For What It's Worth
Apply now to be an Entrepreneur 360™ company. Let us tell the world your success story. Get Started »
Dave Lakhani knows the value of value. Beginning at age 13 with the proceeds of an insurance settlement, the now-32-year-old Boise, Idaho, entrepreneur has started or invested in and eventually sold eight different businesses. They ranged from a security company to a pawn shop and from start-ups to established firms, but all had one thing in common: They were worth more when he left them than when he started.
"Establishing value in your business allows you to make sure that the thing you've worked on most of your life continues to pay you," explains Lakhani, currently the owner of consulting firm Direct Hit Marketing. Building value also allows him to sell at a profit when his skills and the needs of a changing business no longer match, or when he just feels the urge to move on.
Unfortunately, few entrepreneurs take the same attitude, according to Don Taylor, chairman of TD Inc., the Newport Beach, California, franchisor of VR Business Brokers, a national network of business brokers. "They don't care," says Taylor, "because they [figure] they're not going to sell it anyway."
But value can be valuable even when you're not selling your business. Being able to place a high valuation on a business may be critical to success when an entrepreneur is obtaining financing, negotiating with a potential partner or strategic ally, hiring a key employee, setting up an employee stock ownership plan or at myriad other points in the life of a business.
"As much as we believe we're going to be doing this for the rest of our natural lives, eventually we wake up and realize there's more to life than our business," says Lakhani. "Or we come to a state in life where our business outgrows us, and it's time to get someone else who has the vision to carry on. Or it's just time to retire."
What Is Value?
Value, like beauty, is in the eye of the beholder. There probably are as many ways of defining value as there are businesses. The basic one, which all or at least most others come back to, is how much money the business could sell for on the open market. But that, too, is dependent on what a hypothetical buyer is looking for, how the business has positioned itself and exactly who is doing the valuing.
"In finance, any asset is valued based upon its expected future cash flow," says Glen A. Larsen Jr., associate professor of finance at Indiana University in Indianapolis. "So in the purest sense of the word, you build value by building expectations of future cash flow to the holder of that asset."
Value doesn't necessarily equal net profits or even break-even performance. Soaring expectations of future positive cash flow are behind the extremely high valuations the stock market places on shares in companies such as Netscape Communications, maker of Netscape Navigator software for browsing the World Wide Web, even when such companies have little in the way of sales and no short-term prospect for any profits, explains Larsen.
Cash flow is usually more important than profit when valuing small businesses. Unlike publicly held firms, which seek to maximize reported profits to attract investors, entrepreneurs often seek to minimize profits for tax or other reasons, says Karl H. Vesper, a Seattle-based University of Washington management professor and author of New Venture Experience (Vector Books).
An entrepreneur may allocate a trip to a meeting in Hawaii as a business expense or keep a spouse or child on the company payroll when a publicly held company would not. To accurately assess the value of a business, values such as the ability to employ family members or mix business with pleasure must be accounted for. And, Vesper notes, these may have value beyond financial considerations.
"Aside from the dollar value of these things, there's the psychic value," Vesper says. "Would you take less pay to sleep later in the morning?"
Value may also come in other forms. Ownership of a patent, proprietary process or trade secret may, by promising exceptional future cash flow, increase the value of a business. Often companies that dominate a market, no matter how small, are sought out for purchase at premium prices by other firms that, for one reason or another, want to add that niche to their existing business. Says Taylor, "There are different kinds of value for different kinds of people."
Many businesses count their physical location as a primary component of value. That's especially true in the case of restaurants and other retail businesses and, again, is not necessarily connected to cash flow or profit. Some retailers make a practice of buying businesses only for their locations rather than how much or what they sell or who they sell it to, figuring that a high-traffic spot will eventually prove to be a winner for some business combination.
"The business may not be doing well," explains Taylor. "But if they got good terms and conditions on their lease and [the site] is in an excellent location, sometimes they can switch what they can sell there."
Location may also be a big part of value if a company is in a resort community with a lifestyle that is attractive to would-be business owners. Other businesses, such as bed and breakfasts and bookstores, may have higher values because they appear glamorous or simply interesting to potential buyers.
On the other hand, a business may also be worth more if the buyer never has to venture near it. "Certain types of businesses have higher value because the owner is not required to be there," explains Larsen.
The intangible known as goodwill is another key consideration. Goodwill may range from a long-established distribution network to a sterling market reputation.
For Haim Ariav, founder and president of Muffin-Head Productions, a New York City new media agency, that's the kind of value that counts most. Ariav started his 20-person company four years ago using credit cards for financing. Now he can get regular bank financing, and he says it's because of the reputation he has won by handling six-figure jobs for clients such as Cadbury Schweppes PLC, Nickelodeon and JVC.
"We show [bankers] who our clients are, what we're working on and what we are going to be working on," says Ariav. "They're pretty major companies, and for them to be giving us budgets of $75,000 to $300,000--a bank will [consider] that almost the same as collateral or receivables."
All told, Ariav counts his firm's reputation as the most critical component of its value. "Can you put a dollar [value] on it?" he asks. "I don't know if you can. How much is a reputation worth?"
While Ariav has a point, other important factors influencing value are easier to pin down. Experts agree: If you want to boost your business's value, one of the clearest ways to do so is to pay close attention to the bottom line of your cash flow statement. "In the majority of businesses that are sold," says Taylor, "the value of the business is a multiple of their adjusted discretionary cash flow."
Despite the value of value, many entrepreneurs aren't building it. In fact, many are decreasing the value of their companies, sometimes without even knowing it.
Sometimes entrepreneurs overpay themselves, taking too much value out of the business in the form of fringe benefits, perks and salaries for themselves and family members or friends. It's not unusual for entrepreneurs to manipulate these outlays to show lower profits for the corporation, says Larsen. But that's risky.
"[The business owner] may not only be taking his profits, but he may also be taking the return on his investment capital," warns Larsen. "He may be harvesting his business without knowing it." Instead, he recommends entrepreneurs pay themselves modest salaries, perhaps nothing at all in the beginning. "Get the short term under control, make plans for the long term and start building value before taking anything out of [the business]."
Even when profits look good, value may suffer. "To build profits in the short run you can neglect maintenance, or you can supply a lower-quality [product]," says Larsen. "But there you're shooting yourself in the foot. You're not building the expectation of long-term future cash flows, and that's really what value is all about."
Another symptom of short-sightedness is the failure to keep accurate records. This, according to Taylor, is where most entrepreneurs make an easily correctable mistake very early on. To avoid this problem, Taylor recommends, "start off with the mind-set that you're going to sell [the business]. Pick a date when you are thinking about selling it. If no date comes to mind, pick 10 years from now. Then, because you have done that, you know to start off with good books."
Good books include more than adequate financial records. They include manuals, handbooks and other documentation on the operational side of the company. This not only makes it more likely that a potential buyer will feel he or she can run the company, but it also aids internal management training, says Lakhani. And building management strength other than your own is crucial to increasing value.
In fact, one of the value errors peculiar to entrepreneurs is
relying on their own leadership to run the firm. Many find it tough to delegate and, believing that only they can make the really important decisions, fail to develop other managers.
That can be damaging and even fatal to a business's value. In the worst case, notes Larsen, "If you simply sell something that only you can run and you walk away from it, it's lost all potential to generate future cash flow."
Another route to weakening value is using others' trademarks, patents and technologies instead of developing your own. Not all proprietary processes, trade secrets and other intellectual property are valuable, of course. But those that are may be worth some short-term sacrifice to develop and own.
Says Larsen, "You don't have to be profitable today if you have a unique product, a proprietary design or a patent that has potential or that investors expect will generate income in the future."
Cutting The Ties
Dave Lakhani has used a wide variety of methods to build value in his companies, from increasing profits to improving record-keeping. Perhaps because he's built and sold so many companies, one thing Lakhani never overvalues is his own contribution.
"I make everything come past me," says Lakhani. However, he also trains other employees so they can fill in for him in a pinch or in the event he were to leave the firm. He takes pains to create a written detailed description of how to do all the major jobs at the company. When he sells a business, he offers to overcome any management shortcomings that may be perceived by offering to stay on and train a potential buyer after the sale.
The paradox of value is that the entrepreneur who creates it must not be too essential a part of it. No matter how profitable your business is, if it doesn't have the management depth to run without you, it isn't likely to be highly valued by others.
Lakhani is justly proud of his ability to start a business from scratch or take over a struggling enterprise and boost its value. But he never forgets that a key to his success is that he himself is not an essential part of the value equation. To make the most of what you've put yourself into, says Lakhani, "the actual running of the business should be able to be duplicated by whoever is buying it."
As William Bygrave says in his book The Portable MBA in Entrepreneurship (John Wiley & Sons), companies are worth different amounts for a variety of reasons. Here are some of the factors Bygrave believes may influence the value of your company:
- Companies with generous after-tax profits of 10 percent to 15 percent or more are generally worth more than money-losers. Those scraping by with less than 5 percent profit after taxes are also likely to carry unattractive valuations.
- Market leaders command significantly higher values than those in second place or further back.
- Companies in emerging markets growing at 30 percent or more annually command the highest prices. However, a market size under $100 million may be considered a drawback.
- Discounted value of expected future cash flow, multiplied by a standard amount for your industry, will often give a fairly accurate sale price.
- A patented technology that is demonstrably superior to alternatives is one of the most valuable properties a small company can own.
- All things being equal, a company that requires heavy capital investment will be viewed as riskier than--and therefore valued lower than--one that doesn't require a similar investment.
Direct Hit Marketing, 770 Vista, Boise, ID 83705, (208) 368-7979;
Indiana University, (317) 274-3794, firstname.lastname@example.org
Muffin-Head Productions, (212) 431-5300, http://www.muffinhead.com
TD Inc., 1151 Dove St., #100, Newport Beach, CA 92660, (800) 377-8722.