When To Sell? Start Planning Now To Maximize Your Value!
All business owners should have a long-term exit strategy. It’s where all business planning begins. There are only 3 possible exit strategies: liquidate, sell, or continue as an absentee owner.
1) Liquidation is easy. It takes no planning and yields the least value of the three strategies. You don’t need to factor in how the business is valued when the plan is to walk away. Nobody wants this option. It takes planning to avoid it.
2) If the intention is to sell or transfer the business to another owner, understanding how the business will be valued at exit is essential to the plan.
3) If you expect to continue as an absentee owner instead of selling, the business will create taxable value to your estate, but will not necessarily provide enough cash to pay the tax. Regardless of which exit strategy you choose, there’s no downside to understanding how the business will be valued.
Plan for value
Here is an example of how a vision for a timeline and value proposition can establish a framework for your long-term plan value plan.
|Sample Long-Term Value Planning Worksheet|
|1||When will the transition take place?||5 years|
|2||How much do you want the business to be worth then?||$3,000,000|
|3||What EBITDA multiplier is realistic for your industry?||4x|
|4||EBITDA target for your investment (line 2 divided by line 3)||$750,000|
|5||What’s the average EBITDA for a franchise unit in your system?||10%|
|6||Sales required to generate target value (line 4 divided by line 5)||$7,500,000|
Your priority is to execute growth strategies to support the plan. This can be achieved, for example with one territory with sales of $7.5 million, 2 territories averaging $3.75 million each, or 3 territories averaging $2.5 million each.
Accountants use the term EBITDA a lot, but not everyone understands what it means. (EBITDA is an acronym for earnings before interest, taxes, depreciation, and amortization.)
EBITDA is commonly thought to measure cash from operations. Some refer to it as “free cash flow.” It is derived by starting with the bottom line from the income statement (net profit); this includes adding back discretionary expenses to the owner, taxes, interest, and the two primary expenses that don’t require cash: depreciation and amortization. These are accounting entries that represent the decline in fixed assets (depreciation) and intangible assets (amortization). You don’t write a check for them.
In this way, we attempt to estimate how much of the revenue was left in cash after paying all the expenses. Unfortunately, EBITDA ignores many other things that consume cash in a business, such as increasing inventory, accounts receivable, property, and furnishings. For these reasons, EBITDA does not indicate the amount of cash flow the business produces.
The capitalized earnings approach works on the theory of the goose that lays golden eggs: Buy a goose today that will return golden eggs tomorrow. Based on the volume of golden eggs anticipated and the acceptable ROI, we can work backward to find out how much we would be willing to pay for the goose (its price or value). Let’s take our earlier example.
If you think the investment can earn profit of $100,000 per year and expect a 10% ROI, how much would you invest? Easy: If 1) ROI% = profit divided by amount invested, then 2) your value of investment (price) = profit divided by ROI%. Thus, in our example, to generate that profit of $100,000 per year with a 10% ROI, you would have to make an investment (price) of $1 million.
When attempting to establish price (value), we estimate EBITDA and then choose a reasonable ROI percentage. When the price is known and we’re deciding if it’s reasonable, we work backward to measure the implied return. The implied ROI is referred to as the capitalization rate, or cap rate. In this example, the asset’s cap rate is 10 %.
Investment (price) ÷ anticipated profit = cap rate (ROI)
$1 million ÷ $100,000 = 10%
Generally speaking, the capitalization rate is the yield necessary to attract investors, given the risks. The capitalization rate is selected subjectively, considering the return you would expect to receive on other investments of similar risk.
Cap rate & EBITDA multiples
Here is how capitalization rates compare with EBITDA multiples. A 50% cap rate is equivalent to a 2 times multiple, 33% is 3 times, 25% is 4 times and 20% is 4 times.
So why does a higher multiple yield a lower ROI? Because the buyer pays a higher price (investment) for the same EBITDA dollars (return), which reduces the ROI percentage (return divided by investment).
In conclusion, maximizing the value of your company begins with an understanding of what you want to accomplish, when you would like to make the transition, and executing a growth strategy to meet those objectives. If you would like to learn more about how to maximize the value of your company, please connect with us at firstname.lastname@example.org and request our 25 tips list.
Barbara Nuss is president and founder of Profit Soup, a financial education organization specializing in providing services to franchisors and franchisees to enable them to trust their numbers, focus on priorities, make better decisions, and earn more profit. She can be reached at email@example.com or 206-282-3888.
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