Most small business owners measure Business Worth as Potential Sale Amount.
And yes, I’m going to give you an equation that will help you determine the value of your business before this article is over, but first, I have a point to make.
I argue that that’s one of the reasons we are in the mess we’re in regarding small businesses & why so many shut down or fail to grow.
Businesses should be paying dividends & profit distributions through-out the majority of the life of the business. The ROI should not be lumped into a single payment at the end of your career.
Too many business owners intend to retire on the sale of their business, only to find at the very end that no one wants their business and they are stuck working indefinitely.
Long-story-short: a business is only worth what someone else will pay. Very few prospective owners are interested in purchasing a struggling or sick business that is going to require continued slavery to eek out a mediocre income for excessive hours of work for an indefinite period of time.
If you’re struggling to keep your business afloat, selling your business should not be forefront on your mind. Instead, focus on setting the business up so that it is providing you with the free time and profit distributions that will be most appealing to a prospective buyer.
Good point! (Yes, I just completed my mind-reading classes so I know you were thinking “Great! That sounds so easy Steph... but in practicality, it’s not that easy!”)
How do you set up a business that pays you in time and money?
It starts with a mindset shift. Instead of the business just being a job to keep you busy, start looking at your business as a vehicle for ROI. You wouldn’t leave your money in a stock that barely stayed level and never paid out profit distributions would you? Absolutely not! You’d shift to a stock that was increasing in market value and/or paying out profit distributions regularly.
Most businesses end up having little to no retail value because they aren’t sitting on a large quantity of assets, a brand that has strong local value, recurring revenue contracts, or cash. The business is nothing more than a job and no one needs to take out another loan to get a job (Well, most of the time).
The challenge is that once you have a healthy business that buyers are interested in, it’s often paying you the time and money you need to live a balanced life, and you become much less interested in having to sell. It’s a business you love to run. And when you’re ready to retire, it’s usually fairly easy to find a buyer.
So my point is: Focus first on building a business that you love that runs itself and pays you in time and money. The sale will come later.
Three things to understand prior to the magical equation!
There are three numbers to understand for this equation to make sense: Revenue, Expenses and Net Profit (Or Net Income).
Revenue: The money that comes into the business. Period.
If you ran the card for $10 because someone bought a sandwich, that’s your revenue. If you run it for $1000 because someone booked a catering gig, that’s your revenue.
Expenses: All the money you spend to keep the business going.
The cost of the bread, the cheese, the meat, the lettuce, the tomato, the worker, the store, the marketing, the utilities, these are your expenses in the scenario described above.
Net Profit/Net Income: Revenue minus expenses is what’s left over and should be left in your pocket to reward you for owning the business and investing all the time and money you did to make the business work.
Net Profit is where most buyers will base their value of your company.
If the business carries loans and debt, those loans and debt will have to be paid out of the proceeds of your company and that’s where businesses tend to get underwater and they owe more debt than they could sell the business for, and of course the business is not making any real profit to use to pay off the debt because the profit is mysteriously disappearing (for how to stop this from happening, check out Mike Michalowicz’s book Profit First) so the debt never gets paid off.
Selling in the Small Business Market.
If you’re trying to sell your business in the small business market (business owner to business owner), most of the time, you’ll be able to sell the business for 5x the Net Profit.
For example, if you have revenue of $10 million and $9.95M in expenses, you end up with only $50,000 in net profit. Most of the time, you can find a buyer (and a bank willing to finance it) for $250,000.
It’s amazing how small that number got, huh? (And by the way, .5% net profit is not what I would consider a healthy company, but it’s amazing how often I’ve seen those kinds of numbers).
Now, if you have a large amount of assets (land, a building, company vehicles, an established brand that can be proven to be worth something in the marketplace even without you being involved), typically you will be able to receive 3x Net Profit plus the value of the assets.
Selling to a Private Equity Firm
Private Equity Firms are typically managing money for investors and have been charged to find and purchase small businesses with the opportunity to create massive growth. These guys typically will buy a business, shore it up and integrate it inside their systems and resources and create something that they can either take public or resell at a much higher rate.
Private Equity Firms will often pay 10x your Net Profit. Suddenly a $250,000 sale turns into a half-million dollar sale!
There is one more arena you can sell your business too and it’s the most lucrative. The Public arena.
If your business reaches the point where it can have an IPO, or catch the attention of and get picked up by a company like Facebook, your payout skyrockets. Large businesses are looking for the unicorns. The businesses that are holding patents and loyal following, that have completed research that would take the other businesses large amounts of time and resources to duplicate (or couldn’t be duplicated because the industry is saturated).
Suddenly a 5-10x ratio turns into anywhere from 15x-50x Net Profit.
Clearly, the most money waits here.
Build a business that catches the eye of a large organization. Build a business that is such an asset that the major players in your industry would rather absorb you than allow you to threaten their position as king.
The Magic Equation:
(Net Income x (Market ratio)) - debt + assets = Basic Business Value
Two last things to keep in mind…
1. The more debt you have, the less money you will have once you sell your business.
2. The more recurring revenue (things like regularly renewing contracts or long-term contracts) you have, the more your business is going to sell for.
Stephanie Scheller is a TED speaker, a two-time best-selling author and the founder of Grow Disrupt: a San Antonio based company dedicated to disrupting the way the world does business through training. In just under a decade, Stephanie has been behind the scenes with nearly 2500 small businesses. She has worked in groups and one-on-one to create total business transformation & help business owners live the life they got into business to create!