To maximize value, entrepreneurs must understand how business valuation is derived. As many find out too late, the viewpoint of an investor or potential buyer is much different from the outside looking in. Most entrepreneurs never take the time to learn the concepts of business valuation and develop a plan that can maximize the value of their business before it comes time to sell.
Not understanding business valuation, the keys that increase business value, and the process involved in exiting a business, can cost an entrepreneur significant capital and heartache when the time comes to cash in on all the years of running a business.
The biggest misconception to business valuation is that it is simply an average or similar to other businesses in an industry. In reality, nothing could be further from the truth! Average is simply the middle point of a set of data points. To have a middle point, there must be an equal number of values or data points on either side. Some will be below average, others well above average, and some right near the middle. Many factors, each unique to the specific business, impact the value of a business and move the value either above or below average. Business valuation is the analysis of these factors, the risks, and their impact on a business’s value.
An entrepreneur armed with the knowledge of these concepts can develop a long-term plan that can significantly increase the value of their business. With the knowledge of the valuation process, an entrepreneur can build a business that is worth significantly more than “average.” It is important to take the time to maximize the value of the business and the years of work put into it.
A business is ultimately valued based on the expected cash flow that the business will generate for its owners. But not all cash flow is the same! Cash flow that is predictable, consistent, and recurring is less risky and more valuable.
All the efforts, strategies, decisions, and years of work come down to this. While the business owner has a long history, and an emotional connection to the business, investors and business buyers don’t care about that and are purchasing for the cash flow that will be generated or the strategic benefits to their company and not for the sentimental value.
Terms such as EBIDTA, Net Income, EBIT, after-tax income, free cash flow, and many others are commonly used to describe this stream of cash flow. However, it is critical to realize that what matters most is Free Cash Flow or “FCF.” Free Cash Flow is the amount of money that is available after paying all expenses including debt, interest, preferred shareholders, taxes, capital improvements, and any cash that must be used or left in the business for increases in working capital.
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