Earning Your Way to a Profitable Business
By: Jessica Rickard | June 4, 2021
As a business owner, you have three options when it comes to leaving your business:
1. Close it down
2. Hand it down to someone in your family
3. Sell it
Now, closing your business without selling or handing it down is not the best choice, but it is an option. I listed it first because there isn’t much to say about that one. If you can’t find anybody to purchase your business and you don’t have someone who wants to inherit it, well, you have to close it down.
Option #2 of passing it along is pretty common in the small business world. Usually, the business moves to the next generation – it stays in the family. This process is also easy to understand. Everything moves from one name to another, but everything basically stays the same. There may be some shift in the name on everything but usually the person inheriting the business has been working in the business.
What I want to focus on in this blog is how you sell your business. You may be years and years away from selling the business you have worked so hard on, but you need to run your business like you are trying to sell it. Keep accurate records and do everything you can to be successful, that way when you try to sell, the buyer sees a successful business and you may get multiple people interested.
In order to run your business like you are trying to sell it, you need to know what your business is worth and how decisions you are making affect your value. When valuing your business, there are three approaches:
2. Market Value
3. Earning Value
The asset-based approach to valuing your business is focused on the total investments in the company and can be done in two different ways:
- A going concern asset-based approach looks at your balance sheet, lists your total assets and subtracts the total liabilities. You can also call this the book value of your business.
- A liquidation asset-based approach calculates the liquidation value. This is the net cash you would receive if all of your assets were sold, and you paid all of your liabilities.
You may have heard the term market value before – usually in real estate. The same idea applies here. The market value approach to valuing your business looks at companies like yours that have recently sold. The downside here is that there must be a decent number of similar businesses in order to make an accurate judgement.
The earning value approach is centered around the idea that your business’ value lies in its ability to be profitable in the future. Like the asset-based approach, there are two ways you can look at this
- Capitalizing Past Earning calculates an expected level of cash flow for the company using the record of past earnings. This approach normalizes those earnings for unusual revenue or expenses and multiples the expected normalized cash flows by a capitalization factor. The capitalization factor can vary and is based on the rate of return a reasonable buyer would expect on the investment. It also considers the risk that the expected earnings will not be achieved.
- Discounted Future Earnings is slightly different in that instead of an average of past earnings, the average of the trend of predicted future earnings is used and divided by the capitalization factor. The capitalization factor in the same in this scenario.
In another case, for the earnings approach, you could take your EBITDA (that’s your earnings before interest, taxes, depreciation, and amortization) and multiply that by the median amount companies sold for in the top 10 industry types in the last year. This compares your company to unlike companies based on how profitable they are.
What does this mean for my accountant?
Don’t get me wrong, your accountant can do a lot for you when it comes to analyzing your business and your financial health, but not all accountants can preform business valuations. In fact, you have to in order to have the designation of Accredited in Business Valuation, you must hold a CPA’s license, have significant involvement in at least 10 prior valuations, pass an 8-hour written exam, and maintain 20 or more hours of annual continuing education in business valuation.
That sounds like a lot and I know you are probably thinking “Now Jessica, you just told me all this complicated stuff I have to do to get the value of my business…how am I supposed to run my business like I am trying to sell it if I can’t see the value of my business on a daily basis?”
Well – let me tell you! Your accountant may not be able to perform a full valuation on your business whenever you would like BUT they do have some valuable insight to add to a valuation. The solution to keeping track of your business’ value is Path by Simplex. In Path, we perform a Snap Value of your business using the earning approach. We take the data directly from your QuickBooks Online account and give you a month-to-month calculation of the Snap Value of your business. In Path, you can even walk through some what-if scenarios to see how you can increase your Snap Value.
With Path, you can have your accountant or financial advisor as a user on your account and they can provide feedback on your Snap Value and give you insights on how to increase that number. You can do this on a daily basis if you wanted! Now you can always see what the estimated value of your business is and you can be ready to sell whenever you need to. Path has a free 7-day trial. So create your account, connect your data, and see the value of your business!