Do you know how much your business is worth? And by worth, we mean what price it would realize if it was sold today. It is not unusual for business owners to think their business is worth more than it actually is. This difference is often referred to as the value gap.
If your business represents a significant part of your net worth and will be critical in funding your retirement, you will want to determine the amount of this gap sooner rather than later so you can take action to maximize the value of your business.
There are many reasons for this value gap and we will discuss a few of them below.
Is the value of your business due to your expertise, relationships and reputation? Ask this question: Can your cash flows or earnings be replicated in the future without your presence? If not, your business has little value to a purchaser.
However, your individual goodwill can be transferable if you recognize it and take the time to substitute other people with similar skills and experience into your role. The easiest construction companies to sell are those that have skilled management to carry on the business in an owner’s absence and those that have a marketing plan in place which enables them to develop new business.
Is part of your company’s profitability due to paying for management services, rent, or other expenses at amounts below market rates? A buyer will adjust your company’s earnings to reflect market rates, which in turn will reduce the amount they are willing to pay.
How does your company’s financial performance compare to industry averages? Buyers will examine key ratios to see how your business compares to the industry.
Do you have sufficient working capital? Are you properly leveraged? Are your operating expenses high? Companies that perform below industry averages will likely sell for a lower amount.
Are your financial reporting and control systems reliable? An example would be to have established good job cost records. This helps establish the reliability of the back-log amount, which can be a major component of the value of your company. Back-log is a view of the company’s future and helps a buyer assess the reliability of your company projections and growth assumptions.
Has your company kept up with the capital expenditure requirements needed to maintain assets? This is of particular importance in capital intensive companies. If a buyer believes they will have to incur significant equipment replacement costs and or repairs and maintenance costs to maintain existing earnings, they will lower the price they are willing to pay for your business.
Value changes over time due to changes in economic and industry circumstances. The construction industry is cyclical, and is one of the most affected by changes in the economy. Therefore, relying on the past as an indication of value can be suspect. A forward-looking approach is likely the most reliable in determining value.
Relying on Rules of Thumb
Have you been estimating the value of your business by relying on rules of thumb or formulas provided by friends or associates? Suppose you heard through friends or associates that a competitor sold their business for three times earnings. This can be misleading as you don’t know what type of earnings were used. Was it earnings before taxes? Earnings after-taxes? Owner’s discretionary earnings? Earnings before interest, taxes, depreciation and amortization? Also, rules of thumb do not consider the specific risks of the company.
An up-to-date business valuation will identify the above factors and the amount of any value gap. This is an essential starting point for a successful retirement plan.