Although the net proceeds number is critical to determine what your business should sell for, it is only part of the equation. Net proceeds help establish the three financial gaps in your life. Those gaps are the solution to deciding what your business must be sold for in order to live a fulfilled life after exit.
The Three Gaps: Wealth, Profit and Value
When thinking about selling your business, timing and what it would fetch, ask yourself the following questions:
• What do I want to do after I sell? And do I have the money to do it? I.e., Wealth Gap
• What are the best-in-class businesses in my industry earning? How far is my business from that profit margin? I.e., Profit Gap
• How valuable is my business if I sold today? If I took it to market right now, would it fetch anywhere near what best in class businesses in my industry might? I.e., Value Gap
Let’s review each of the different gaps in detail.
Your wealth gap is the difference between your current wealth and the amount you need in order to live the life you want. To understand your wealth gap, you need to investigate your personal goals and ambitions outside of the business. For example, an owner who wants to own a minor league baseball team in the next phase of their life will need more funds than an owner who wants to retire and live quietly on an old farm.
Your goals, family, extended family and personal ambitions should all be considered. Once identified, you can determine your wealth gap. Your net worth outside of the business plus the value of your company today equals your goal. In other words, if your goal was $10 million and you had $2 million of assets outside of the business, your wealth gap would be $8 million.
Using this example, the next step in the process is understanding if the business today is, in fact, worth $8 million. To get to the root of this, you can start by calculating your company’s profit gap. At a very high level, a profit gap is calculated by understanding the best-in-class earnings before interest, taxes, depreciation and amortization (known as EBITDA) of businesses in the same industry. Next, assess your current EBITDA performance.
The profit gap then is calculated by understanding how you can drive toward best-in-class performance by subtracting your company’s current EBITDA performance from the best-in-class EBITDA performance. For example, if your company is currently earning $1 million in EBITDA while the best-in-class companies are generating $3 million in EBITDA, your business currently has a $2 million profit gap.
This EBITDA number is then applied to the sale price of the company. Small and lower middle-market companies sell in a range of industry multiples dictated by the private capital market. For example, upon research, a plastic manufacturing company could be selling in a range of multiples from one times the EBITDA to six times the EBITDA, with the best-in-class companies selling at the higher range.
Given the same industry research, you will be able to identify your company’s value gap. The value gap takes into consideration the best-in-class performance and applies it to your company in its current state. For example, if best-in-class companies are performing at 15% EBITDA to revenue and the current business owner’s company is performing at 10% EBITDA to revenue, the company could improve performance, even at the same level of revenue, and generate another 5% in EBITDA.
To illustrate this further, imagine a company currently generates $20 million in annual revenue. At 15% EBITDA, this company would generate $3 million in EBITDA, whereas at 10% EBITDA, the company would generate $2 million in EBITDA. Given 15% EBITDA is best-in-class performance, these companies would sell at the best multiples. In this example, if best-in-class companies are selling at six times the EBITDA, that would be an $18 million sale price. An “average” company performing at 10% EBITDA, on the other hand, would likely sell for an average multiple. Let’s assume that multiple is 3.5 times the EBITDA, which would equate to a $7 million sale price. This represents a Value Gap of $11 million between two companies with the same revenue!
Selling your business involves a lot of strategy, advisors and planning. But without considering your personal goals as well as business value, you will have a hard time determining if you and your business are ready and what your ideal sale price may be.
Founded in 2001, FocusCFO is the leading onsite fractional CFO services provider in the Midwest and Southeast. FocusCFO works closely with small to medium sized businesses helping business owners gain control over three key financial and operational areas: increasing cash flow, reducing business risk, and creating a platform for scalable growth. This allows business owners to then realize full financial control and increased value in their businesses. For more information, follow us on LinkedIn.