By Alan Simpson and Gene Gall, Business Management
According to several nationally respected business reference guides, most small businesses (less than 99 employees) sell for multiples between one and three times owner discretionary cash flow (ODCF). This is commonly defined as operating earnings plus one owner’s compensation and perks before interest expense, income taxes, and depreciation/amortization.
For a typical service trade company, a multiple of ODCF results in compensation (sales price) equal to 25 to 35% of the company’s average gross revenue for the previous three years. Please note that a percentage of average gross revenue is not a defensible or acceptable method of valuation, and is only mentioned here as a “wild guess” rule of thumb designed to shake any reader out of any exit strategy fantasies.
Three main reasons why service trade companies are worth so little in comparison to the sophistication of service provided, as well as the high employee and management skills required, are:
1. A service trade business is considered a high risk venture compared to other investment opportunities. Investors are reluctant to invest in any risky business, and if they do, most want a low capital exposure and a high rate of return on that cash. Risk is a key element in all valuation methods. Once the concept of risk factor valuation is understood, you can take specific steps to improve your company’s value.
2. Many owners overlook shortcomings in their business skills by mentally compensating with high technical abilities. On a daily basis, there is much more satisfaction in solving a technical problem than enforcing a time-consuming administrative procedure. Most service trade businesses are leaky buckets of profit held together by the entrepreneurial spirit and drive of the owner. They aren’t worth much without his or her presence.
3. Owners often don’t realize that the best buyers are usually non-technically based individuals with no previous experience in a service trade. We tend to think a new owner must have technical skills in order to run the company. Many owners pass up the vast majority of potential investors who can and would pay more if the service trade company presented itself properly.
The table on page 70 lists the major risk factors of a company that an “outside” investigator will consider before purchasing a service trade business. To rate your company, choose a rating in each category from 1 to 3 that best describes your company, 3 being the best and 1 the worst. Multiply the rating you have selected by the weight (Wt) for that category to obtain the category score. Add all the scores and divide by 42 to obtain your multiplier. Multiply your owner discretionary cash flow (discussed earlier) by the multiplier to obtain the enterprise value of your company.
For example using the first category, “Sales Trend”: If your company’s annual revenue is growing at 15% or better, choose 3 (the best) as the rating. Multiply the rating (3) times the weight, in this case 3, for a score of 9. If your company is dropping in annual revenue, the rating would be 1 (the worst), times the weight of 3, for a score of 3.
Try to be as accurate as possible rather than always choosing the middle rating of 2. If you don’t know for sure, choose 1 as the rating rather than guessing “somewhere in the middle”. The fact that you don’t know for sure, or that written answers can’t be easily found in company records or manuals, are value risk indicators in themselves.
Keep in mind that this exercise may help you recognize some of the value risk factors of your business but it is not a substitute for an accurate, professional valuation.
If the resulting multiplier seems low, you are not alone in your opinion. Every potential sale or transfer of a business starts with an initial offer that is acceptable to the seller. (If the initial offers were not acceptable, a seller would not begin the selling process in the first place.) It’s during the investigation process, most often called due diligence, that the market value of the company begins to drop. If the owners discretionary cash flow can’t be validated within the buyer’s guidelines, the final enterprise value of the company will be substantially less than the initial offer.
Although this is the pattern in nearly all transfers of ownership, you can take certain pre-sale steps to mitigate any loss in the company’s enterprise value.
1. Create an exit plan. An exit plan is an action strategy designed to protect the net worth of a business owner and maximize the value of a business. Done properly, it provides a blueprint for satisfying personal needs and achieving financial objectives. It places the business owner in control of the “why, when, and how” to exit. Done poorly or not at all, there is a risk of being controlled by circumstances that result in reducing the financial rewards.
2. Create a business continuity plan. For most of us, it’s easier to go toward something than away from something. The thought of exiting one’s business may not be pleasant to consider. Rather than avoid transition planning altogether, why not consider a plan to keep your business alive and healthy long after you leave the helm? Business continuity planning actually includes a personal exit strategy along with establishing the highest value of a company, setting terms and conditions of a buyout or transfer of responsibilities and ownership, and defining the best method of continuity.
3. Choose what’s best for all concerned. An outright sale may not be your best choice of transition. Be sure to consider your employees, the company itself, and even your customers. There are at least a dozen other choices including intra-family transfers, mergers, buyer-of-choice agreements, recapitalization, initial public offering, sale of stock to employees, and even in some cases, liquidation.
Perhaps the first step in any owner’s transition planning is to decide what he or she wants. Which is preferable, having bragging rights of a huge single sum buyout, or the comfort of continuing retirement cash flow for decades to come? Whatever your final plan may be, don’t try to do it on your own. Consult as many experts and experienced fellow contractors as is necessary. It’s a big step, but with the right planning, it can be a most rewarding experience.
|Rating: Best to Worst Examples
|15% or better – At or about inflation rate – Negative
|Growing faster than sales – Slightly faster – Negative
|50 % of gross revenue – 40% – 30% or less
|No license required – Minimal – Specific trade license
|Rate using “few” to “many” and the ease of new entries
|Estimate the outlook based on economic and population trends
|In-house trained – Vocational schools – Number of answers to ads
|Stable, well trained – Average – Poor attitude, skill level
|Strong management team – owner micro-manages
|Op. Exp. Trend
|Dropping as % of sales – Stable – Increasing
|Large # of small customers – Small # of big customers
|Plenty of expansion room – Not critical – Small, tight
|Daily w/monthly reviewed accrual – Cash basis annual
|Above industry bench marks – Same as – Lower than
|Debt to Equity
|No debt – One to one – Below one to one
|Diverse income mix (hvac, plumbing, etc.) – Single income category source
(just hvac for example)
|Mkt. Size/ Share
|Large market, large share – Small market, small share
|Formalized jobs/descriptions/procedures – Haphazard
|Flat rate pricing — Service agreements — Automated dispatch, Accurate inventory control
— Customer follow up — Referral rewards — Results tracking and management —
In-house profit bonuses, etc. (Rate how committed company is to this type of systems)
|Own – Long term rental with option – Month to month
|Marketing programs — Career opportunities — Benefits — Profit sharing — Mandatory
continuing education, etc. (Rate how committed company is to this type of systems)
|35% or more service revenue (rate how close company is to this)
|Service/replacement — Profitable contracted — New construction bid work
|Add score and divide by 42 to obtain multiplier