Bob Walton had been ready for several years to sell his company and retire, but he felt that the proceeds from the sale would not provide the funds needed to achieve his financial goals.
His company was in an industry where businesses typically sold for their net asset value and Bob used this value in determining the timing was not right. So Bob continued to work in the business well past the point where he found it either fulfilling or energizing. In doing so, Bob made the common ownership mistake of working after the fun and challenge are gone on the assumption that his business could not be sold for sufficient value.
Because Bob failed to engage a valuation professional to determine the value of the business, he also failed to realize that the business could have been sold for significantly more than the industry “rule of thumb” had indicated. An industry “rule of thumb” is a mathematical formula developed from the relationship between price and certain variables based on experience, observation, hearsay or a combination of these. While these measures may be useful in testing the reasonableness of a valuation conclusion, they typically should not be used as the sole valuation methodology.
Bob’s mistake was a common one among business owners: He had failed to put a plan in place to exit his business.
Exit planning is the preparation for the exit of an entrepreneur from his company to maximize the enterprise value of the company in a mergers and acquisitions transaction and thus shareholder value, although other nonfinancial objectives may be pursued, including the transfer of company leadership to the next generation; a sale to employees or management; or some other altruistic, non-financial objective. Exit planning differs from succession planning in that the latter is a sub-component of exit planning and refers to the hiring, training and retention of a successor president/CEO of the company in a planned manner. Succession planning is but one of the many considerations when conducting exit planning. Company owners commonly do not see their company from the standpoint of a potential buyer, thus they ignore the strategic management of the company.
Part of the exit planning process involves determining the value of the business and using this information as a strategic asset in the operations of the business. By developing an understanding of the variables that drive the value of the company, owners can maximize the potential value. It can also help to establish whether the owner’s financial objectives can be met by a sale or some other transfer of the company.
While Bob used an industry “rule of thumb,” the proper approach would have been to obtain a formal valuation of the company. Business valuations should be performed by a qualified business appraiser who possesses specialized certifications in valuation such as the Accredited in Business Valuation (ABV) certification awarded by the American Institute of Certified Public Accountants or the Accredited Senior Appraiser (ASA) certification offered by the American Society of Appraisers.
Due to the fact that there is no secondary market for closely held business interests, appraisers must turn to other methodologies to approximate the value. Generally, there are three approaches used in preparing the valuation analysis: the income approach, the market approach and the asset approach. Valuing a business may involve one or more of these approaches. For example, the appraiser may use the income approach to appraise the value of business operations and then use the market approach as a “reality check” to test the value conclusion.
The income-based approach estimates the value of the business based on the present value of expected future cash flows or operating income. It is probably the most widely recognized and utilized approach to valuing an entity.
The idea behind the market approach is that the value of a business can be determined by reference to “reasonably comparable guideline companies” (sometimes called “comparables” or “comps”) for which values are known. The values may be known because these companies are publicly traded or because they were recently sold and the terms of the transactions were disclosed. The challenge with this approach is to find transactions for companies that are truly comparable. Consideration must be given to the comparability of the industry, the size of the company, location and other relevant factors.