Three Misconceptions about Exit StrategiesChia-Li Chien
Chia-Li Chien, PhD, CFP®, PMP® Nov. 10, 2018
I often ask two questions of business owners and their employees during my speaking engagements.
- How long can a human being survive with water but no food?
- How long can a human being hold his or her breath without going brain dead?
I love food, and I can’t skip one meal ever. The typical answer I get for food often ranges between 10 and 30 days. And for oxygen, the range is often between 2 and 10 minutes. Why do food and oxygen have anything to do with finance or exit?
You see, in the business world, net income from the profit and loss (P&L) statement is one of the key indicators of how well the business is doing. The net income or profit represents the food in a business entity. Equally important is the cash flow statement because cash flow is like oxygen in a business. For example, John, who is in a service industry for twenty years, is proud of his success in business with 20% net profit. But when I asked him how much cash flow his company has, John indicates that he is not sure. Upon reviewing his financial statements, his cash flow was nearly zero. John’s business enjoys plenty of food (20% profit) but potentially could choke to death (cash flow near zero) before he can eat the food.
In succession planning or when considering an exit, it is imperative that an owner understand what his or her business equity value is. Business value could be subjective for many reasons. For the most part, the business value is often driven by what’s in the financial statements. EBITDA is one of the key components of determining a business value from the financial statement. EBITDA comes from the P&L statement; the acronym stands for Earnings Before Interest, Taxes, Depreciation and Amortization. EBITDA is closest to cash but not cash. EBITDA is not a line item on the P&L, and often needs to be calculated based on the P&L line items. In reality, we often determining value of the business by using recast EBITDA. Recast EBITDA removes one-time expenses such as excess expenses, excess owner’s compensation, etc.
But when preparing for the succession, I often see three misconceptions from owners about business value.
Misconception #1: Revenue drives the business value. To increase recast EBITDA, I agree that increasing revenue is one of the value driver activities. However, owners must also closely monitor ways to lower the cost of goods sold as well as control the operating expenses to increase the recast EBITDA.
Misconception #2: Pay attention to only the biggest customers. Your largest customers are important; however, diversifying them is as important as servicing them. If one customer comprises more than 25% of your overall revenue, that is too much risk for any buyer or lender to take. Ultimately, a highly concentrated customer base will reduce the value of a business.
Misconception #3: Invest with the industry trend. The hottest gadgets may not be the best investment options for the business. It is critical for owners to invest in positive net present value (NPV) or economic value added (EVA) projects. I will talk about the investment in the business in a separate article.
Well-balanced food and oxygen in your business ultimately yields higher business equity value.
Chien, C.L. (2017). Advising Privately Business Owners Industry Specific Selling Factors. Nashville, TN: 2017 Academy of Financial Services.
Chien, C. (2017). Selling a Planning Practice: The Relationship Between Revenue Multiple and Revenue Size. Journal of Financial Planning, 30(3), 52-61.
Chien, C. (2014). Actions that Affect Business Value. Value Growth Institute. Retrieve from: https://vgi168.com/wp-content/uploads/2020/06/vgivgoal.pdf