“Your key people are all going to retire when you sell the business? Who the heck is going to know how to run the business?????” This is not a conversation that you want to be having as a buyer or seller.
If you are trying to buy or sell a business, you know that the key people who make the business run can be an important part of the value of the business. For most small businesses the value of the company goes home every night and you hope it comes back the next morning. Of course, now the employees may just work from home and not come in but the concept is the same — employees are a huge part of a business intangible value. As a seller, your business has more value if your quality staff is staying after you leave. Your business cannot function without knowledgeable management and trained competent staff that are reliable. Here are 4 ways key people fit into business valuation.
Employees are part of the valuation.
Businesses are people applying processes to make profits. Looking at the basic market method business valuation equation, Cash Flow x Risk = Value, employees impact BOTH sides of the equation. On the one side, employees drive the processes that create cash flow. On the other, the risk of loss of the institutional knowledge that is in your employees heads is a huge factor in the risk component of value.
Employees create value.
Few small businesses make money based on their hard or fixed assets. Yes, you need those assets, but ask most clients why they use a certain business and you will hear, “We use this business because they provide great service.” Great service comes from good people. The price may count, but quality includes the quality of the service your people provide.
Employees are related to growth.
In addition to quality management, more focus is currently being given to mechanics and trained technical staff. The ability to find and keep new trained or even trainable personnel is one of the biggest growth limitations.
People are your value.
While many owners can’t imagine it, the business is not the owner. In fact, in order to have value a business must be able to operate without the owner. Therefore you must keep your people. In a recent post, I explored how you can create value through your employees (which is something you need to do long before you begin selling your business).
When we evaluate businesses, especially for tax and gift purposes, employees represent the single most important factor when calculating a business’s intangible value. This is value that you want to keep for yourself as your business grows or a value you want to include for future partners in or owners of the business.
Contact me today to learn more about business valuation and what your company is worth.
By Greg Caruso, JD, CPA, CVA, The Art of Business Valuation, Harvest Business, LCC.
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The following are quotes related to small business valuation, business owner succession or exit planning, business brokerage, SBA and more from “The Art of Business Valuation, Accurately Valuing a Small Business,” by Gregory R. Caruso, published by Wiley, 2020, ISBN: 978-1-119-60599-7
You are authorized to use these quotes by providing the following reference to the book, Caruso, Gregory, “The Art of Business Valuation, Accurately Valuing a Small Business”, 2020 Wiley, along with the page number. If there is not a page number, then it is just a quote of the author, Greg Caruso. If possible referencing this website www.theartofbusinessvaluation.com is always appreciated.
Micro and Small Business Valuation in the age of Covid-19
“Small business is under unbelievable stress from Covid-19 related economic issues varying from shut-downs to product shortages. Business valuation is based on future cash flows of the business. Micro and small businesses have a difficult time projecting cash flows in stable times which has become greatly magnified in the current environment. Yet outside a few “loser” industries and locations good businesses and good business people will preserver and create business value. As business valuators our job is to apply valuation basics along with professional judgment to properly assess business value and assist owners in growing that value particularly in times of uncertainty” Gregory Caruso, Author, “The Art of Business Valuation, Accurately Valuing a Small Business,” Wiley 2020
“How does one equate a large number of deaths, 10%+ unemployment, and a soaring stock market (at least as of August, 2020) when trying to predict the future cash flows of a small local business?” Yet this is what business valuation analysts do. The reliance on basic valuation principals augmented with professional judgement is how we value micro and small businesses in this environment. After all, business people will continue to need business valuations to buy, sell, get divorced, obtain loans etc. even in these uncertain times. Gregory Caruso, Author, “The Art of Business Valuation, Accurately Valuing a Small Business,” Wiley 2020
What creates errors in business valuation?
“Most major errors in business valuation are the result of missing facts or patterns and misinterpreting those facts or patterns, not from the improper application of the model. For instance, failing to factor in falling fuel prices into a bus company valuation that results in a very high valuation. P.26
Why is it hard to prepare a business valuation for Main Street, micro, and very small businesses?
“Small and very small businesses are just not very good at data collection, much less providing it to third parties. Most small business owners manage by walking around. In addition, the best owners have a few indicators that tell them where they stand; perhaps incoming orders and cash balance; perhaps today’s cost of goods. They have their one or two simple indicators and a feel for the business. This way owner/operators can run great businesses and keep overhead down. While this limits long-term growth, it creates significant overhead efficiencies. Consequentially, this lack of data makes economic and business sense.” P. 29
What is the Art of Business Valuation?
“No matter how complex a company or situation may seem while working through a valuation, when complete, the valuation analyst should be able to provide a concise and clear analysis. If the analyst cannot do that, then more work is needed. Being able to simplify is a major indication that you are achieving the Art of Business Valuation.” P.37
“Small businesses have less quantifiable financial data. Therefore, more reliance must be placed on qualitative, or soft data. This requires more professional judgment, hence, Art in performing a business valuation.” Gregory Caruso, Author, “The Art of Business Valuation, Accurately Valuing a Small Business,” Wiley 2020
Importance of business systems
““Quality business systems are when average people get extraordinary results every time.” Use this as the standard to determine systems. One indicator is if there are, “lots of reasons why things are not working,” generally, their systems do not work. P. 52
Importance of people to business value
“Does the business have a culture of: “forever and continuous improvement” or resiliency in the face of problems?” These two factors often are the biggest indicators of future success or failure. They also are cultural matters that may be hard to quantify.” P.55
Why is small business more risky than larger businesses?
“Concentrations kill. Concentrations are the main reason why small businesses are so much riskier than larger businesses. A large customer or supplier or other concentration can cause major disruption and bankruptcy when relationships end. Small and very small businesses have all sorts of concentrations. Many concentrations are unavoidable at least for periods of time. This include, customer concentrations, product concentration, supplier concentrations, referral concentrations, geographic concentration, key people concentration, commodities risk concentration.” P.60
Valuation Discounts, (Primarily Lack of Control and Marketability Discounts (DLOM))
“The purpose of a discount is to fully factor adjustments between the interest being valued (usually partial ownership) in the subject company and the comparables that are not fully accounted for elsewhere in the valuation model. Discounts are even more justified with small and very small companies due to the high levels of risk because of owner relationships, limited customers, limited suppliers, small geographic market, limited management depth, etc. These concentrations create volatility and risk that do not exist with larger companies and often are not fully accounted for in market data, capitalization rates, and discount rates.” P. 252
Exit Planning For Business Owners
“Many employees when asked, “Would you like to be an owner?” hear, “Would you like an upside bonus plan?” not personal guarantees and real ownership risk. This requires a clear and detailed conversation – early.”
“One area that could use more focus is the emotional side of the business exit and purchase process. Buying or selling a business is a major life change. It is stressful and difficult for most people. Numbers are easy compared to emotion and fear. Therefore, most people, even those who should know better, just avoid the topic.” P. 318
“Owners are sellers when their TIME is worth more than their MONEY. Most owners are not sellers because their business is how they want to spend their time. Their business is worth more to them than other potential owners. That is why business brokers are so concerned about what owners are going to do next. The void of time becomes bigger as closing gets closer.” P.324
What business buyers want
A “working model” to generate the cash flow. This means systems that work today. People who can operate the systems today who are staying after the sale.” P.325
“A very clear buyer adage is, “If you want to be paid for it, prove it.” In other words, buyers pay for what exists. An apple seed has the potential to be an apple tree. But no one pays for the tree when they are getting the seed.” P. 325
SBA 7(a) Business Loan Program
“Prior to the SBA most small transactions required the seller to finance as there was no one else…… This is rarely necessary with cash flowing businesses any more. In the last 25 years the SBA has removed these issues and brought stability to the market.
It appears that part of the reason why transaction sale data has become more useful is because there are more consistent transitions. In the end, most sellers take the SBA’s loan amount and the sale price is reasonably close to the loan amount. Few sellers want the risk associated with providing financing. The availability and stability of financing have brought predictability to the small and very small business sale market” p. 337
“Should the SBA program be restricted or if the terms for obtaining an SBA loan become very restrictive (for instance, requiring 35% down instead of the current 10% down), the value of small and very small businesses will be greatly impacted. This is yet another assumption underlying most small and very small business valuations that no one even thinks about.” P. 338
Business brokerage in the business sale process. How to maximize a price?
“The point of the business brokerage process is to make a market across the likely buyer pool for the business…… The goal is to get three or more LOI’s (Letters of Intent or preliminary offers) at about the same time to allow negotiating power on behalf of the seller and to verify the market….. Fear of loss brought on by multiple bidders is what creates negotiating power.” P. 345
“Businesses are selling current cash flow. Many a seller becomes so focused on the sales process that their profits fall, reducing value. A good business broker minimizes this distraction. After all, sellers need to run their businesses like they will never sell.” P. 350
Reviewing a Business Valuation
“Finally, does this make sense? Given the overall fact pattern, would someone pay a price that reasonably relates to the value found, based on the facts both specified and the reasonable assumptions with what was known or knowable on the valuation date?” p.394
The book, “The Art of Business Valuation, Accurately Valuing a Small Business” has over 400 pages covering many aspects of small business valuation and market sales including working with business brokers, increasing sales value, descriptions of a well-run sales process, due diligence including a checklist and guidance on SBA loans.
If you value or use valuations of businesses with revenues under $10 million, you need this book on your desk. The book published by Wiley is available through your favorite bookseller.
Finally the author, Greg Caruso, JD, CPA, CVA, is always available to assist with exit planning, brokerage, and to prepare or review business valuations with an emphasis on increasing value and likely transaction values and terms.
Greg is available for interviews, podcasts, quotes, presentations and more. Contact Greg at or 609-664-7955.
