Valuing and Selling Your Business: A Quick Guide to Cashing In (2014)
Chapter 1. Country Club Lifestyle
Do You Know Your Value?
A sophisticated businesswoman in her sixties called me late one summer afternoon. “Mr. McDaniel, I would like you to value my company in order to complete a transaction with my nephew.” We spoke further and arranged a meeting for the following week. When I arrived at her company, I noticed how nice the furnishings were. It had the appearance of a very successful company. She provided me a tour and explained how the company started, her role in the business, and other relevant facts that were needed to prepare a business valuation. She explained to me that she was selling the business to her nephew, who worked in the company. He was in his late twenties and had been in the business for about six years.
I had seen numerous engagements like this one—a client wanting to use an independent valuator to set the price between related parties. It is required by the Internal Revenue Service (IRS),1 and it often saves some bad blood between relatives down the road.
However, I was very surprised to find out that this engagement was different. When I asked her if my services and valuation report would be used to set the purchase price, she replied, “Oh no, the price is set. We just need a valuation report in order for my nephew to obtain a bank loan.” I asked, “What is the price?” She said, “$2.5 million.” I continued, “How did you determine that price?” Without hesitation, she said, “This is the amount I need to support my country club lifestyle. I belong to an exclusive country club and if I obtained $2.5 million, I will be able to maintain my membership at this club and live the lifestyle I want.” I was stunned by her answer. At that point in my career, I had been involved in more than 1,000 valuation engagements and never had a client provide an answer like that.
I proceeded with the engagement and determined that the company was worth significantly less than her expectations. It was my opinion that the company was valued at about one-third of her expectations—only $800,000. Besides the $50,000 salary that the nephew received from the company, he had no other financial resources and no bank would provide him with an $800,000 loan, let alone a $2.5 million loan.
How could this very smart businesswoman be so wrong? Why did she wait until she was in her sixties to find this out? Unfortunately, to maintain her country club lifestyle, she would have to continue working or find a fool who would grossly overpay at $2.5 million.
Her compensation from her business was $250,000, enough to provide her with the lifestyle she wanted. There was only one catch. She had to go to the office each day and work hard to make sure that her customers were happy, the employees were doing their jobs, and the bills were paid. If she would have sold her business at the true fair market value, she would have received close to $600,000 after paying taxes and transaction fees. Like most business owners, her business interest was about 75% of her net worth. With her spending habits, the proceeds from the sale of her business would provide her with the lifestyle she wanted for only a few years.
While no one had ever told me they arrived at a price based on the country club lifestyle they desired to have, the details here are commonplace. Business owners guess at what their business is worth (their most important asset), and they typically guess wrong. Unfortunately, their guesswork leads to undesirable consequences such as:
· Being unable to retire at the lifestyle they expect
· Working more years than they had hoped
· Choosing the wrong time to sell their business
· Not being able to exit their business on their own terms
What if the client had known that her business was only worth $800,000 when she was 55 instead of 63? She could have implemented strategies to increase the value of her business and then lived the lifestyle she wanted. Alternatively, she could have changed her lifestyle to fit the actual proceeds she would receive when she sold her business. But now, it was going to be very difficult for her to remedy the situation at age 63.
Important There are major consequences to you and your future in guessing wrong at the value of your business.
Treat Your Business Like an Investment
The majority of the net worth of most business owners is tied up in the value of their business. It is their most important investment, but it is rare that they view it this way. Business owners spend more time and money managing liquid assets (stocks, bonds, and mutual funds), which are easy to value and do not have the large potential for growth like their business does. Typical business owners do not view their business as an “investment.” It is more of a “piggy bank,” “identity,” or “a job.”
Treating your business as an investment is critical for you to accomplish your long-term financial goals and increasing your net worth.
Your business is no different than your other investments. Small changes in the annual rate of return will have a large impact on the future value of the investment. The major difference between your business investment and your other investments is that the business is a much larger part of your overall net worth. Growth in the value of your business will have a greater impact on your net worth than the growth in your other investments. Consider this example.
Elle owns a business, and she has a total net worth of $5 million. Her net worth consists of the following assets:
· Value of the business: $3 million
· Marketable securities: $1 million
· Real estate and other assets: $1 million
She reads the Wall Street Journal on a daily basis and has quarterly meetings with her investment advisor to discuss her marketable securities portfolio. Her goal is to earn a 7% annual return on her marketable securities over the next ten years and then retire. If she achieves her goal, the securities will be worth $1.97 million. If there is no growth in the value of her business and other assets, her net worth would grow to $5.97 million.
Now let’s assume that she is also focused on growing the value of her business at the same 7% rate over the next ten years. If she achieves her goal, the business will be worth $5.90 million. If both the business and marketable securities investments grow at 7% annually, her net worth would grow to be $8.87 million in ten years.
By focusing on growing her business along with the value of her securities, Elle’s net worth will be $2.9 million higher ten years from now.
How can you treat your business like the important investment that it is? In order to treat your business like an investment, you must take the following steps:
· Know the true value of your business.
· Have specific plans to increase its value.
· A plan to realize value “cash in” through a sale of the business.
Your business is every bit as much an investment as stocks, bonds, and mutual funds. Treating your business like an investment is the key to increasing value and building wealth.
Most business owners have a vague sense of the selling price for their business. It is usually in terms of the amount they believe they need to live the rest of their lives comfortably without working. Not much thought is given to who the best buyer for their business is and when is the best time to sell their business. These business owners usually sell their business at a price much lower than they anticipated and at times are forced to sell their business due to life circumstances,
I have met very few business owners who actually have specific written plans to grow the value of their business and know the importance of having their business in its sellable position at all times in order to provide them with the best opportunity of selling their business at the right price and the right time. The business owners that actively work these specific plans are able to move on to their next phase of life on their terms.
Summary
It is critical that you actually know what your business is worth. Guessing at its value based on your personal needs will lead you down the wrong path. It is important to have an “investment mindset” towards your business. It is your most valuable asset and, by focusing on growing this asset and having a plan to realize value from a sale, you can increase your net worth significantly.
In the next chapter, you will learn more about what a business valuation is and who is qualified to prepare one. By the end of Chapter 4, you should have a solid understanding of the entire business valuation process and how to increase the value of your business.
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1Transactions between related parties need to be at “fair market value,” or they may be considered a gift by the IRS and thus taxable.