have two divergent 'values'. The first value is in the mind of the owner, who has expended blood, sweat and tears in building the business over many years. The second value is what the market will pay for the business. We often see a gap between the two values, which can prevent a business owner from realizing their goals.
Jim asked what he should consider to help close the value gap. He is thinking in the right direction, because business owners can often close the value gap by working on the company. Value drivers are the business attributes that give a business real and perceived value. Value drivers are the business areas that a buyer will ask about.
A buyer will ask questions like the following. What is the proven cash flow of the business? How likely is that cash flow to continue under new ownership? What impact would result from the business losing a customer, key employee, supplier, etc? Does the business hold intrinsic value or is it highly dependent on the owner? How are the products or services positioned in the market? Is there proprietary product or service, or can a competitor easily replicate it? What is the real growth opportunity? Is the workforce stable, high performing and satisfied in their jobs?
Each question is simply seeking to understand the relationship between the expected cash flow and risk of the business. The value formula can be written as Value = Cash Flow/Risk. Expected cash flow adjusted for risk determines the value and salability of a business. Though the value formula may seem theoretical, it describes decisive value drivers that real buyers look for in the real world.
Jim is like a lot of business owners. He has worked hard and built a profitable business that benefits its employees and customers. I am confident that Jim will continue to think about the value drivers in his business and form a plan to capture the value he has worked so hard to build.