Eliciting Excellence

The Time-Value of Business Valuation

An important goal in any exit or succession plan is to develop the business in a way that maximizes its value.  But the truth is that the value of a business is only realized if the owner actually gets paid that money.  And therein lies the difficulty…

Many times with an internal sale to a family member or key employee, the buyer doesn’t have the cash to pay the full value up front.  Therefore, the owner receives the majority of the business’ value over time, paid with future cash flow.  The time-value of a business’ value is analogous to the time-value of money.  In other words, money in hand now is worth more than the same money received later.  To account for this timing issue, a succession plan is often structured so that the payout over time is higher than if a lump sum were to have been paid up front.

But most succession plans are structured assuming that all payments will be made even though studies show that about 70% of all successions fail!  Therefore, the likelihood of future payments not being made must be taken into account when determining a business’ real value.

There are four ways to address this issue.  One is to try to get a commercial bank to fund the sale in order to shift the risk.  Unfortunately, many times this route is impractical.  The second strategy is to front-load the payments, receiving the lion’s share of the value as soon as possible.  Typically, this route is also impractical because it generally cripples the cash flow and working capital of the company, virtually ensuring that it will fail and be unable to finish paying the owner.

A third route is to have equal payments, but charge a much higher premium to offset the risk of non-payment.  In other words, treat it as a high-risk loan.  Like the previous approach, this generally impacts cash flow too heavily and jeopardizes the success of the company.

Therefore, the fourth strategy is the best solution if you’re serious about ensuring the likelihood that the full value of the business is realized by the owner.  This fourth strategy is to reduce or eliminate the risk of failure. One approach to reducing this risk is to have the owner remain involved until he or she is paid in full.  But of course, this approach defeats the whole purpose of selling the business.

A much better approach to reducing risk and ensuring success is to develop the successor more effectively.  Most owners help their successor master the mechanics of the business.  That’s not the problem.  The problem is that there are a couple of critical competencies that won’t be addressed if grooming stops with the mechanics.  First off, learning the business doesn’t necessarily hone leadership skills.  Strong leadership skills are essential for success.  Managing can keep a business running smoothly for a while, but leadership skills are needed to successfully take a business into the future – things like good judgment, strategic thinking, conflict resolution, and the ability to influence others.

The second critical competency is the need for the successor to adopt an Owner’s Mindset.  Typically, up to the point of the sale, a successor has only been an employee.  But owners and employees think and act differently.

Employees tend to think narrowly. They usually focus on the task at hand and/or on their specific domain of responsibility (operations, finance, engineering, etc.). In contrast, an owner needs to consider the bigger picture and how his or her decisions impact each aspect of the business.

Employees also tend to think short-term. Their focus tends to be on current matters, current revenues, current expenses, and current profits. They also tend to be reactive.  In contrast, an owner needs to 1) consider both short-term and long-term success, 2) learn to make decisions without having all the information, and 3) must learn to balance risk and reward. (Rarely is a decision about the future risk-free.) And owners tend to be proactive.

And finally, employees know that if they make poor decisions or the business doesn’t do well or they become dissatisfied or they lose their job, they can always find a new job elsewhere. Owners, on the other hand, understand that failure is not an option.  There is no “Plan B.” Owners understand that the business is their future, and this understanding must color their decisions and their actions.

When a successor’s leadership competencies aren’t developed and they haven’t adopted an Owner’s Mindset, he or she can’t effectively guide an organization.  In the absence of these competencies, the future of the company becomes less certain and the future cash flow is put in jeopardy.

Please don’t throw an inadequately prepared successor into the role of leading a company.  Whether you use our services or some other solution, bring in a professional to help – someone skilled in leadership development and experienced in working with successors.  If you’d like our help developing a successor, please give us a call to discuss your specific situation.  We offer executive assessments and executive coaching, all designed to help successors succeed and owners get paid.