If you read too many business magazines you might find yourself believing that creating a valuable business is more luck than skill. Business value can be managed and if you manage the value you will become more profitable.
Small business owners often confuse business earnings or profit with the actual value of a business. All profits are not created (or valued) equally. A fundamental method of measuring the value of a business is applying a multiple to earnings. Take two businesses that have the exact same earnings of $100,000. Will they have the exact same value to a business buyer? No.
Why not? There are many, many reasons. Here are some examples of why business buyers value earnings differently, we’ll use the $100,000 earnings for company A and B example.
- What is the quality of the earning? Company A earnings have been growing for 5 consecutive years, company B earnings have been down for 5 consecutive years. Which is more valuable?
- Company B financial statements are cleaner than company A and a buyer will pay more for a company with cleaner books because there is less risk. Uncertainty in the quality of the business financial records drives down value.
- Company A has 5 lawsuits against it, company B never had any lawsuits.
- Company B has well documented processes and it’s easier to train employees, therefore B’s owner can take lots of time off. Company A, with no processes, couldn’t stay open a week without the owner at the business. Which business has lower risk and therefore higher value?
- I could give you a hundred more variables as to why one business’ $100,000 profit is worth more, or less, than another business’ $100,000 profit.
As you can see business value and corresponding multiples of earnings is based on a number of fundamental factors that a business owner can control and these factors effect how valuable the business is. There are many businesses that are very valuable to the current owner but of little value, or much lower value, to a buyer. There have been several good books written about building value in a small business including Built To Sell.