What drives value
Sooner or later, every business owner will transition out of their business. A 2023 report from the Exit Planning Institute (EPI) claims 49% of business owners want to exit their business in the next five years and 75% in the next 10 years. PricewaterhouseCoopers surveyed business owners who had exited their business and found 75% regretted their decision within 12 months. Don’t be one of them.
If you missed part one of this series, you can read it here: Preparing for an internal transition vs. a third-party sale.
How do you prepare for an exit?
Too often, owners are so focused on running their business that they fail to properly plan for their exit. Data from the Exit Planning Institute suggests that 70% of transactions fail to close. The number one cause is that the owner gets cold feet.
This can happen for many reasons, but two of the most common are:
- No plan for the “next act.” What will the owner do with themselves if they are not coming into the business every day?
- Not financially prepared. Will they have enough money to maintain their lifestyle once they are no longer on the payroll?
The solution to these problems is personal and financial preparation. These two areas are often neglected while the owner is focused on running the business, but they need to be treated as equally important. Think of personal and financial readiness as two legs of a three-legged stool, with business attractiveness and readiness being the third.
Create a personal plan
- Lifestyle plan: Create a vision and action plan for life outside the business. This is not your bucket list. That won’t satisfy you for very long. It must address how you want your life to unfold. It should include activities that stimulate and motivate you. Involve your spouse or family as you create this vision for the next chapter. Find your “why” for when the business is no longer the dominant feature in your life.
- Personal financial plan: Work with a financial planner to define your financial needs and develop the strategy to meet those needs. As a business owner, a significant amount of your net worth is likely represented by the business itself.
- Estate plan: Work with a financial planner, CPA or tax advisor, and estate planning attorney to develop a written estate plan.
- Will: Work with your advisory team to create a written will.
It is important not to wait on these action items. Start the process at least three to five years before your expected exit date, but the sooner you start, the better. You will significantly improve your likelihood of a successful transition and of enjoying your post-exit life.
Prepare the business for a successful transition
When owners evaluate their business, they often think only in terms of profits. Shift this mindset and start thinking about value instead.
What’s the difference?
Profits are tangible. We can measure them on the income statement. Business valuations are often based on EBITDA, or Earnings Before Interest, Taxes, Depreciation, and Amortization.
However, 80% of the value in a premium business is tied to intangible assets.
Let’s consider an example. Suppose businesses in an industry have sold in the current market for anywhere from 3x EBITDA to 8x EBITDA. That means a business generating $1 million in EBITDA could sell for anywhere between $3 million and $8 million.
What is the difference between the $3 million business and the $8 million business?
It is not profit. Both companies generate the same EBITDA. The difference is intangible capital, which does not show up directly on the financial statements, even though the financial statements reflect the quality of that intangible capital.
The four drivers of intangible value
These intangible assets can be divided into four categories:
- Human capital: The value of talent
- Structural capital: The value of systems and intellectual property
- Customer capital: The value of customer relationships
- Social capital: The value of brand and culture
If a business is highly owner-dependent, has high customer concentration, lacks documented processes and procedures, and operates within a low-performance culture, it may not be transferable at all. If it is transferable, it will likely receive a valuation at the bottom of the range, such as 3x EBITDA in our example.
If the business is being transitioned to the next generation instead of sold to a third party, the heirs may be set up for failure.
Shift from profit thinking to value thinking
The shift from thinking about profit to thinking about value requires a focus on strengthening the intangible capital inside the business.
The good news is that improving intangible capital often increases profits as a side effect. As the team and systems develop, owner dependence decreases, which is a prerequisite for a high-multiple business. In turn, owners often gain more time and experience less stress, two things most business owners desperately want.
Much like financial, tax, and legal advisors help prepare an owner’s personal and financial readiness, business advisory firms and value advisors can help prepare a business for transition.
They can assess the business, provide a scorecard on intangible capital, and develop a roadmap for closing gaps that create value. Reach out for a business assessment to learn where your company stands. It could be the catalyst that gets both you and your business on the right path toward a successful transition.
