Saturday, June 16, 2012

I'm Not Worth as Much as I Thought

A Chief Executive Boards International member, asked on a recent Executive Summit Evaluation for his major takeaway said, "I learned I'm not worth as much as I thought." He was talking about a workshop session titled, "What's My Business Really Worth?", where we had a panel of valuation experts walk through how businesses are really valued. 

Most business owners don't have the net worth they think they have, because their businesses aren't worth what they think they are. There's an old adage in the mergers & acquisitions business -- "You never want to be the first person to tell someone what his business is really worth." Business owners have a fanciful idea of what their businesses are worth, driven by both a host of misinformation sources and some fundamental misunderstandings about how businesses are valued.

So what's your business really worth? Strap yourself in. Businesses are valued on what I call the "magic coffee cup principle". I have a magic coffee cup. For its owner, it will spit out $1 million in cash a year from a slot on the side of the cup. Every year - forever. Like most things, there's some risk. You could lose the cup or break the cup, but otherwise you've got a $1 million per year annuity.

So, what am I bid for a magic coffee cup? I usually get a bid right off of $1 million. That would be a really good buy - pay only $1 million for a $1 million annual return. Somebody will quickly bid $5 million. I ask "what's your return on that investment?" and someone figures out 20%. Then someone else, figuring that a 10% ROI isn't bad in this market, says he's good for $10 million. That's 10 times the perpetual cash flow of the magic coffee cup.

Businesses are valued just the same way -- as a multiple of their free cash flow -- the amount of cash an owner can take out each year. But they're not magic, like a coffee cup. A lot of things can go wrong in a business that could cut the forecasted cash flow in half. Or worse. As a result, most businesses don't command multiples like 10x free cash flow. A 10% ROI is just not enough to cover the risk.

Notice the switch between "multiple of free cash flow" and "ROI on the investment". Actually, they're reciprocals. Take 100% and divide by the cash flow multiple and you get the ROI. A 5x multiple is a 20% ROI. 4x is 25%, and so forth.

That's why most businesses sell for multiples between 4x and 6x free cash flow. Those represent investment returns (25% to 17%) that are substantially high enough to offset risk of owning a small business.

Most owners then would then like to add to that valuation some balance sheet items, like inventory, fixed assets, accounts receivable and so on. Wait a minute. As a buyer, I realize I'm going to need all that stuff just to produce the current free cash flow. That's part of the deal -- the assets needed for the business to perform, and I'm not going to pay more for any of that -- it's essential to producing the cash stream (magic coffee cup) I'm willing to invest in at a multiple (price) I'm comfortable with.

That's where most business owners' bubble bursts -- when they realize that they're likely going to get paid only about 5 times their current annual cash flow for their business, and then they won't have it any more.

Are there ways to get more for your business? Sure. Here are a few:
  • Intellectual Property -- If you have protected intellectual property that would be far more valuable to a buyer than it is to you, that's a factor. For example, you have a patented product that a company 10 times your size could put in the hands of its sales force and sell 10 times as many units as you do (and could cover the working capital to make them, etc.)
  • Distribution -- You have customers that would be far more valuable to a much larger competitor than yourself
  • Geography -- You already cover a geography that a competitor doesn't cover, but would like to have -- particularly in a different country, continent or language.
  • Product Synergy -- You have products a much larger competitor doesn't have, but could add to his line and multiply the margin you've been able to generate yourself on those same products
  • Market Segment Synergy -- Your products are substantially up scale or down scale from a competitors', thereby giving him a "premium" product or an "entry level" product he doesn't have to develop. Especially if he's 10x or 20x your size.
  • So, what's a business owner to do to increase his net worth? Drive free cash flow. Figure out how to get your business generating more cash. Interestingly, that not only makes the business more valuable to a future owner, but also makes it more valuable to you, as well. Your spouse will no doubt appreciate that. 
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Terry Weaver

Chief Executive Boards International
Chief Executive Boards International: Freedom for business owners & CEOs -- Less Work, More Money, More Freedom to enjoy it

1 comment:

  1. This is a very good article on a very important topic. Since my role is to work with independent business owners, I focus on this topic a lot, since my ultimate objective is to assist business owners to realize their PERSONAL goals THROUGH their business. Building value in the business is always a good strategy, whether getting ready to sell it or pass it on, or not. I have a really cool tool on this topic that can be used (and does not cost anything) which is described and can be reached by going here:


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