A good way to look at your business is as an investment. By this I mean it produces an income for as long as you own it (the dividend) and you want to maximise the proceeds when you eventually sell it. No different to a portfolio of shares really except you have all of your eggs in one highly specialised and personalised basket.
As with most investments the income from the investment is often overlooked as the much bigger number is the sale proceeds. However, for many the sale proceeds are simply the value of the assets held in the business that has not yet been distributed, i.e. net asset value. The income the business generates on a monthly basis is far more important than the ultimate sale value for most private business owners. As accountants we would generally advise clients to hold cash and key business assets outside the trading company simply to remove them from the business risk. This means that the only assets held in the company at sale are working capital as everything else of value has already been removed.
In this instance the main business value is goodwill. That is the premium that a buyer will pay over net asset value for the business. This is usually stated as a multiple of profits and tends to be much lower than quoted company multiples for most owner managed business. The reason for this is that most owner managed companies do not manage to create the characteristics that buyers are willing to pay a high multiple for.These are things like:
- Visibility of earnings. That is contracted future cash flows that the buyer knows will be coming in.
- An experienced management team that can run the business once the business owner has left.
- Clear systems and processes that are documented and understood by all employees so that the business runs like clockwork (McDonalds were held out by Michael Gerber in his book The E Myth as the ultimate way to run a business)
- A customer and supplier base that is not dependent upon the business owner and will not lose faith or look elsewhere once that person leaves
The reality is that many owner managed businesses struggle to obtain any significant multiple of profits on sale and actually settle for net asset value once assets have been revalued (usually downwards) on sale. The reasons are that they do not meet at least one of the criteria above, usually the one on creating a business that really has value once they have left.
But all is not lost, indeed for many business owners the true business value is the income from the business rather than the sale proceeds on sale. It makes eminent sense to maximise profits and tax efficient profit extraction each year and to put that cash in some other tax efficient investment that is not related to the company. The reasons for this policy are it:
- minimises risk by generating profits that are extracted on an annual basis
- provides income today rather than the hope that the big sale will be as big as expected, you may not even live that long!
- enhances profits which can only come about by running the business well
- takes away the risk that the economy takes a downturn, that banks will not lend, that businesses are all cutting costs and not looking to invest because they can’t borrow, that the only buyers don’t need to pay that much. A bit like now really.
- takes away the need to sell the business for a high multiple as you have made your money from high earnings each year that have been invested wisely and outside the business risk.
- enhances the chances that you are able to meet the criteria noted above as you have more money to invest in preparing the business for sale as you are by now financially independent.
The real secret to successful business exit is to plan for it. Don’t wait to the age of 60 or 65 to start that planning process. The ideal time to start planning is around your mid 40s, some would say you should start exit planning the day after you start your business. It’s never too early!
Andy Parker
Chartered Accountant, Birmingham