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Business Valuation: Implications for Exit Planning

04.13.2020

The business valuation is a crucial starting point for exit planning. An accurate assessment of a business accomplishes several goals:

  • It is the basis for determining a “wealth gap” – the delta between sale proceeds and what an owner needs to meet their goals for the next step in their life. The valuation is one side of the equation.
  • When updated annually, it gives the owner a way to monitor progress.
  • The valuation provides a baseline by which to judge the effectiveness of an exit planning strategy.
  • It provides a basis for tax purposes, which allows the owner to begin planning for tax implications of various sale structures and exit options.

The exit planning process is intended to add value by determining a baseline, then analyzing a business to assess why their valuation multiple is below that of the industry average. In instances where the multiple differs from other comparable sales that are at the top end of the range, the valuation process forces an owner and advisor to turn over numerous rocks and ask questions about the nature of the financials, which provides “nuggets” of information and opportunities to add value.

Creating value

Valuation, in general, is driven by several components – earnings, growth and risk. The only valuation component that is truly out of the hands of any owner is market conditions. The sale metrics of comparable companies dictate the overall market value, similar to how comparable house sales can drive the value of your home. You have little to no control over what happens on a systemic level.

A business owner, however, can control by many of the components of valuation. The earnings component speaks to past earnings and the likelihood those earnings will be repeatable in the future. So an owner needs to look at their business and ask themselves questions like, “What is driving my earnings? How do I make those earnings stable, if not growing? Are those earnings at risk for a loss?”

The first consideration of earnings is customers. A business needs a diverse customer base without concentration or reputation issues. It is important to determine how “sticky” those relationships would be in the event of a change in control. The more entanglement we have with our customers in the way of proprietary products, market knowledge, contracts and agreements, the more value we have in our company. Another component of earnings is the structural capital in the context of processes and technology. The goal is to create a sustainable cash flow that is reliable.

The next component to consider is growth. The main drivers of growth come from a few areas – namely, human and structural capital. The social capital aspect speaks to the people behind the business. Do you have the right people in the right positions to drive growth? Are they adequately trained, adequately supervised and sufficiently incentivized to achieve the company’s growth objectives? Secondly, do you have the structures in place to drive growth? Is your business scalable? Do you have scalable technology? Do you have documented processes that are understandable and repeatable?

Finally, there are risks to consider. Where do you see the danger in your business, and what have you done to mitigate risk? Adequate internal controls are vital in minimizing exposure for any business. The right internal controls should be in place, regardless of the size of the company. Further, do you have a stable management team that is motivated to take this business to the next level? Without a steady management team, the company faces significant risks. The last aspect of risk management comes down to insurance and planning – do you have plans in place in the event of a disaster? Maybe not a natural disaster, but a failure in the sense of an unforeseen event that prevents the company from realizing future earnings.

These components of value will be the decider between an average or below-average valuation and one that is above industry standards. Most businesses can achieve an outrageous price with the right planning.

A valuation is the starting point for any exit planning process. It’s difficult to determine where to go without first understanding where you’re starting. When you know the real value of a business, you can make long-term, strategic value-creating decisions. If a company does not take valuation seriously, it can significantly hamper an owner’s ability to plan for succession effectively. The ill-prepared owner can end up with a business that either is not saleable or ends up transacting at a value that is significantly less than expected.

For more information on value creation or utilizing a business valuation as a part of your exit planning strategy, please contact David Killion, Transaction Advisory and Litigation Support Services Principal, at dkillion@bswllc.com or 314.983.1304 or Jason Buhlinger, Transaction Advisory and Litigation Support Services Principal, at jbuhlinger@bswllc.com or 314.983.1310.

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