Whether it’s an employee of one of the many technology companies we have in Portland, a retiree, or an entrepreneur, they all want an answer to the same question: am I on track to achieve my financial goals? And like any goal, answering the question requires knowing both the objective and the starting point. What do you want to accomplish and what are the resources we have to work with?
In financial terms, this means quantifying how much money you need to support your desired lifestyle and quantifying your current resources.
For employees and retirees, quantifying the existing resources is pretty straightforward: collect statements for each individual account and tally up the total. Or better yet, look online and get the balances as of the last minute.
But for business owners, many times their biggest asset is a privately-held, illiquid asset—one where the price can’t be tracked from minute to minute like a 401(k) or brokerage account. However, it’s obviously still a critical factor in answering the question of am I on track for a business owner.
Because of this, related to the am I on track question, we often get two additional questions from business owners like: What’s my business worth? And how do I model my business in a financial plan?
In this post, we are going to look at a few ways to value a business and then some steps to think about to increase the valuation. In a later post, we’ll pick up with some thoughts on how to model an illiquid asset in a financial plan.
How to value a business
When it comes to valuing a business, there are three main approaches: the value to the assets, the value of the cash flow, or the value of a comparable company.
- Value of assets – If you operate in an industry that requires significant assets to run or if you plan on closing your doors tomorrow and selling the assets of the business, this might be the valuation method used. It’s less of an ongoing value of operating the firm and more of a one-time value today. In personal financial terms, it would be the amount of cash you have in the bank today versus the sum total of your future earning power. The assets included could be any equipment, facilities, real estate, or cash held in the business which would be totaled before being netted against any liabilities.
- Discounted cash flow – Under this approach, the cash generated by the business is calculated and then, depending on growth assumptions, projected into the future. A reasonable discount rate (think a rate of return adjusted for the risk of the business) would then be applied to arrive at a valuation today. One key factor here to consider here is that the cash flow should include a market rate salary for someone operating the business (even if you don’t pay that to yourself). Think of it as Revenue – Expenses (including salary but less personal expenses) = Cash Flow
- Comparable approach – Under this approach, a valuation would be reached based on other similar businesses that have sold. Typically, the valuation is expressed as a multiple or some financial metrics such as 2 times revenue to 5 times net profit. However, it could vary widely by industry based on the most critical metrics for the business.
Now that we’ve looked at a few ways to value the business, we will quickly look at a few ways to increase the value.
How to increase the value of your business
We mentioned above the notion of a ‘reasonable discount rate’, which is a sensible return adjusted for risk. Essentially, this means the higher the risk of an investment or business, the higher the discount rate and therefore, the lower the value today. Makes sense: the riskier the company, the less you should be willing to pay for it.
However, this creates an opportunity: lower the risk and increase the value. Here are some ways to decrease the risk in your business and therefore, increase its value.
- Increase Recurring Revenue – Obviously, a business with recurring revenue versus one that starts at zero each January is less risky (all else held equal). Is there a way to build in recurring revenue to your business model?
- Build Your Team – Would your business survive without you? If not, you might have yourself a well-paying job but not a company you could sell. On the flip side, a business with a well-trained and competent team in place will be less risky and therefore, much more attractive and valuable to someone looking to buy the business.
- Decrease Revenue Concentration – What percentage of your revenue comes from your top 1, 10, and 20 percent of your customers or clients? The more concentrated, the more risk the business has in these few valuable relationships.
- Don’t Defer Maintenance – One way to keep profit margin high is to ignore or postpone needed investments into the business. This could be obvious as neglected maintenance of the machines required to operate or as subtle as not investing in your people, which would also affect #2 above. Any prospective buyer will factor in the expense of the deferred maintenance to the offer and therefore, lower the value of your business.
For business owners, your largest asset, the one that may determine if you are on track, may also be the most difficult one to value and require the most work. However, it’s also likely to be the most significant opportunity to move the needle and accelerate progress toward your financial goals.
If you’re interested in more, last month, we created a business owner wealth assessment. You can download the assessment here.
At Cordant, we have the opportunity to work with busy business owners to help them achieve financial clarity in life. Part of this responsibility includes doing this type of assessment on their behalf and pushing progress forward in the critical areas. If this is something that you’d like help with, please get in touch.