While mentioning a business exit within the same context as a startup may seem incongruous, the two are very much correlated. Stephen Covey’s “7 Habits of Highly Effective People” and Habit 2, “Begin with the End in Mind,” can be applied to business. An effective startup begins with a written business plan which contains an exit plan. Every entrepreneur will exit their business in one way or another, and it is inevitable. The US Bureau of Labor Statistics tracks and publishes business failures over time, and those statistics reveal that most businesses fail within ten years. To mitigate failure, entrepreneurs must articulate their exit plan at the outset. To maximize their exit potential, they need to understand some key factors and variables of the process to sell or transfer a business, including valuation.
An Exit Plan
A clear and specific understanding of an entrepreneur’s ultimate goals and objectives and defining what success looks like for the entrepreneur is where to begin. Business is a journey, and knowing where you want to end up should be an important part of the entrepreneur’s initial focus. Having an exit plan at the start gives peace of mind and improves the odds of a successful journey’s end. The journey needs a destination.
Every new business plan should be able to answer the question of where I want my business to be in five years. Give yourself specific goals and specific timelines. Entrepreneurs should think backward, beginning with their overall goals and moving to short-term goals. Of course, business plans may need to be adjusted to reflect current conditions; however, keeping the end goal in mind is a guide as to how to handle shorter-term situations.
An exit strategy should answer questions such as when and how the entrepreneur potentially exits the business and what kind of return the entrepreneur would like to achieve. There are, of course, a myriad of factors on the journey that include market environment, competition, your team, and what are the potential exits. With an exit strategy, the entrepreneur has greater flexibility and control over how, when, and why they decide to leave the business when the time comes.
Entrepreneurs with an exit plan have less stress. They are relieved of the afterthoughts of having left something undone, having missed an opportunity, and not really knowing where they are going. Writing it down and making it precise results in less stressful personal lives, providing some welcome relief considering all of those decisions that have to be made, all those deadlines that have to be met, and those sleepless nights worrying about the business.
Valuation
Entrepreneurs need to be aware of how companies are valued, as this informs their business decisions from the very beginning. The entrepreneur is optimizing a successful outcome by articulating a business exit as part of the business plan.
Much like engineers who reverse engineer products or manufacturing processes, entrepreneurs need to reverse engineer their profit and loss statements and consequently adopt best practices upfront to obtain satisfactory exit valuations. After all, valuations are heavily influenced by how revenue and expenses are handled during the journey. There are other important factors, of course, such as business reputation, brand image, market strength, management team, future opportunities, etc., that are also quite important.
Every dollar in positive cash flow has a multiplier impact on the company’s value. So, the entrepreneur seeks to increase revenue and continuously seek better, faster, and less expensive ways to operate optimally, thereby increasing net cash flow. How the business is managed depends upon the end goal; is it to sell the business for a gain, or perhaps to maintain the business to offer the founder/owners a satisfactory lifestyle?
If the entrepreneur believes the ultimate outcome is to sell the business to an external party at some time in the future, they will focus on making the business appealing to a potential purchaser by maximizing the value. In this situation, profit margins will greatly impact decisions such as owners’ compensation. You will also want to ensure the business goals are understood even by those outside your industry.
If, however, the entrepreneur’s ultimate outcome is to develop a business that they envision will grow over an entire career – all the way through retirement, then the entrepreneur will focus on maximizing personal income rather than on the bottom line of the business. In a closely held business, owners can build and evolve their businesses as they suit them, and adjust goals based on the business’s success and what suits their personal lifestyles.
Valuation Methodologies
As mentioned earlier, it is helpful for the entrepreneur to understand some of the key business valuation concepts. Helping them in this understanding is their business advisor. Selecting a business advisor with integrity, experience and expertise is fundamental in guiding the entrepreneur’s growth path toward a successful exit.
Valuation methodologies are varied, and the business advisor can help the entrepreneur choose the best one depending on many factors, including the size of the business, the business fundamentals, the industry, competition, management team, growth projections, etc.
Fair market value is a term often used in valuing a business, with a common definition of what a willing buyer and a willing seller would pay for a company in an open market where there is a reasonable knowledge of the relevant facts and neither the buyer nor seller are under any compulsion to either buy or sell.
If a company is not making any profits, it can be sold in whole or in part based on its net assets (total assets, less total liabilities), and therefore, this type of approach would not give value to the business on an ongoing basis, having positive earnings. This is valuing the business on a liquidation basis.
There is a market comparison approach that, in many ways, emulates the approach used to evaluate real estate assets. Using public and private databases, comparisons between similar businesses in the same industry can be made to arrive at a valuation.
For growing businesses with strong growth prospects, an income approach is often used by taking the present value of future cash flows by discounting future earnings. In this situation, there is a reliance on future projections and growth rates, and so the underlying assumption is that the buyer will be able to minimally maintain current levels of income and that historical earnings are a reliable indicator of future earnings.
While the valuation of larger companies relies more on EBITDA (earnings before interest, taxes, depreciation, and amortization), smaller businesses are typically valued using the seller’s discretionary earnings. It comprises net earnings before tax and interest before the owner’s benefits, non-cash expenses, extraordinary one-time investments, and other non-related business income and expenses. Therefore, it begins with EBITDA; the calculation then eliminates one-time expenses, e.g. construction costs, renovation costs or the purchase price related to a new building or addition; it also eliminates expenses that can be directly related to the business owners’ personal lifestyle, such as auto expenses when a car is not necessary to the operations of the business. What is ultimately included/excluded from the seller’s discretionary earnings reflects the overall sales negotiating process, which in practice is more art than science. This is an area where the entrepreneur’s business advisor can play a key role in guiding the sales process.
Another methodology that is commonly adopted by companies to make decisions that impact valuation is called economic profit. Economic profit is the total revenue with fewer explicit and implicit costs. Explicit costs are normal business costs directly affecting profitability with clearly defined dollar amounts in the income statement expense section, such as wages, lease payments, raw materials, and utilities. Implicit costs are already incurred but not reported as a separate expense. This is an opportunity cost when using internal resources for a project without any explicit compensation for the utilization of resources. A company may finance its expansion from its surplus funds or retained earnings and forego the investment income, such as interest from those funds. The calculation is a helpful way to compare various opportunities and projects and select the most profitable option.
At the end of the day, it is always the ultimate buyer that determines the value of a business, and to know that the same business will be valued differently by every prospective buyer. Having the exit plan as part of the entrepreneur’s overall business plan and knowing the factors of a business’s valuation is a difference maker. Whether the entrepreneur is “hitting the ball out of the park” when the business booms to the point that it outlasts the entrepreneur, and the business goes public. Even in this very selective category, there is a need for an exit plan. Or when the entrepreneur loves the team and wants to see them take over the company. The exit plan should articulate the internal talent qualities/qualifications of the team coupled with the patience to groom them for the job going forward. Or, when the entrepreneur expects to sell to another company, naming potential acquirers and having a target date in the exit plan, which assumes a minimum timeframe of at least 2-3 years in advance, all help to maximize the potential value of a business.
Summary
- Write an exit plan as part of the startup company’s business plan and
- Be as specific as possible with goals and objectives – and your timeframe and
- State the names of potential acquirers and the possible exit scenarios and
- Be aware of valuation methodologies and their components during the journey and select a trustworthy, experienced business advisor along the way, and
- Be pragmatic throughout