What is the true value of your business? If you're like most business owners, you do not really know.
At best, you may have an ‘estimate,’ based on some financial multiple associated with your industry – one that reflects a vague ‘average,’ but does not consider the myriad specific qualitative, planning, and trend-related factors unique to your situation. It views your business through the rear-view mirror (where it's been) rather than the windshield (where it's going).
Not knowing that true value could have profound, long-term, negative implications for you and your family’s financial well-being. The arrival and economic impact of COVID-19 potentially magnifies those implications.
I recently revisited this topic with valuation expert Cathy Durham, a shareholder of Madison-based Capital Valuation Group. Cathy reminded me of five very important reasons for determining the value of one’s business. Here they are:
- You'll find out whether your business is transferable. Not all businesses are transferable or saleable. An appraiser's first move will be to determine whether your business has value to a buyer, beyond the value of its tangible assets. This question arises when the business’s success and continuation are dependent on the owner, and the ability to generate enough profits to provide ROI are limited or non-existent. Most businesses can become transferable, though getting there can take planning, investment, and time.
- You'll get a realistic, supportable value conclusion allowing for meaningful planning or negotiation. Business owners often have an inflated sense of their business's value. This can happen when one considers only historical performance and applies a multiple to get a “back-of-the-envelope” result that fails to consider future changes. Privately owned businesses are dynamic – they're constantly growing, shrinking, hiring, firing, re-investing in capital expenditures, funding working capital needs. Too often, owners mistakenly assume the operation is worth the number they need it to be worth to retire.
- You'll identify the drivers of your business's value. Business valuation needs to include more than just a calculation of numbers on an income statement. There are a significant number of other qualitative factors that can result in increased (or decreased) value. Identifying and understanding these factors empowers you with the ability to implement strategies to increase value over time, before the time to sell arrives.
- You'll be able to track your largest asset and plan realistically for the future. A business is generally its owner’s largest asset, often by a lot. Realistic retirement planning depends heavily on the value assigned to the business. Just as you would not go 20 to 30 years without looking at the value of your 401(k), you should understand the current value of your business, or the value of your ownership interest in the event you have partners. Further, business valuations completed over a period of time can provide insight into whether the company's value is increasing or decreasing.
- You'll ensure that buy-sell agreements will work. If you do not own 100% of your business, a buy-sell agreement is possibly your most critical legal document. When drafted well, it will include the valuation provisions for each of the six triggering events – death, disability, resignation, termination with cause, termination without cause, and retirement – that could occur. A business valuation gives owners the opportunity to define their intent under each of these circumstances by considering the impact on value. This allows the owners to define “fair” before they know which owner or event will trigger the agreement.
It's important to note that not all business valuations are created equal. For example, calculation-based valuations simply use a multiple of some historical earnings figure, and assume that the company’s future results will be the same as past results—no real growth or decline. This is not a realistic assumption for 99% of privately owned businesses.
The devil is in the details; therefore, a meaningful valuation will include comprehensive modeling that analyzes past performance and trends, projects future business plans, and considers qualitative factors that can increase or decrease value, as well as market and economic trends.
Contact our Wealth Management team if you're considering a valuation, and we'll be happy to recommend some options.