Valuation; a Tricky Business

Will you sell your business now that you are looking at retirement. What is your business worth? 

How much is your business worth?

If you are like many baby-boomers, it is getting close to the time when you'll need to divest from your assets to pay for retirement. It is now time to sell the business. But how much is it worth?
There are many books and articles covering different ways to value a business. Some use profit multiples. Others look at revenues. And there are those from the tech-boom years that focus on future growth.
The reality of it all is that none of these methods matter if the author is not willing to buy the business from you. How much is a valuation worth if no one would pay it? In a market, prices are set by market players willing to sell or buy an asset. Everyone else is just noise.
Let's look at Apple's stock to help us understand better. Two days ago, on January 28th at 10:30 AM, AAPL reached a per-share valuation of $513.00. Today, also at 10:30 AM, each share dropped to $498.69. In just two days, the shares dropped $14.31.

Apple Inc. Logo

The change in price was not due to earnings surprises or anything that could hurt valuation. In fact, Apple's earnings were announced on January, 27th, leaving enough time for the market to adjust.
Can an industry analyst argue that the company remains just as valuable today as it was two days ago? Yes, of course. I am even sure that the analyst would offer great reasons why the valuation should remain at the $513.00 price. But his opinion is garbage. To talk costs nothing and thus has no value. There is no way in hell that Apple is worth the $513.00 today. How do I know? Simple; because no one paid that price. No one who was willing to part from their cash was willing to do it at $513.00. And believe me, with close to 25 million shares sold, there were plenty of opportunities for someone to pay the higher price. Yet, not a single buyer did.
What's interesting is that all sellers would have preferred to sell at the higher price of two days ago. But with no willing buyers, they had to settle for the lower price. Alternatively, their other choice was to sit on the shares and not sell.
The same applies to your business. You may think that your business is worth, say, a million dollars. You may even have documented evidence of why it's worth the price. But does it mean that it's worth the million? No! Not if the highest bidder offers much less for it. This means that you too may have to select between taking a lower price or to not sell if your highest bid is lower than the million.
The problem here is that many business owners never plan an exit strategy. As a result, they usually try to sell the business when they have no more time to wait. This is why, after listing a business for sale with a broker, the owners often get tired and give up. They take home whatever inventory is left and break the lease. From one day to the next, a viable business is closed. Because of a lack of planning and the unwillingness to take a lower price, the owners run out of time and get nothing instead.

Do you have an exit strategy?

Think about it. How many people do you know who are out there looking to buy a business? How many have the money to do so? For sure, I know many people who want to start a business, but they are not thinking about buying one. In fact, most of them lack the business experience to know that brokers exist. Moreover, these aren't the kind of people who would walk into your business to ask if you would sell. So even with willing sellers, these buyer don't know where to find them. In short, there aren't enough buyers available who know where the sellers are. In technical terms, this means that the market of small businesses for sale lacks transparency and liquidity.
When it comes to buyers and sellers finding each other, selling a business is worse than the real estate market. Just the fact that a home seller is willing to advertise to everyone while the business seller isn't should clarify the reasons behind the difference.
Compare this to buying Apple stock. Within a fraction of a second, I can sell my APPL shares without any concern of who is at the other end of the transaction. There is plenty of liquidity in the Apple shares market. Furthermore, I know the exact price it is worth at any time. Pricing information is publicly available through the stock exchanges. Better yet, the price is not determined by analysts but by buyers putting out their cash. There is a high degree of transparency in this market. Clearly, selling your business lacks both, transparency and liquidity in the market. This means that selling requires adapting.

Time compensates for liquidity

What can you do? Well, first understand that allowing plenty of time is essential for a successful sale. This is the only way to compensate for the lack of market liquidity. Plan ahead. Don't leave this until your optimism for the business fades. Most people fail to plan because they think that tomorrow will be better than today. So they get their heads deep into the business. This means that the blinders only come off once they starts losing interest. By that time, doing what's necessary to get a higher valuation for the business will be impossible. It will be too late.
Remember that your goal all these years was to run the business in a way that would give you the highest standard of living rather than the highest valuation. They are not the same. In fact, many common business practices destroy valuations. Now that if this happens to you, don't worry; you are not the first.
Next, you should understand that any valuation given to you by an expert is garbage. The only valuation that you can take to the bank is that from a willing buyer with cash on hand. So, have some flexibility.
There is nothing wrong with thinking that you are the best negotiator in the world and that you will get the best deal; every business owner thinks the same. But no amount of negotiation will reliably help you sell your business if your valuation is unreasonable. If you ask me, I think that your odds would be close to those from playing the lottery. I would advise to take an alternative with a higher probability of success instead.
Think of the following:, buyers do not want to buy your business just to make you happy. Rather, real investors, the kind who would know how to find you, are interested in making money and don't care much about anything else.
To make money is not to buy and sell stuff. Many businesses buy and sell every day until they go bankrupt. High profit percentages aren't good enough either, if sales are so low that receipts do not cover costs. Even high profits in paper are useless. Most naive business owners fall under the trap of thinking that the P&L is all that matters to the business.
No! They don't want funny P&L's. Investors want positive net cash flows. Just look at what commercial banks measure when deciding on a loan for your business. Cash it's what matters. Even Warren Buffet is famous for looking at cash rather than the P&L.

When cash flows are negative

Did you know that Enron had great P&L's before they collapsed? Their whole mirage begun to unravel after short-seller Richard Grubman challenged Enron's CEO, Jeff Skilling, for the absence of a cash flow statement with their earnings during the earnings call on April 17, 2001. In paper, Enron was the most profitable company in the world. But, like a Ponzy scheme, they were running out of cash and needed to create new ways to get capital infusions to stay alive. Just like a Ponzy scheme, they eventually failed; leaving a trail of total devastation. They weren't producing any cash.
So tell me, how much is your business equipment worth if your business is not creating positive cash flows? The answer is "nothing". How much is the building worth, assuming that you own it, if there are no cash flows? Zero! Have you ever heard that many businesses are worth more broken apart than together? Well, you now know why. If your business is located in a building you own, I may advise to sell them separately. If the business produces very little cash, it will drag the value of the building down. Subsequently, a buyer looking at having to buy both may not be willing to pay the price you are asking for; which will surely make you think that the buyer is unreasonable. But in reality the opposite is true. Think of it in the following way. If a buyer seeks to get the highest return on his capital, why would he put cash into a asset that doesn't improve returns. Often, large capital outlays will reduce return on capital. This is why Dell's model is much more profitable than Apple's. Dell never had to use cash to buy a piece of inventory. Apple does.

What is your return on capital?

You see, to buy a building, the buyer will have to park a large amount of money in exchange for small savings with the hope that it will appreciate in the future. This is why businesses who keep a close eye on return on capital prefer to pass the burden of sinking lots of cash to financial institutions and opt to rent instead. This is a way to leverage other people's capital. The math is simple. If you can get higher returns on the cash you have by renting rather than buying, then rent. This is certainly the case when rapidly growing a business. It is best to put valuable cash into whatever yields the fastest turns. And buying a building achieves exactly the opposite. It turns scarce capital into slow money.
I can not stress enough the point that the way you run your business may not be what gets you the highest valuation. Things like high net cash flows, fast growth, and high returns on capital are very important when attracting serious buyers. As you can see, these three prioritize money. Your management style, on the other hand, prioritized you.
Finally, be flexible. Whenever I look for buyers, I always try to find what the buyer values more: P&L, Statements of Cash Flows or Balance Sheet. Are they seeking to show the highest difference between input and outputs? Are they in a capital intensive business or are they growing fast? Are they trying to improve their Debt Ratio? This is because a buyer may be willing to pay a higher price if it helps them improve cash. Terms are a great alternative in such cases. This brings me to asking you: which of the three is most important to you. Knowing what matters to you and to the buyer will help you both get a deal where everybody gets what they want. The message here is that you need to customize to get the best deal.
In conclusion, plan your exit as soon as possible. Do not wait a minute more. After your business earns you a comfortable living, learn the things that can get you a higher valuation. Incorporate this knowledge into your business. Give yourself time to find the best buyer. Be flexible with the price. There are ways to exchange an asset for something other than just cash-at-front. Be creative when making the deal. Good luck.

Bank loans not for start-ups

Starting up? Do you have a great idea that could be launched and transformed into a successful business? Let me guess. You need funding.
For many entrepreneurs a bank is the first place where they think to look. Unfortunately my experience has shown that even in normal times, which we are far from experiencing now, banks are quite risk adverse. Therefore, I would definitely not suggest for you to waste your time with one. Don't take me wrong. You could try as a way to learn from the experience. But doing the search with the hope of actually getting money will, in my opinion, be wasteful; especially when there are many other things that you need to get done to make your dream a reality. To understand why I am being so direct, think of loan opportunities in terms of what will you use to repay the loan.

• Past sales - You can pay a loan with the money that you already have earned. The collateral is the money already in a bank. This carries the lowest risk for banks. As a result, they love them so long as the company has a good credit record. In reality, these loans are for businesses that have already succeeded and somehow found a need for cash. No, it is not impossible. Apple and its massive balance sheet in foreign accounts needed to borrow to pay dividends in the US without incurring taxes from importing its foreign cash, for example. But since you are starting up, you have no sales and have yet to earn any money yet. You must therefore be excluded from this type. 
• Present sales - You can pay the loan when you get paid for sales that you are making right now. These could usually be Purchase Order (PO) loans or Factored orders. The collateral is the invoices being raised. In many cases, banks seek other collateral. The risk is now higher since invoices may not get paid for many reasons. Buyers could complain about the invoiced amount, the product quality, the method of delivery and many other things. Thus, many retail banks will not take on these loans, leaving you with having to seek commercial banks. Be ready, at this level, interests are not what make loans expensive. Fees can turn seemingly low interest loans into expensive monsters that will end up costing you an equivalent to 20% more in annualized interest. Here again, this may not for the typical start up. You do not even have the the inventory needed to attract the kind of buyers or the volume in business that would allow you to explore these loans.
• Future sales - In this case, you would pay the loan after monetizing or selling the inventory that you have at hand. In other words, there are no sales yet and you are trying to use the inventory as the collateral. You are now far from most bank's risk profile. The answer you will most likely hear from bankers if you ask for these loans is: "if you can't sell you inventory, what makes you think that we can?" Obviously if you had prior success selling the inventory already, you would have no need for a loan, have the cash to back up a different loan or at least have the invoices from present sales. Start up or not, you are out of luck. 
• Way-in-the-future sales - As in after I build a team and get a place to work from and get my idea turned into a great success and get CNBC to talk about it during Squawk Box. In other words, the idea and your enthusiasm, become the collateral. Good luck. The only banks that would touch these are those that issue unsecured loans: credit cards.

Now that you do not have to take my word for it. I found a great article titled How Entrepreneurs Qualify for Funding from Banks by Martin Zwilling that will surely prove helpful to you if you happen to the in the 0.1% of entrepreneurs. If nothing else, he does a great job describing the characteristics that will help you with all other sources of funds.

To me, the fact that banks are risk adverse means that they are a poor match for risk seeking entrepreneurs. Neither side is wrong; they are both just seeking different things. Banks are happy picking up pennies in front of a slow moving steam roller. Entrepreneurs want to swing for the fences even if it means striking time and time again. 

Financing is always risky; the difference lies in how risky it is. At the core of this distinction resides the separation between the patient capital that builds infrastructure and the risk-intolerant capital that rushes out of a country's financial markets at the first sign of trouble. These differences help explain why bank financing is far from normal today. The economy is flush with risk-adverse capital and lacks equity-underwriting patient capital. As a result, consumers and small businesses will have to pay large premiums for loans, if they can get loans at all. We should also expect to see many more flash crashes, where capital rushes out of the US towards other markets as was the case during the hacked AP Twitter account crash. To compound the issue, banks borrow money short-term and lend long-term. So the pervasive uncertainty about the nation's future does not help banking models. Perhaps one day in the future, when the country can find White House leadership that promotes a normal business environment while supporting entrepreneurship as opposed to punishing success, will banks begin offering real opportunities for new businesses. Until then, don't hold your breath and find other ways to fund your great ideas.

Sell your Business, Keep the Growth

Is it really possible to sell a part of your business as a way to get more from it? In short: yes.
Let business be the place where this sort of thing can happen. I can already imagine sparking protests from Wall-street-occupies everywhere about how business always wins at the expense of everybody else. Unfortunately for all proponents of an anti-business world, we are not talking about taking away from anyone. On the contrary, this is about sharing wealth with others. Let me explain.

I recently read Anna Vital's great How Funding Works – Splitting The Equity Pie With Investors article. It nicely describes the various stages of capital funding a company can go through. The article reminded me about a misconception many business owners have. Often, business owners evade the idea of one day selling their business. They think that the day they sell will be the day they quit building wealth; that selling means no more income. It is almost equivalent to becoming old and irrelevant. A real tragedy for someone who has grown accustomed to constantly finding ways to make things better. As a result, owners everywhere refuse to plan an exit strategy. And who could blame them. Who would want to become irrelevant?
Rather than seeing it as part of an exit strategy that'll allow them to take some money off the table while diversifying what they have built, their thinking leads them to believe that selling part of their business is similar to selling an asset like a car. When you sell a car, you stop getting transportation. But selling a business does not stop the benefits. Selling to the right people who will invest in the business will make it grow; making the owner's leftover shares worth much more in the end.

If you do sell, make sure that the new partners have much more fire power than you did. From access to cash, to access to professionals, to access to strategic partners and access to better customers, anything that they can bring to the table will increase the value of your diminishing share of the business.
As a result of the growth after each sale, the founder's unsold share can in fact grow to be much bigger than it was at the time of the first sale. How much bigger? Well, much, much bigger. In the case illustrated in Vital's article, the 17.6% portion of the company that the founder kept all the way to the  IPO became worth more than $450 million. Not a bad chunk of cash for an owner who originally sold half of the business for nothing.

Launch Funders & Founders

From zero, his share of the business turned into $12K, then $310K, then $760K and finally $450 million; all while it went down from 100%, to 50%, to 37.5%, to 31.2%, and finally to 17.6%. Clearly, it is much better to sell to the right buyers to give the business a better chance to rapidly grow. Remember the Walton's? Sam Walton's family members are many times wealthier now than before taking Walmart public in 1970 at $16.50 per share. Forbes has Christy Walton pegged at $28.2 billion, Jim Walton at $26.7 billion, Alice Walton at $26.3 billion and Robson Walton at $26.1 billion, for a total of $107.3 billion for their inherited share of a company selling half a trillion dollars in stuff. In 1985, Sam Walton's 20% share of Walmart was worth just $2.8 billion in comparison.
I strongly believe that this tendency to take advantage of what equity markets offer represents a clear advantage for American company owners over their European counterparts. Europeans usually keep their business ownership for much longer than Americans. Case in point, giant furniture retailer IKEA continues to be privately held. Ingvar Kamprad, its founder, has a 100% stake in the company that in 2011 was estimated at $23 billion by Forbes. Because it is impossible to test the counter-factual, we can not argue that Kamprad's shares would be worth more if his company was publicly traded. But what we can surely prove is how people like Microsoft's Bill Gates and Facebook's Mark Zuckerberg are worth a gazillionth each despite having sold most of their businesses. Zuckerberg's share is estimated at $13.3 billion by Forbes after selling 71% of Facebook. Gates' is estimated at $67 billion after selling a whopping 95% of Microsoft.

I will leave you with at least the curiosity to explore a partial capitalization of your business. It can be done to help bring in new skills and energy to the company's management while infusing needed growth capital. It should help you safeguard part of what you have built while allowing the remaining part to grow much larger. A partial sale of your business does not need to be the end. On the contrary, it may be when you start building "real" wealth for your family.