Understanding Business Value is the First Step to Exit Planning
One of the reasons that 83 percent of exit strategies fail is that owners have unrealistic expectations of the true value of their business. Over the years, I’ve come to realize that this error is caused by a number of factors. Let’s talk about some of them. By the way, this blog is taken right out of my book - Maximize Business Value, Begin with the Exit in Mind. Here is the link to get a copy of it or scroll up to see it right on our website's menu.
First and foremost, there is precious little data regarding transaction statistics, particularly as it relates to non-publicly traded companies. The only real news that people can find on a regular basis is from large publicly-traded company acquisitions, or some disruptive technology company sale, or investments made in “unicorns.” A unicorn, of course, is what the investment world calls a private company, typically a startup, that has a valuation north of one billion dollars.
I won’t get into my opinions regarding unicorns. Purely based on my definition above, these unicorns are able to attract investors at their valuation so it would appear that the valuation is valid—at least to the people writing those checks. Those valuations are wildly inflated compared to any other reasonable valuation method. Therefore, due to the publicity surrounding them, people are left to draw their own conclusions about this valuation being the norm.
Of course, if a company has some wildly disruptive technology or business model—think of companies like Airbnb, Uber, or Tesla—no rules regarding valuations really apply. Again, because of the massive press around these types of companies, the average person is driven to think that these valuations are the norm for all businesses, rather than the exception.
Next, The Retirement Requirement
One of my favorite valuation methods is the “what I need to retire” method. Don’t laugh. I did the first time I heard this requirement years ago, but it’s really more common than you think.
Several years ago, I was leading a massive rollup in the retail technology space. My team was buying companies at a pretty healthy clip. We used a clearly defined, proprietary valuation method that made it very easy for us to make an offer and cut right to the chase regarding whether a seller was serious or not. We typically wound up purchasing about one in ten of the companies with which we talked. For most companies, we never got to an initial offer, but for the ones we did, it certainly led to some interesting conversations. One, in particular, stands out.
We were looking at a software company that would have been a great tuck-in. These transactions are also called a bolt-on, which is an acquisition that adds value and can be rolled into an existing business. It had about $900 thousand in revenue and had been losing money for several years. Based on our valuation model, we could get somewhere between $750 thousand and $1 million for our initial offer, not bad for a company that had been bleeding red ink for a long time.
When I tossed that offer to the owner, his response was that the company was worth about $4 million. At this point, I started probing about how he came up with that valuation hoping that we could find some common ground, and his response was classic. “Well, that’s what I need to retire.”
On the inside, I was screaming “REALLY? That’s your valuation method?” But what I said was “Well, most buyers are not particularly altruistic in their valuation methods. But if that’s what you need, give me another thirty minutes and I’ll tell you how to get there. If you follow my advice, you’ll be worth that much in two or three years, and I’d be happy to pay that price, or even more if you achieve the results.”
I then proceeded to outline the changes that needed to be made in his business, and before we hung up, we agreed that he would reach out in a year with a progress report. So, what happened when he called? Sorry, that’s a trick question. Of course, he didn’t call. He was too busy living his lifestyle business to make the necessary improvements to get his valuation. Last I heard, his revenue had dwindled even further, and the company may have ultimately folded. It’s a shame, really. I was hoping he’d turn it around and sell it to me.
How About The X Factor
Another fun and common valuation method I hear on a regular basis is the “We’ve invested X dollars, and so we need at least that to sell the business.” Now, if you’re genuinely a unicorn with some disruptive technology, that requirement might be a valid valuation method. Then again, if you genuinely have a disruptive technology, you’re probably not looking to sell the business for merely what you’ve invested.