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ask SCORE: A Critical Element for a Favorable Exit Strategy by Establishing the Value of a Privately Held Business
A Critical Element for a Favorable Exit Strategy by Establishing the Value of a Privately Held Business
By Richard N. Walton
Co-Chairman, SCORE, Hagerstown
The sale of a small privately held business is a critical component of the Small Business Life Cycle. The SBLC contains four phases, 1) the startup, 2) growth, 3) maturity, and 4) exit strategy. It is this fourth and final phase of that SBLC that we will be concerned with in this article. And it is important to note, as the author Steve Covey did some years ago, "that we should begin with the end in mind". ("The 7 Habits of Highly Effective People" by Steve Covey). As it applies to an exit strategy, this is the time when an entrepreneur or business owner has reached the point where he/she wishes to retire and realize the rewards of a career in managing a business for profit. And following Covey's advice, we have to be thinking about Phase 4, the exit strategy, from the very beginning of the business. Since there is no established market for privately held small businesses, it is necessary for the seller to establish the value of the business through the four sources of value we present below. The variables are 1) Earning Power, 2) Asset Valuation, 3) Intangibles, and 4) Negotiating Strategy. And each of these variables must be managed continuously throughout the life of the business in order to be optimized and fully valued at the point of retirement.
The first is Earning Power. It is demonstrated by the record of past earnings coupled with the outlook for future earnings. The past record can be valued as a multiple of yearly net income. If the business earned $50,000 (average for the past three years) and the buyer wants a 5 year payback on his investment, a working figure of $250,000 may be applied. (Five times the yearly average earnings). The future outlook is a more complicated estimate based upon the growth of the industry in which the firm operates, including the competition, and the health of the economy (both local and national). If these factors are positive it is entirely possible that the earnings valuation will be higher that a multiple of past earnings (as per the example above).
The second is Asset Valuation. It begins with the assets reported on the balance sheet, minus the claims against them. Total assets minus total liabilities equal the book value of the firm. Taken as a whole (rather than individual valuation) the book value of the firm represents the net difference between assets and liabilities, The higher the asset value, the higher the selling price, however a buyer may dispute the book value of assets as being too high. For example, obsolete inventory carried at cost on the balance sheet may be impossible to sell without significant a write down in value. The seller must make every effort of validate the reported value of any asset listed on the balance sheet, and if the net value of assets minus liabilities is small (less than the earning power in the example above), then the selling focus should be on earning power rather than asset valuations.
The third item is Intangibles, such as long-term customer and supplier loyalty, company reputation, specialized expertise that other competing firms do not have, patents, custom designed software and individual employee (as well as management) knowledge and problem solving capability. Each of these items increases the value of the firm to the extent that they can be used to raise the earning power of the firm. For example, company reputation can be measured as a factor that builds customer confidence and patronage, and is therefore a source of value.
The fourth item is negotiating strategy and expertise. Strategy can increase value through raising the point to the buyer that the seller has other options for a transfer of ownership and retirement. Or providing information about a new product that will be introduced shortly by the firm that may obsolete a competitor's product. Or as a good salesman or saleswoman, understanding the motivation of the buyer and his main objectives, and making sure that the sales presentation provides positive information that the purchase of the business will help the buyer realize his objectives.
Establishing a fair valuation of the business is critical both from the standpoint of the seller as well as the buyer. It is the duty of the seller to present the business in as favorable light as possible while adhering to high ethical standards and fairness in presenting information to the buyer.
Mr. Walton teaches Financial Management, Operations Management, Corporation Finance, and Entrepreneurial Finance at Frostburg State University and is the co-chairman for SCORE, Western Maryland, and is president of ERMACORP, a Hagerstown based Management Consulting Firm. Call 301-462-9850 or him at Richard@ermacorp.com. Find him on Facebook(r) at "Small Business Life Cycle" for inquiries and an exchange of ideas on small business management, issues, resources, and experiences.