Understand what drives value in the eyes of a buyer
By Andres Kirtley, Owner, Allusions, Cinncinati, Ohio
Perhaps the simplest approach to positioning your business for sale is understanding the question, “What is the value of my business?” Sure, the value will eventually be represented by a dollar amount, but the dollar amount is a monetary reflection of the value, not the value itself. As such, the next owner of your business will be buying the value that the business will bring to them.
The No. 1 question in every potential buyer’s mind will be some version of, “To what extent is the opportunity in this business greater than the risks?” This question goes beyond the financial risks and opportunities and includes things such as lifestyle, stress, threats, meaning and purpose, longevity, fun, growth, stability, and so on. This fundamental question will be asked of you in several different ways so it is important to think about how you’d like to be able to answer these questions when the time comes.
What is the owner’s total financial benefit you enjoy annually? Seller’s discretionary earnings or SDE?
Most larger businesses that earn over $1 million in profit or $10 million in revenue will be valued by a multiple of EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) If your business falls in this category, congratulations. Private equity firms will be lined up trying to buy ASAP. But if you are like most small businesses, you do not meet that threshold and will be valued by a multiple of your total financial benefit. This is often referred to as SDE (Seller’s Discretionary Earnings) or ACF (Adjusted Cash Flow) or ODI (Owners’ Discretionary Income.)
SDE is not visible on a P&L, balance sheet, or tax return because it includes amounts that are normally included in cash and non-cash expenses in addition to the net operating income of the business. For example:
▶ One-time expenses
▶ Owner’s W2 salary
▶ Charitable contributions
▶ Owners’ health care and retirement contributions
▶ Salary and exorbitant wages and payments to family members
You will need to know your SDE for the past three to preferably five years. There is a lot of information available for free online that will help you calculate SDE. Most of your CPAs will be able to help you calculate this number as well. A business broker would also guide you through this process, but that’s an issue for another article.
Ultimately, SDE answers the buyer’s most fundamental question, “What is the total dollar amount that is available to me annually once I own the business? Or in other words, “What is the true profit?” Once you have three to five years of defensible SDE, you can begin to home in on the multiple that will be applied to the SDE for the sale price. As a rule, the larger the SDE, the larger the multiple. Also, a consistent annual SDE with consistent year-over-year growth can increase the value.
During my due diligence process, I learned that the average small business in the U.S. sells for 2.2-times SDE. Salon Business Boss said in that 2019 the average multiple for hair businesses was 2.14-times SDE. After exhaustive research and the business appraisal of my own business, I can confidently say that most hair replacement businesses will be valued between two and three times SDE.
Next, let’s understand some of the questions and factors that will influence the valuation multiple.
Why are you selling?
Getting clear on why you want out of our business will be one of the most important things to convey to a prospective buyer. It is important to be honest in everything you convey to a prospective buyer.
The biggest fear of any buyer is that you are wanting out because of a significant problem or problems and you are hiding that from the buyer. Yes, negative aspects of your business may lower the multiple, but being caught in dishonesty with even the little details will plant the suspicion that you are willing to hide something larger of which the buyer is unaware. This scenario will raise the perceived risk of acquiring your business, which will lower the offer or cause the buyer to walk away.
Honesty is the best policy. Share the things you hate about the business and be fair in your perceived Strengths, Weakness, Opportunities, and Threats. While this may seem counterintuitive, the right buyer will be well-poised to deal with the good and the bad. For example, the previous owners of Allusions hated doing payroll, which was a laborious, tedious, and time-consuming manual task for them. I saw this as an opportunity to implement technology to streamline this process. Also, like many owners, they had tired of dealing with the complexities of the human nature of employees. I saw that as an opportunity because I have been well-trained and am passionate about servant leadership and find navigating human complexities fascinating and rewarding. The bottom line is that you want the buyer to know the good, bad, and ugly so both parties can evaluate if this is the right fit and the business can thrive under new ownership.
What are you going to do with the proceeds of the sale?
This question may seem odd but the reason for you to think about this is that the question of seller financing will come up at some point. If you think you are going to invest the proceeds after the sale in the stock market, consider seller financing as an investment. Why would you invest in other businesses but not the one business in the world you know the most about? Also, one of the best ways to get a better valuation is to be flexible with the payment terms. Some call this the law of price and terms. For example, a buyer may be willing to go to a higher multiple if you carry some of the note with a longer amortization. Seller financing offers great leverage to increase the perceived value because it shows your confidence in your business’s future performance. Are you willing to put your money where your mouth is?
What are you selling? A job or a business?
This is one question that will have one of the largest impacts on the multiple you can expect, the type of buyer, and the number of potential buyers.
If you are behind the chair as a technician, involved in consultations and the day-to-day operations of the business, for example, you are selling your job. The more critical you are to the business the more risk your departure is to the new owner. If you are the most valuable employee, you are the product, not the business.
Perhaps the best illustration of this concept of working on rather than in your business is Michael Gerbers book “The E Myth.” It is a classic must-read for any business owner.
For example, a two-employee hair replacement business with the owner doing consults, payroll, marketing, hair replacement, and answering the phones with an SDE of $200,000 is likely to be valued between 1.2- to 1.8-times multiple ($240,000-$360,000). Contrast that to a 15-employee business where the owner has professional management, sales, marketing, financial management, and technical execution in place, and mainly spends limited time on strategic initiatives with little time involvement and $800,000 in SDE may be valued at 2.8- to 3.2-times ($2.24 million to $2.56 million.) The former is self-employment while the latter is a business, and this reality will be reflected in the multiple.
Think about it. If you are the secret sauce, how can the business continue to be successful if that “secret sauce” is gone? Therefore, the more involved and critical to the success of your business you are, the less valuable it is. Could you go away for six months and return to find your business in the same or better condition than before you left? If not, the reasons why are your greatest opportunity to build value in your business.
After the sale, what’s your business’s likelihood of success?
The real business is not the product or service you offer but the systems and processes that generate the product or service. My grandmother was an excellent cook. She never used a recipe and the food always turned out wonderful. When she passed away, so did her amazing cooking. Even though all the same ingredients still can be easily purchased, we cannot replicate what she did because so much of it was in her head and heart. Most businesses are the same. So much of your business’s success lies in the head and heart of the business owners or other key employees. This is why it is important to have the recipes of your business clearly established and organized.
▶ Business systems – Operational Systems – Standard Operating Procedures (SOPs) – Flywheels
▶ Training protocols and manuals
▶ Monthly reoccurring contractual revenue (Program Hair)
▶ Sales processes
▶ Cross-functional training
▶ Marketing plans
▶ Advertising tactics
▶ Vendor relations
▶ Established Key Performance Metrics (KPIs) and scorecards
These are a few examples of business recipes. The more clear, robust, accurate, and replicable the recipes, the more sustainable the results, which lower the risk and increase the value.
The full scope of all of the intricacies in valuing a business cannot be fully captured in one article. These questions, however, are a few of the considerations you can begin to think about to set yourself up for a successful exit while ensuring the continued success of your business, employees, clients, and dream. The Chinese proverb says that the best time to plant a tree was 20 years ago. The second-best time is now. The best time to position and prepare your business for sale was 20 years ago. The second-best time is now.
ABOUT THE AUTHOR: Despite having a successful and lucrative career in the medical and biotech industry, Andreas Kirtley was ready for a radical career change. After exploring real-estate investing, franchising, starting a business, and many other options, he, like many other millennials, found that acquiring an established successful business was the perfect fit for him. In July 2019, the right opportunity came his way and he acquired Allusions Hair Replacement Studio in Cincinnati, Ohio, from a retiring owner.