John came to us with high expectations related to the sale price of his company. He was confident in this number because he had seen comparable companies sell for a similar multiple of gross revenue.
What John failed to understand was that buyers are only partly interested in top-line revenue. Equally if not more important than negotiating the sale price is the company’s net cash flow. By underestimating the buyer’s specific valuation expectation and what the impact of net cash flow meant for him and his company, John wasn’t likely to achieve the value acceleration he envisioned.
The Next Step Transition Growth and Value Acceleration Process (Next Step Process) is specifically designed to address and overcome each of the 12 principal reasons that can cause business owner transitions and value acceleration to be unsuccessful. Each of these reasons impacts the company’s ongoing annual profitability as well as an owner’s transition and future value acceleration results.
The Next Step Process is specifically designed to address and overcome each of the 12 critical building blocks. We use this program to help business owners design and implement their Transition Growth Plans to successfully achieve their transitions and value acceleration.
Knowing the value of your business and how this value is calculated is critical if you want to successfully complete the Next Step Process.
One of these 12 reasons is illustrated here: The impact of cash flow on a company’s price can be misunderstood.
Often, business owners do not recognize that their exit is dependent upon a buyer’s expectations and needs regarding their company’s future cash flow. They also haven’t demonstrated how their company’s exit-appropriate, buyer-specific valuation is to be determined.
If you are a business owner, in order to understand your company’s valuation it’s critical that you take the following three actions:
- Identify valuable, transferable, intangible assets
- Normalize your financial results
- Determine business “exit-specific value”
A universal ownership objective is to secure the income stream you will need to support the lifestyle you and your family plan to enjoy. Knowing the value of your business and how this value is calculated is critical if you want to successfully complete the Next Step Process.
During the transition and value acceleration process, many different types of business valuations are often discussed. The various types of valuations all tend to have the same objective: to determine what your company or business is worth, which allows you to establish a value for your ownership interest in the business that you (or your family, in your absence) expect to receive, or would be satisfied to receive. The differing types of valuations can come into play at or during various parts of the value acceleration process.
Your business valuation initially provides some idea as to what your company is worth. However, it also provides an estimate of the value that your efforts have achieved, and an estimate for your advisors for wealth-planning purposes.
One of the most commonly used methods of determining a company’s value is the EBITDA (earnings before interest, taxes, depreciation, and amortization) multiple method. This method reflects a valuation of the business enterprise operations without deduction for depreciation, amortization, or income taxes, and without reflecting the interest inherent in the debt structure of the company. The EBITDA to be used might be the most recent year or some simple or weighted average of the past few years, or a reasonable projection of the coming year or years. The multiples typically range between four and seven, although a smaller or larger multiple may apply depending on the quality of the company and its expected future prospects.
For example, if the EBITDA for the company is $1M, and the appropriate multiple is five, then the business (before debt) is worth $5M for purposes of that valuation. If you have $2M of interest-bearing debt on the balance sheet, the value of your ownership (equity) in the company would be $3M.
In order to arrive at a valuation estimate (and to determine exit options and key employee retention alternatives), your exit advisors must have a good estimate of the expected annual cash flow that your business can generate. Without this valuation of your company, a realistic Transition Growth Plan cannot be successfully developed. The EBITDA method is just one method for arriving at some indicated valuation for your company.
EBITDA does not represent a substitute for a good company appraisal by a qualified business appraiser. However, determining a company’s EBITDA does provide a preliminary valuation, which is very useful in the Next Step Process because it can be arrived at fairly quickly without the need for an interim stoppage to obtain a full business appraisal. Setting expectations in this way can be very useful and make the rest of the process more predictable.