Build Business Value: Take Action Now, Increase the Value of your Business, Get the Most when you Sell

One

Show Net Profit

Run a Profitable Company

You would think it goes without saying: run your business to make a profit. But not showing annual profits is one of the biggest mistakes small business owners make.  

Your tax adviser may well tell you that your goal is to do just the opposite: to maximize deductions in order to have little or no end-of-year taxable income. After all, why pay tax when you don’t have to?  And while this may be sound short-term cash flow advice, it will not help you sell for value when the time comes.

Let me stop here and say, you don’t have to operate your small business with an end goal of building its value and selling it some day. Operating a business to make money now and then shut it down, or hand it off to your kids, or sell it for just a little at the end – those are all perfectly acceptable strategies you may wish to employ. If you are operating your business this way, minimizing current taxes may be an excellent way to implement that strategy.

But this book is about growing business value with an eye to eventually selling your business at a good multiple. An exit. And if you are about building business value, showing increasing annual profit is an absolute must.  

Small business valuations are driven by a net present value of the business’s profits. Often, the valuation will be based on the company’s EBITDA – which is simply its net profit (earnings) with payments for interest, taxes, depreciation and amortization added back to the bottom line.[1]

Most valuators and purchasers will use a formula that takes into account the last three, or even five, years of a business’s EBITDA. Showing a strong, growing EBITDA will result in a higher valuation than a small EBITDA, or one that goes up and down from year to year. This is because a yo-yo ing EBITDA either implies risk or deception.  Let me explain:

If I am to buy a business, and I assign a value for that business, I want some reasonable certainty that the business will either continue as it is or will grow. If your business makes $1 million per year in profits, and I pay you $5 million for the business, I want to be reasonably certain that the business will continue to make $1 million per year, or more. If your profits go wildly up and down each year, then I am uncertain how much the business will continue to make in the future, and I will lower my estimate of the business’s value in order to minimize my risk.

I’ll also consider that you may be achieving the highly profitable years by manipulating invoicing and cash flow to artificially inflate one year at the expense of the years on each side. This will make a savvy buyer look closely at your invoicing and check depositing and may result in a loss of trust as to the rest of your numbers and assertions, which could be fatal to the deal. At a minimum, the buyer is going to average the profits over several years, and you won’t likely get a multiple based on your highest profits.

I should explain here the word multiple because you will hear it quite a bit when it comes to valuing businesses. A multiple (sometimes people will call it a turn) is simply the number by which you multiply profits (or EBITDA) to get a value for the business. If your company has $1 million in EBITDA, and someone tells you it is worth a 3x multiple or 3 turns, then they are saying your business is worth $3 million. How many multiples or turns on profits a business gets is dependent on a lot of factors, including:

The type of business and industry

The level of profits (businesses with $10 million in profits get higher multiples than businesses with $1 million in profits, generally)

The age of the business

Growth over time

Confidence in the business’s financial records

Professionalism of the business and staff

Intellectual property

Recurring revenue

Contracts

Etc., etc. etc.

But no matter how many turns your business will generate, the base number will likely be some form of net profits or EBITDA. That’s why showing strong, growing, annual net profit is the foundation of growing business value. And, because the buyer is going to look back three or even five years, it is a step to begin to take today. You can’t just show one year’s profit when you are ready to sell and expect to get good value.

People will tell you that you can have the best of both worlds. That you can show little or no profit year over year, and yet show value when it is time to sell, through the magic of recasting. It is true that a valuator will often recast your financial statements to show more income than you reported to the IRS (or less, as the case may be). How?

The financial evaluation of your business during the due diligence period of the purchase transaction will include the buyer looking over all the deductions you took from gross revenue to reach net profit. They will also look closely at items you capitalized and amortized or depreciated rather than deducted. They are trying to determine the real net earnings of the business in order to be more confident in their valuation. If you deducted