Transferable value is one of the most critical elements of a successful business transition. 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?
For a closely held business, transferable value is most simply what it is worth to someone else without its original owner.
Transferable value should not be confused with profit. Just because your company brings in millions of dollars of profit each year does not necessarily mean it has transferable value. True transferable value in a business is determined not by how well you run the business but by how well the business runs without you.
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 business’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?
Think of it this way: why would anyone want to buy your business if its continued success depends on you – the departing owner?
Buyers are more likely to pay top dollar for businesses that will not miss a beat when the original owner is no longer in charge.
How to Build Transferable Value
Value Drivers
One way to build transferable value is to evaluate your value drivers.
Value drivers are internal characteristics of a business that buyers look for in acquisitions.
Whether you plan to keep your business forever, transition it to family members, sell it to your management team or find an outside buyer – value drivers can give you more options, flexibility, and money from your ownership interest.
Strong value drivers are effective and will continue to operate once the original owner departs. Consequently, those are the value drivers that increase both EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) and the multiple of EBITDA (“business multiple”) buyers may be willing to pay.
Installing and enhancing value drivers, you are enhancing the transferable value of your business – by creating a business that can be transferred to someone else – without you, the owner – with minimal disruption to its cash flow.
I recommend owners focus on eight specific value drivers. I use the acronym FROGSCCC to summarize these value drivers: –
- 1. Financial Controls, Performance & Projections
- 2. Recurring Revenue
- 3. Owner Dependence and Management Team Talent
- 4. Growth Strategies
- 5. Systems (operational, financial, marketing)
- 6. Competitive Advantage
- 7. Concentration of Customers & Suppliers
- 8. Cash Flow
One might measure the effectiveness of the first seven value drivers in two ways:
- 1. Their positive contribution to cash flow.
- 2. Their ability to continue to contribute to cash flow under new ownership.
Let’s look at a couple of examples.
A manufacturing business with strong value drivers (let’s call this Business A) can demand (and receive) a higher business multiple with the same amount of EBITDA than a business in the same industry with weak or non-existent value drivers (known as Business B).
Let’s say EBITDA is $600,000 for both businesses.
However, Business A has a higher business multiple of 4 (due to its better-performing value drivers) than Business B’s multiple of 2 (due to its weak-performing value drivers).
Using the Business Multiple equation to value a business, we find Business A’s valuation @ $600K x 4 = $2.4M, whereas Business B’s valuation @ $600k x 2 = $1.2M.
Picture another example where three identical transport companies move time-sensitive freight for customers.
All have a national presence, $2M in EBITDA and about $25M in annual sales. Therefore, it would be logical to assume they all have the same value.
But in reality, one had little value; one sold for 3.5 times EBITDA and one for 5.5 times EBITDA. So the difference in value was $3M to $7M to $11M.
Neither gross sales nor EBITDA alone determined the price and terms of these deals. Instead, the key to the variation in purchase prices was the presence or absence of value drivers in the companies and the ability of these value drivers to survive the owner’s departure.
Just by simple math, a change in the business multiple can also have a much more significant effect on business valuation than a change in the profit margin. So in one way, you could say an improvement in the performance of the value drivers (that increases the business multiple valuable) is more valuable for an owner than just a change in profit.
In ideal circumstances, by implementing high-performing value drivers, owners should improve both the EBITDA value and the business multiple factor, leading to a much higher business value.
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 is just as motivated as you are to grow the business to new heights.
Understanding the weaknesses in your business is vital in knowing who you must attract to help plug those weakness gaps (including the liability of owner dependence).
So ask yourself … “Am I focusing on attracting people with the skillsets the business needs to accomplish growth independently of myself?”
Picking the right personnel is one thing, but establishing this highly qualified team long before you think you’ll transition from the business is another. It would be best if you did this ASAP so you can give them the time and space to prove their ability to perform.
So you’ve now attracted the right team and you’ve given them time to show their wares … but there s still one more thing that acquirers look at when assessing your management team.
It’s what is termed “golden handcuffs”; knowing that the management team will be retained long after your departure is vital to an acquirer.
So how can you do this?
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.
So with the concepts of value drivers and building a sustainable management team now addressed, how do you think the transferable value will be created in your business?
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.
