What's your worth? | Run your company like it's about to be sold to maintain value | Run your company like it's about to be sold to maintain value
Our descent into the current recession was driven greatly by the decline in home sales. Of course, as home sales dropped, the value of those homes dropped commensurately. Now, in our third year of the economic doldrums, there is some sign that home sales are trending upwards. Unfortunately, in many areas, while home sales are up, home prices continue to fall. This is painful for many folks, as their home represents their biggest asset. For small business owners, that is not usually the case — most of them have a more considerable asset.
Over the years, it has surprised me how few business owners have a handle on the true value of their greatest asset: the business they own. Certainly, business values have declined over the past few years. Still, most businesses with employees have greater value to a business owner than the home the business owner resides in. I mention employees because they can be a key factor. Many people in Maine are self-employed, but do not have any employees. These folks play a significant role in the health of the state’s economy; however, in terms of value, most such enterprises are thought of less as a business and more as a self-created job.
Having employees provides some indication that the business can operate without (or sometimes in spite) of the owner. My own definition: If commerce can happen without the owner on the premises, it’s a business. These are the type of enterprises that create greater value. Having value translates to the ability to obtain financing and for the business owner to develop a profitable exit strategy.
Taking a hard look
So what determines the value of a small business? The key elements are the net income of the business, the compensation and benefits paid to the owner and the market value of the firm’s assets. These assets can include real estate, inventory, accounts receivable, fixtures, equipment and so forth. There is also a component called goodwill. Goodwill is an estimate of value based on the firm being well known, that the phones are ringing, the employees are trained and systems and procedures are in place. Goodwill is figured as a multiplier applied to the total of net income plus total owner compensation. Without a long explanation, the average multiplier for small businesses is three times cash flow. Needless to say, if a company is not profitable and the owner is not taking any salary, then there is no goodwill.
The most obvious reason for the decline in small business value is that revenues have been lower than what was enjoyed in previous years. A drop in revenue usually, though not always, results in a drop in net income. Many business owners, however, have a hard time accepting that their enterprise has slipped in value.
At our firm, we have heard many times over the last couple of years that “only three years ago my sales were 30% higher.” We also have been admonished that “in two or three years my company will be back where it was.” No question that these are true statements, however, they do not help in determining current business value. It’s understandable that business owners voice these thoughts as they struggle with the realization that the recession has taken a serious whack at their nest egg.
Buyers of businesses will buy based on potential, but what they will pay is based on results. The same is true with banks. They do not lend based on potential, they lend based on performance.
Staying positive
When preparing valuations during these difficult times, we often find ourselves asking business owners why their expenses have not decreased commensurately with their decline in revenues. Almost universally, we find business owners have carried a higher percentage of payroll during the recession than they did during better times. What a lot of folks do not understand, and to the credit of small business owners, is that many operators have elected to keep employees on the payroll to the detriment, in terms of value, of their businesses.
A business owner who needs to sell during these difficult times can still do so. Entrepreneurs in this position need to concentrate on cash flow, which represents the total of net income plus owner compensation and benefits. Obviously, if you’re judicious about bringing in inventory and more vigilant collecting receivables, cash flow improves. If payroll is well managed and capital expenditures are kept to only those things that are absolutely necessary, cash flow improves. With strong cash flow comes defendable business valuations and subsequent successful business sales.
In good times or in bad, if every business was operated with the idea that it was about to be sold, we would see a lot more healthy companies. Recessions really can make us better business people.
Stephen Vlachos, principal at Caswell Vlachos Group LLC, a business brokerage firm in Portland, is a serial entrepreneur and business consultant. He can be reached at svlachos@caswellvlachos.com. Read more On Your Own here.
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