Business owners invest significant amounts of energy, time, and finances in building profitable businesses. The primary objective of creating a business, besides generating income, should be to develop an asset with realisable value at a convenient time. The value of a business hinges on its ability to operate independently, without being dependent on the skills or knowledge of any one individual. This poses a challenge for many business owners who construct their businesses around their own abilities or personalities. However, it is a fact that businesses reliant on the expertise, personality traits, contacts, or specialities of one or two individuals hold minimal worth in the marketplace. Although it may be gratifying to know that the business cannot run without them, it restricts the owner’s ability to take breaks or extended absences from the business. A business that operates independently of the owner allows them to explore other interests while also ensuring that the business they have worked hard to build holds considerable value for themselves and their family.
This paper will explore ways to maximise the value of a business, as well as the creation of a succession plan for transferring or selling the business.
HOW TO MAXIMISE THE VALUE OF YOUR BUSINESS
1. Make a profit!
In order to guarantee that a business holds value, it must be profitable. The profitability of a business is determined by whether it generates a profit after compensating the working owners with a commercial salary that reflects their skills and efforts.
2. Generate a return on the investment
In addition to being profitable, a business should also generate a return on the owner's investment to compensate for the risk associated with the provided capital. A prospective buyer is looking for a reasonable return on investment, and therefore, if a business is valued at $500,000 and only returns $25,000 annually (i.e. 5%), it may not be attractive to investors. Investors can obtain this level of return or better on a commercial property (around 8%-12%) or cash in a bank account. Professional business advisors generally recommend not investing in any business that provides a return of less than 20% to 25% per year. Return on investment is also referred to as multiple earnings, which indicates the number of years it would take to recover the initial investment amount. For instance, if the business owner paid $1,000,000 and earned a rate of return of $250,000 per year, the multiple earnings would be 4 (indicating the number of years to recover the initial investment). Well-performing small businesses have multiple earnings of three to four years, and anything above this indicates that the business may be overpriced. Therefore, to maximise a business's value, it is essential to generate a high return on investment.
3. The business should not be reliant on a few large customers
While there is a certain amount of risk involved in being in business, a good business should not be heavily reliant on a small number of significant customers. A valuable business is characterised by having many customers, each contributing a small portion of sales. If a business has significant relationships with one or two large customers, it becomes vulnerable to significant declines in sales if it loses one or both of them.
4. The business should not be dependent on the owner’s relationships with customers
Customer relationships should be established with the business, rather than with the owner or any specific person within the business. If customers only interact with the owner, the business may be adversely affected if the owner leaves. If these customers switch to a competitor after the owner's departure, the business's value may be significantly reduced.
5. The business should not be dependent on one major supplier
Similar to customer relationships, businesses that rely on a single major supplier (with no alternatives) are also at risk if that relationship is damaged or terminated. This risk significantly reduces the business's value in the marketplace.
6. The business should not only have ‘fad’ products or services
Businesses that solely rely on the fickle tastes or preferences of a particular market tend to have questionable value. It is crucial to ensure that a business can introduce new products or services in response to the constantly changing market.
7. The business should have good systems in place
The most valuable businesses are those that operate consistently. To achieve this level of consistency, it is imperative to document all business processes and meticulously test these systems to ensure they function properly and are followed. A policies and procedures manual should be in place to outline the following aspects of the business:
- Operations policies and procedures
- Marketing systems
- Sales systems
- Accounting and financial management systems
- Terms of trade policies and their administration
- Human resources policies and procedures
- Technology systems
Each team member should possess a comprehensive understanding of these systems, or at the very least, those that are relevant to their respective roles. Furthermore, these systems should be regularly tested and enhanced on an ongoing basis, and specific individuals should be assigned responsibility for particular systems to ensure their effectiveness.
8. The business should have consistent results
When attempting to determine the value of a business, advisors typically request the last three years' financial statements (at a minimum). Businesses with high value exhibit consistent, favourable outcomes. If a business achieves favourable results in one year and poor results the next, it is essential to analyse the reasons for this disparity and develop a well-structured plan and systems to attain consistency. A track record of consistent and stable growth is much more appealing to prospective buyers.
Due Diligence
When a potential buyer expresses an interest in purchasing a business, they usually assign their advisor to conduct a "due diligence" report on the business. Due diligence involves scrutinising the financial and other records to confirm the accuracy of the information presented about the business. A thorough advisor will examine all aspects of the business, evaluate its performance, and identify the risks associated with ownership. Neglecting deficiencies in any area of the business is ill-advised, as they can have significant implications for the business's value and appeal in the marketplace. Conversely, addressing all deficiencies can maximise the business's value and attractiveness to prospective buyers.
Succession Planning
One of the most challenging aspects of being a business owner is to detach oneself from the business. However, it is crucial to bear in mind that to establish 'a business' instead of a job, the ability to do so is paramount. Along with having a plan to maximise the business's value, all business owners should have a succession plan in place to facilitate their exit from the business when the time arises. A succession plan involves having a plan for the 'disposal' of the business. For instance, will it be sold or transferred to family members? If the decision is to sell, when will it be sold? What value do you expect it to hold, and how will that value be ensured on the intended date? In the case of transferring ownership to family members, to whom will you transfer ownership, and what expectations do you have in return? Is it a reasonable representation of the business's value? What if the family members do not want to take over the business? What options are available in that situation?
Here are several essential factors to consider when devising a succession plan for your business:
- Avoid making the business solely dependent on your skills. Instead, hire capable team members, invest in their continuous development and advancement, and delegate tasks to them. Encourage their participation in the management of the business and promote a sense of ‘ownership.’ These individuals are the potential future buyers of your enterprise, and fostering ownership will facilitate a smoother transition when the time for sale arrives. Most thriving businesses promote senior management from within to maintain the continuity of the organisation’s values and vision. Offer innovative remuneration packages, such as profit sharing and/or other financial incentives, to retain these key individuals. Refrain from recruiting a General Manager from outside the business, as it is often a costly and high-risk strategy that frequently fails without well-documented systems in place.
- Enhance the profile of the business rather than your personal profile. Companies built on the skills, profile, or notoriety of a single individual are complex and sometimes impossible to sell.
- Determine the desired value of your business. Obtain an independent valuation to establish its current worth, and consult an experienced external advisor on how to attain the desired value by your planned sale date.
- Formulate a retirement strategy by focusing on the desired outcome. Consider when you wish to sell and retire, and identify how the business must operate at that juncture to allow you to disengage. Utilise a structured Business Action Plan to document specific tasks, deadlines, and personnel responsibilities. Begin implementing your plan immediately. Keep in mind that a critical aspect of business ownership is building valuable assets for your future. If you believe that your business is unique in the market and relies solely on your skills, you do not have a business, but rather, as Michael Gerber states in The E-Myth, ‘you’ve bought yourself a job.’ Reflect on how to enhance the value of your business and develop a succession plan to create future wealth.
CONTACT US
WOULD YOU LIKE TO LEARN MORE?
IMPORTANT NOTICE
Information contained in this document constitutes general comments only for the purposes of education, and is not intended to constitute or convey specific advice. Clients should not act solely on the basis of the material contained in this document. Also, be aware that changes in relevant legislation may occur following publication of this document. Therefore, we recommend that formal advice be obtained before taking any action on matters covered by this document. This document is issued as a guide for clients only, and for their private information. Therefore, it should be regarded as confidential, and should not be made available to any other person without our prior written approval.