Exit Planning and ValuationMarch 01, 2011
Mark S. Campbell,CPA/ABV/CFF
By most accounts there is a wave of small and medium sized businesses that will be sold in the next five to ten years. Studies have shown that of the 78 million members of the baby boomer generation, nearly 10% of them are small business owners.
In addition, nearly two-thirds of business owners in the United States do not have children that plan on taking over the family business. This leaves an estimated 5 to 7 million small businesses without a family succession plan.
In all likelihood, these businesses will come to market in one of three ways:
- The owner will leave the business to his or her estate who will either sell or dissolve the company;
- The owner will become an absentee owner or dissolve the company and retire (leaving market share to be taken by another entity); or,
- The company will be sold to employees or a third party.
Of the three options, maximum value to the owner is typically achieved only by a sale to a third party. This article will discuss some items small business owners should consider from a valuation and planning perspective to increase value from a sale of their business.
For a variety of reasons most small businesses are typically valued based on the cash flows they generate. The basic formula used in valuing the cash flows of a business is comprised of two parts. The numerator consists of the normalized cash flow of the business, and the denominator consists of a discount rate minus a growth rate, which is also called a capitalization rate.
The discount rate can really be thought of as the risk associated with the normalized cash flows of the business. The more risk associated with the cash flows, the higher the discount rate will be resulting in a lower value for the business. Many systematic risks cannot be controlled by the business owner.
However, there are many unsystematic – or company specific – risks that a business owner may have more control in trying to minimize. Two common risk areas are lack of management depth (key man risk) and customer or supplier concentration.
Very often a business owner is focused on growing the top-line revenue of his or her business, which is obviously an important driver of value for a business. However, if the risk associated with those cash flows is still high, the incremental value being generated isn't as high as it could be. Taking steps to reduce the company-specific risk of the company can generate as much or more value for the business owner. Take the following simple example:
As you can see, increasing revenue by 20% increased value by $1 million. However, by just reducing the risk of the company by 5% the business owner increased the value by nearly the same amount. And the combination of the two has a dramatic impact on value.
So how can a business owner reduce risk? As mentioned earlier, the two main ways are by increasing depth of management and diversifying customers and suppliers.
The number one value driver for companies is the management team. For many closely-held businesses, this management team consists of one person. To build a valuable business, the management of the organization should include people with a variety of skills who can successfully run the business after the owner's departure and, collectively, do all that the owner does today.
Developing a strong management team helps in two ways. First, as described, it can increase value to a third-party buyer. However, it may also provide for an alternate exit strategy. If the management team is strong, they may have an interest in working with the business owner to structure a management buyout plan. In addition, delegating some of the responsibility of operating the business can help to reduce stress for the business owner.
A second way to increase value is to reduce customer or supplier concentration, which is often easier said than done. However, if a single customer makes up a majority of company sales, there can be ways to try to reduce this risk.
As mentioned in the beginning, with so many other similarly situated companies out there, a possibility would be to merge with a business operating in your industry to diversify your customer base. Very often, one plus one can equal greater than two, by reducing risk and increasing cash flows.
Other factors to consider in exit planning include:
The Team – It is essential to put together an experienced advisory team to guide you through the exit planning process. This team can consist of one or more of the following: CPA, valuation expert, investment banker, business attorney, estate planning attorney and wealth manager.
- Allow time – Many of these steps and processes take time to develop and implement. Starting early with a written plan for achieving them is key to successful implementation.
Mark S. Campbell, CPA/ABV/CFF, is a Manager with BlumShapirobased out of the company's Shelton office and specializing in business valuation and litigation services. BlumShapiro is New England's largest regional accounting, tax and business consulting firm based in Connecticut, with offices in West Hartford, Shelton and Westport, CT and Rockland, MA. The firm serves as business advisors for today's leading middle market companies, non-profit organizations and government entities, working to strategically tailor and consistently deliver tested solutions for unlocking an organization's full potential. For more information about BlumShapiro, visit blumshapiro.com.