By Profit Soup
A good way to build your business value is to start with the end in mind. For example:
- What do you want to accomplish?
- What do you need, financially, to move on after you’ve accomplished it?
- What is your exit strategy?
To create value is to maximize the combined return that occurs throughout your tenure of ownership and when you exit. If you can identify the return you wish to receive both along the way and at the end of the road, you can build a plan to achieve it. How and when you intend to exit the business will determine what you need to accomplish before that day comes.
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
- Continue as an absentee owner
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 businesses are valued when the plan is to walk away. Nobody wants this option. It takes planning to avoid it.
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.
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. There’s just no downside to understanding how the business will be valued regardless of which exit strategy you choose.
Dream Big: Plan for Value
AKA How to grow a $3 Million business
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 would the transition take place? How many years from now? | 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? | 4.0 times |
| 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 |
Here’s a summary of the sample plan.
| Exit Strategy | Sell the business |
| When? | 5 years from now |
| For how much? | $3 million |
| What needs to happen by then? | Grow sales to $7.5 million generating 10% EBITDA - 1 territory with sales of $7.5 million - Or 2 territories averaging $3,750,000 each - Or 3 territories averaging $2.5 million each |
Your priority is to execute growth strategies to support the plan.
EBITDA Multiple
Accountants use the term EBITDA a lot, but not everyone understands what it means. EBITDA is an acronym for:
E: Earnings B: Before I: Interest T: Taxes D: Depreciation and A: 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) which also 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 – like increasing inventory, accounts receivable, property and furnishings. For these reasons, EBITDA does not indicate the amount of cash flow the business produces.
Capitalized earnings VS EBITDA Multiple
The Capitalized Earnings approach works on the theory of the goose that lays golden eggs: we’ll spend something today to buy a goose that will return golden eggs tomorrow. Based on the volume of golden eggs anticipated and the acceptable return on investment, 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% return on investment, how much would you invest? In other words, $100,000 is 10% of what number?
When attempting to establish price (value), we estimate EBITDA and then choose a reasonable return on investment percentage. When the price is known and we’re deciding if it’s reasonable, we work backward to measure the implied return. The implied return on investment (ROI) is referred to as the Capitalization Rate. For example:
In this example, the asset’s capitalization rate is 10 percent.
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.
Here is how Capitalization Rates compare to 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.
Question: Why does A HIGHER MULTIPLE yield a LOWER RETURN ON INVESTMENT?
Answer: 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.
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