By Scott Balfour
There is a saying among business purists that you should run your company “as if you’re going to sell it tomorrow”. In other words, have all your customer, vendor, and employee contracts in place, train your employees so that you’re irrelevant, streamline your systems and workflow and, most importantly, maximize your cash flow.
Stop right there. Yes, you did read that right. And, no, maximizing cash flow and putting your business in order are not in conflict. It’s true that putting your business in order does require an ‘investment’ of resources that has a ‘short term’ effect on maximizing cash flow, but I’ll contend (and it seems to be supported by my observations in the marketplace) even in the short term the slight hit on cash flow is more than offset by the large price multiple.
It’s not really a question of stay and grow or sell and go; it’s how to best position a business until it sells. There is an old saying that “if a business isn’t growing it’s dying”. This is true but it’s not always obvious. Instead of going through a laundry list of plans, systems, policies, and controls that a business could have in place, I want to focus on a broader perspective. Highlight some things that I run across in some established businesses that seem to get lost in the day-to-day running of the business. It’s more of an owner’s perspective getting lost.
Some businesses file a Schedule C for tax returns as they are run as sole proprietorships. One thing that can get confused in the owner’s mind is that the net income of the business is overstated, for the net income includes both the compensation for the owner’s time, effort, and expertise in addition to the net profit of the business.
Some businesses own the real estate they operate out of. Over time the mortgage may be paid off or substantially reduced. As such they report little or nothing as ‘rent’ for the business. The income that the returns show can lure them into a false impression as to how well the business is doing. In this case the net income is overstating the profits of the business, for it includes the income that the real estate is effectively producing.
Often a business has gotten to the point of having little or no debt. With no interest and principal payment, it certainly helps the bottom line look great, yet the equity in the business might be assumed to be bigger than it is if a simple times earnings approached is used. The owner is earning $ 125,000 and is content supporting his lifestyle. What is wrong with that?
Let’s look at it from a numbers perspective. Net income of $125,000 less $65,000 (owner and spouse’s fair market wage if employed elsewhere), less $48,000 (real estate market rent $ 4000/ mo.), less $40,000 (likely debt a new owner might have) = -$28,000. Negative $ 28,000 vs. positive $ 125,000 is a big difference.
Now let’s look at this from a lifestyle or emotional side vs. just the numbers. First, this hard-working family has enjoyed a good lifestyle along the way. They were expecting to carry that nice lifestyle into their retirement. They always felt that building equity in the business and then pulling that equity when they sold the business would take care of their retirement. After all, that’s when the extra-long hours, short vacations, and stress of owning a business are supposed to pay off, right? Well in this case the business owners are in for a big surprise and perhaps are in a crisis situation. This is a situation that might have been avoided if they had remained focused on growing the business as measured in equity vs. income. For a small business, measuring equity is best done by periodically obtaining a Business Valuation.
Other matrixes to look at to measure growth in addition to the financials performance are numerous. You might take a look at a few by taking the Sellability Score for some guidance.
Magnusson Balfour is here for your exit planning, business valuation, and business selling needs.