Consider for purposes of this brief discussion that there are two kinds of value for your business.
- Value to you as an owner
- Transferable value
These concepts are fairly simple and straightforward, but they are nevertheless important to understand as we talk about successful ownership and management transitions.
Value to You
Ownership of a business, or of a significant portion of a business, especially when that ownership conveys the right to work in the business, can have special value.
There is a concept known as investment value. Investment value relates to value from the perspective of a particular owner. Any given business may not be worth the same to every potential owner. And the value of a business may have unique value to a particular, say the current, owner.
A business may have special value to a particular owner for a number of reasons, including:
- The business represents life. The business owner is so devoted to the business that s/he cannot imagine life without owning and working at the business. In my more than 30 years in the business valuation profession, I have seen numerous clients and other business owners who never left their businesses – until the moment they died. I’ve seen numerous others who missed good, great, or even phenomenal opportunities to transition their businesses because they could not let go.
- The business represents position and prestige. Some business owners get caught up in their positions in their companies, their communities, and their industries – all of which they believe are the result of their owning and working at a successful business. This makes it difficult to step down. There may be similarities between this and the first reason, but their psychological underpinnings are different.
- The business represents lifestyle. Particularly with some smaller businesses, but even in businesses of significant size and value, the owners’ incomes and benefits may provide a larger lifestyle than could had living off of investment income. This can be a real trap. Before successful transitions can occur, this problem must be resolved, either by an increase in the value of the business, or by a reduction in lifestyle, or a combination of the two.
- The owner is a key person. The owner may be extremely critical to the ongoing success of the business, either because of special knowledge or expertise, customer or supplier relationships, unique operational abilities, or other critical attributes. In such situations, the business is worth more to a particular key owner than it is to any other investors – unless the key person risks can be significantly reduced or eliminated.
The “special value” of your business to you may make it “priceless.” However, if your business is not transferable, it may be “valueless,” or at least worth a great deal less, to the other investors you need for successful ownership transitions.
My definition of transferable value relates to a company that has characteristics that other investors find attractive – and are willing to pay for. I’m going to use an expression a number of times, because it is important: “Other things being equal.” That is a term that economists use because the world in which we live is an alternative investment world. In Latin it is “ceteris paribus.” Investors will always have the option of investing in your company, or in alternative company, that is just like your business, except for one or more things that may be positive or negative.
I’ve often used the acronym of READY to provide a shorthand description of a business that has transferable value, or is ready for sale.
- R – Risks. Specific risks, like key person risks or heavy customer concentrations, are minimized. Value is a function of expected cash flow, risk, and growth (Value = Cash Flow / (R – G)). The R in the equation is the discount rate which is reflective of the risks associated with a business. Since R is in the denominator of the fraction, if risks are reduced, then value increases, other things being equal. Given two businesses that are otherwise identical, the riskier one will sell for less and will probably take more time to sell.
- E – Earnings. In the Value equation, Earnings are Cash Flow. A company that is ready for transfer or sale will have a good level of earnings. Good? Relative to what? To alternative investments in companies in the same industry. Increase expected cash flow, other things being equal, and the value of a business, and its transferability, increases.
- A – Attitudes, Aptitudes, Actions. These three “A’s” relate to the momentum of a business. Do you have attitudes, aptitudes and actions that foster good earnings and risk minimization? Are you working to get better at what you do and to provide better products or services? Other things being equal, a company that has momentum, or is positively moving in the direction of improvement on a continual basis, has more transferable value than one that is stagnant. Momentum has been defined as: “The rate of acceleration of a security’s price or volume. The idea of momentum in securities is that their price is more likely to keep moving in the same direction.”
- D – Driving Growth. Okay, I cheated. The relevant issue is Growth but it doesn’t hurt to be Driving it. Remember the simple Value equation above? G is in the denominator with a negative sign. If growth increases, the denominator decreases, and Value increases. Other things being equal, a company that is growing faster than another will be more valuable and transferable than its slower-growing counterpart.
- Y – Year-to-Year Comparisons. How is your company doing relative to last year? Is it improving or deteriorating in performance? A company that is improving in performance, other things being equal, is more valuable and transferable than one that is experiencing a decline, if only temporary.
Does your business have Value to You? Does it have Transferable Value? Until the Transferable Value of your business is equal to or exceeds the Value to You, you will be reluctant to engage in the logical transfer activities that are important for every business owner.
As always, if you wish to talk with me about any business or valuation-related matter, or to discuss management or ownership transition issues in complete confidence, give me a call (901-685-2120) or email (firstname.lastname@example.org).
Until next time,