Why you need an Exit Strategy Business Plan
By Dennis Zink
May 11, 2019
When you exit your business, you will need a plan. I call it an Exit Strategy Business Plan.
A business is valued as a multiple of its annual cash flow or earnings.
According to one of the largest business brokers, only one in five businesses listed, sells. Let’s start with some definitions. EBITDA refers to Earnings Before Interest, Taxes, Depreciation and Amortization. SDE refers to Seller’s Discretionary Earnings. Okay, now that we have that out of the way. What is this all about? It’s about business valuation, determining the selling price for a business and having an Exit Strategy Business Plan to sell the business.
A business is valued as a multiple of its annual cash flow or earnings. Based on the particular-industry, NAICS (North American Industry Classification System) code, multiples (or multipliers) are determined for each code as a function of risk adjusted returns. These multiples vary from industry to industry and, to a lesser extent, from business to business within an industry. Many variables affect multiples, and hence, business valuation. The primary factors relate to the quantity and the quality of the company’s earnings.
Quantity of earnings
When it comes to earnings, more is obviously better. If someone were to buy your business, they are obviously looking for a return on their investment. A business earning $1,000,000 in profit has more forgiveness than a business earning $100,000 in profit. With the larger business and greater profits, you can make some mistakes and it won’t put you out of business. In general, a larger business is preferable to a smaller one when it comes to financial return. In this case, size matters. There is more risk in buying a business with smaller earnings. Of course, it will cost more money to buy larger, more profitable businesses. A long track record of profitability, taken to an extreme, increases the multiple substantially. An example of this would be the multiples for public companies.
Quality of earnings
The quality of earnings consists of variables, including the value of the brand, management team, employees, market share, condition and value of assets, physical location, diversity of customer base and having organized books and records.
Getting back to EBITDA and SDE
Larger businesses are valued using EBITDA and smaller business valuations use SDE. There is no definitive cutoff point; however, $1,000,000 in earnings is often used as a differentiator among small and large companies as it relates to earnings. With SDE, the main difference is that a small business includes the owner’s salary (functioning as the manager) as part of the earnings. These companies tend to be “mom and pop” small businesses.
If a business owner pays himself more or less than the going rate to replace him or her as the manager, then an adjustment is made, up or down, to normalize an amount that a buyer would have to pay to hire a manager in that position. This normalization process is used to show a buyer what the earnings are likely to be after an acquisition. Other adjustments that are made to normalize earnings include adding back both owner benefits and one-time non-recurring expenses that a new owner will not have to make. Interest, taxes, depreciation and amortization costs are also added back to get a more accurate picture of the company’s true cash flow.
A non-profitable business
The value of a non-profitable business is generally limited to the value of the assets as compared to an ongoing-concern that is profitable. Since anyone can start or operate a business and lose money, there is no value attributed to unsustainability. A buyer is, after all, buying a future earnings stream of what the business is anticipated to generate. The buyer will, however, pay for the business based on the most recent results, with the past year’s earning weighing heaviest.
A 2x multiple
In general, if you look at the selling price for small businesses chances are good that they sold for an average multiple of two-times SDE. For example, a business with an SDE of $100,000 will sell for approximately $200,000. Two reasons that businesses do not sell is because business owners have unrealistic expectations of the value of their business and the marketplace for selling and buying businesses is not efficient. Often, small business owners think that because they have invested more money in their business than replacement value, a buyer should pay more.
Realistically, this doesn’t change the value. Typically, the selling range for small businesses is between two-times and three-times earnings. Outliers may be multiples of one-time or less or four-times or more. In rare situations, I have seen well-run businesses in a growing market garner as much as seven-times earnings.
Public companies in the S&P 500 sell for an average of 17-times earnings. The range this past year was between 16 and 23. The reason that multiples are much higher for public companies has to do with the stability of income streams, the degree of risk and the ease of liquidity. If a public company buys your great business for a multiple of six-times earnings, their purchase is immediately worth more than double or even triple the next day.
What you can do now There are steps that you can take now to improve your chance of selling later and garnering a greater return when you do. The key is for you to have an Exit Strategy Business Plan and SCORE has created an Exit Strategy program with an experienced team of mentors who can help you better understand and prepare for your exiting process. You’ll explore how to maximize profits; diversify your income streams; reduce dependencies on yourself, key employees, suppliers and customers; improve customer satisfaction; and document processes. These steps will add to your businesses value. Go to SCORE.org and request a free confidential mentor, or you can write to me at [email protected]