Businesses that rely on their owners as the primary source of success are common. Unfortunately, they’re also the most dangerous kind of business to own if you want to maximize the value of your wealth.
Unless your goal for your business ownership in the future is to liquidate the business and shut it down, you’ll likely need to build your business so it can operate without you … and, in doing so, increase the business’s “transferable value”.
No matter what an owner sees for the future of the business, transferable value can be the common denominator that makes all goals more achievable.
What is Transferable Value?
The transferable value of a business should not be confused with profit. Just because your business brings in millions of dollars of profit each year does not necessarily mean it has transferable value. Actual transferable value in a business is determined not by how well you run the business but by how well the business runs without you.
One way to define transferable value is “What is a business worth to a qualified buyer without the owner present?”.
Essentially, a business that relies on its owner for success is worth less to a buyer than a business that can run smoothly without its owner. For some businesses, overreliance on the owner can make the business not only worth less but also worthless to buyers, despite all other indicators of success.
This might seem at odds with the tenets of entrepreneurship, ownership, and job security in general. Many of us are taught to take on as many responsibilities as possible to make it harder for a business to do without us.
Entrepreneurs often take pride in how many different hats they wear as they build their businesses. This attitude is admirable but also dangerous for owners who want to plan for the future of their business.
The Henry Rutherford Devaluation Story
Consider the story of Henry Rutherford and how his owner-centric operations affected his planning and, ultimately, his wealth.
Henry Rutherford had built quite an empire. Over 35 years, he turned his three-person propane distribution business, Rutherford Propane, into a six-location regional empire. He employed 45 people and owned a well-maintained fleet of 30 delivery trucks.
At 70 years old, Henry still coordinated the routes, worked with the largest customers and led the company’s marketing efforts. His employees looked up to his work ethic and often wondered how Henry could do so much. He was a model of hard work.
Privately, Henry was exhausted but hopeful. He wanted to get out of his business within the next year before he completely burned out.
Two of his primary but friendly competitors, Wyatt Durndel and Theresa Seels, had recently sold their businesses. Wyatt had ended up with “north of $5 million” for his business, and Theresa had managed to make “about $9 million out the door.” Henry knew that his company did more business than Wyatt’s. He also knew that his company had more large contracts than Theresa’s.
When he thought about all the hard work he had put into marketing and building a strong, reliable, and diverse book of business, he figured he could get at least $10 million for the company. So he reached out to an M&A advisor, Brian Buttersworth, to seek out a buyer for the business.
Over several months, Brian found three buyers interested in Rutherford Propane. Each offered Henry between $8–9 million on the condition that Henry stays with the company for at least five years to help train replacement leadership.
“That doesn’t make sense,” Henry said. “I’ve built this company and created a strong book of business. So why do they need me to stay?”
“They don’t feel that the company is worth much without you,” Brian said. “They think you do all the heavy lifting; without you, the company won’t function how they want.”
Frustrated, Henry asked, “What if I refuse to stay? What will they give me then?”
“I can ask,” Brian said.
A week later, Brian reported back to Henry. “Two buyers said they aren’t interested unless you stay,” Brian began. “The last one offered $1.5 million for your delivery truck fleet, book of business, and company name.”
“But that’s barely 10% of what I’m looking for!” Henry said. “And, what, my employees lose their jobs?”
“That’s what they implied,” Brian said. “They worry that your bigger clients like to do business with you and that if you leave, most won’t renew their contracts. Without you, their only value is finishing your existing delivery contracts and adding your trucks to their fleet.”
“Aren’t they responsible for replacing me with people they’ve trained?” Henry pleaded.
“That $1.5 million offer took that into consideration,” Brian said. “They figure it’ll cost them at least $5 million to train others to do everything you did as you did it, build the market back up, and get new contracts in the door. But, they aren’t confident they can retain your business without you there.”
How to Build Transferable Value
Business owners aren’t always aware that transferable value is more than a formula involving multiples of earnings or some calculation of discounted future cash flows.
To get a more accurate representation of the current state of your company’s transferable value, you can start by asking yourself a few questions:
- If you permanently leave your business today, would it continue with minimal disruption to its cash flow?
- Who will be responsible for running the business without you—and with minimal disruption to cash flow?
Improve the performance of your Value Drivers
One way to start to build transferable value is to evaluate your value drivers. Installing and enhancing value drivers can help create a company that can be transferred to someone else (whether that’s the next generation of family members or an outside third-party buyer)—without the owner—with minimal disruption to its cash flow.
Some examples of value drivers that you should focus on are:
- Financial Foresight and Controls
- Recurring Revenue that is Sustainable and Resistant to Commoditization
- Owner Dependence & Next-Level Management
- Proven Growth Strategy & Demonstrated Scalability
- Operating Systems Demonstrated to Increase the Sustainability of Cash Flows
- Good and Improving Cash Flow
- Competitive Advantage
- Diversified Customer & Supplier Base
I have discussed these drivers in the blog “How can FROGS drive up the value of your business?“
One might measure the effectiveness of value drivers in two ways:
- Their positive contribution to cash flow.
- Their ability to continue to contribute to cash flow under new ownership.
A company with strong value drivers might demand (and receive) a higher multiple on the same amount of EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) than a company with weak or non-existent value drivers.
Build Transferable Value with Your Management Team
Building a management team with which you can confidently leave your business can be challenging. You may want to create a loyal “next-level” management team that will not only maintain the value of your business, but be as motivated as you are to grow the business to new heights.
Understanding where your business may have weaknesses is important in knowing who you need to attract to fill the gaps. It’s worth asking yourself whether you are focusing on attracting people with the right skill sets to accomplish growth independently from your efforts as the current owner.
Establishing this highly qualified team long before you think you’ll transition can give them the time and space to prove their ability to perform.
Attracting the right team is the first step; retaining the team long after your departure is the real task. Holding onto these vital team members may require more money or some percentage of ownership as a condition of employment. Creating an effective incentive plan that fits the needs of your team is the best way to ensure your management team stays in place and continues to increase business value after your departure.
Why You Must Be Dispensable & Your Business Must Be Transferable
Working hard is admirable and necessary for success. But it’s wise to make yourself nonessential to enhance business value and deliver future wealth.
If the business cannot succeed without you, you probably won’t find transition options that deliver your financial goals and personal desires.
The information contained in this article is general in nature and is not legal, tax or financial advice. Contact a lawyer or a tax or financial professional for information regarding your particular situation. The information in this newsletter is provided with the understanding that it does not render legal, accounting, tax or financial advice. Clients should consult their legal, accounting, tax or financial professional in specific cases. This article is not intended to give advice or represent our firm as qualified to advise on all areas of professional services. Master Planning is a discipline that typically requires the collaboration of multiple professional advisors. To the extent that our firm does not have the expertise required on a particular matter, we will always work closely with you to help you gain access to the resources and professional advice you need.
Any examples provided are for illustrative purposes only. Examples may include fictitious names and may not represent any particular person or entity. This article has been sourced from a licence agreement with Business Enterprise Institute, Inc.
