Your Business Isn't Worth What You Think

Hey, you know what? You get bang for buck. You get value for money if you're out there with more shots, right? That's true. Counterintuitive.

A lot of exercise. Yeah, exactly. We did all right.

There was a few shots. That's the first time I played this year. There were a few straight ones.

It was fun. Yeah. Good times.

I'm excited about this episode, episode seven. We're talking about valuation of business. I think it's a super interesting topic and really it's the purpose that we generally all go into business.

We want to make some money. We want to turn around and sell it. I think this one will be interesting to a lot of people out there.

A lot of owners are walking around with numbers in their head of what they think their business is worth, but they're normally way off track. How far are they usually off when they come to thinking of the current valuation for their business? Wildly off, John. Their business isn't worth nearly as much as they think it is.

We'll get into why that is. My good friend and colleague, Justin Goodbread, wrote a book called Your Baby's Ugly. It's about this topic itself.

He has a podcast out there where I was actually on there. You can look at that podcast as well. Essentially, people have a- Were you the good looking one or were you the ugly one? I was the ugly one again.

I'm used to it. I make other people look good, John. That's my whole goal in life.

That's my job. Yeah, exactly. Everybody has a delusion of what their business is worth.

They hear a number, they want a number. The truth of the matter is that it's not worth what you think it is. It's not a rounding error.

It's a different ballgame. It's a different league. It's a different zip code.

Sometimes it's a different time zone of what people actually think it is. An owner will say, well, I want $5 million, but the market, a buyer, says it's only worth two. Then the owner is offended.

What do you mean? My life's work here, my blood, sweat, and tears, building this thing up is only worth $2 million to someone else. We're going to get into the topics of why that is and more importantly, what you can do about it. The problem is people have this number in their mind.

Even when reality is staring them in the face, they've already spent the money on a lake house, on a boat. The difference between $2 million and $5 million is life-changing. There's a huge difference having $3 million more in the bank.

Brokers are to blame, expectations are to blame. Unfortunately, reality is the truth. A little bit of delusion, right? If you're pulling numbers out of thin air, they might make sense to you.

It might be a bit of a wish or a dream, but there's actually a formula. I think we're going to get into the formula later on for how you make these calculations. I worked for an agency owner.

He was doing $4 million, not making a ton of margin, but wouldn't have sold for $20 million was the number in his head. It's an inflated valuation out there, which was just not grounded in reality. Where does it come from? How do owners get there? Why is it so disconnected from reality? There's three places, and all of them are pretty tragic, John, right? They hear a story, whether it's at a barbecue, golf course, or whatnot, and one of their buddies, they sold for 6X.

6X is the multiple, and we'll get into what that actually means. Now everything needs to sell for 6X. That's the expectation now.

What they didn't know is that their buddy had a substantial recurring revenue, 30% margins, and a team that ran without him. They didn't hear that part. They just heard 6X.

And that was in between bites of a brisket sandwich or between golf swings or whatnot. And so I really think that when buddies are telling their story, it should come with a surgeon's general warning. And that buddy at 6X is one of the very few that happens.

So that's one percenter. Second place is that they confuse revenue with value. So $4 million ad agency with very little margins and looking for 20 million.

That's 5X off of revenue. Buyers don't care about revenue. They care about the bottom line.

They care about consistency. They care about cash flow. Those are the things that matter, not revenue.

Revenue hardly ever plays any part of the valuation. The third thing is that they want to charge a buyer for their suffering. They want to charge it for the legacy that they built.

15 years of sweat equity, missed birthdays, sleepless nights. A buyer doesn't care about that. A buyer pays for the machine.

And unfortunately, your tears, your blood, sweat, and tears, they don't show up in the cap table. And I'm going to give you an extra bonus one. Number four is brokers.

Brokers are the worst at valuing things. They want to get you top dollar. That's the only reason they exist, to get you top dollar so their fee gets top dollar.

So when you're selling for $3 million and the broker has a 10% fee, that's $300,000 to the broker for buying you a buyer. If it goes down to $2 million, in reality, the broker loses $100,000. Their fee is now $200,000.

So they're always going to say, hey, I think you can get this, and we'll see what happens. But the market never lies. The market wants what it wants, and that's the way it goes.

So it seems like it's a mixture of poor education or information, delusion, and a little bit of emotional attachment to everything that's been built up. And when you combine those things together, it gets crunched up into a, hey, $20 million. That's my number, which makes no sense to anybody.

Let's delve into the mechanics. Except for the owner. Right.

Well, except then they'll never realize it. You hold that number in your head, and you never get there. It doesn't become a sellable thing at that point.

Let's delve into the mechanics. How does a buyer actually determine what a business is worth? You and I have been through this process, and we're actively engaged looking at businesses. I find it super interesting.

But how does a buyer determine value? So it's a very boring answer. It's a multiple of earnings. So it's adjusted EBITDA times the multiple equals the price.

Adjusted EBITDA, meaning that you might have heard it as seller's discretionary earnings, SDE, those kinds of things. So essentially, if my adjusted EBITDA is 1 million, and I have a multiple of 4, then that is 4 million. That's the price of the company.

The multiple is where every dream is made and where every dream goes to die. So that 4 million in revenue with 1 million EBITDA, and he wants $20 million, that's a multiple of 20. Nobody in their right mind is going to pay for that.

That's where that came from. A $1 million to $10 million business typically will see between 2 and 5x, which is the multiple, so 2x, 5x is a multiple of adjusted EBITDA or SDE. But that's not a range, it's a chasm.

There's a big difference. So if I have 500,000 of EBITDA and I have a 2x or 2 multiple, that's a $1 million check. If I have a 5x or 5 multiple, that's 2.5 million.

That's a difference of 1.5 million. It's the same business on paper, but it's a completely different boat. We're not buying a dinghy anymore, we're buying a yacht.

I think the wrong question is, what's my business worth? The right question is, what's my multiple and how do I get it to increase? How do I go from 2x to 4x? That could mean millions of dollars out there. And that's the lever, almost nobody is pulling it as to how do I get there. They're too busy yanking on revenue, which by the way, it doesn't move the needle.

What moves the needle are gross profit margins, net profit margins, recasted or adjusted EBITDA. And that's why we talked about revenue being a vanity metric a few episodes ago. Revenue doesn't account to a hill of beans when you're actually turning around to sell your business.

But yeah, let's keep digging. What moves the multiple? What makes a buyer pay 4x versus 2x, for example? Well, I think there's eight factors. This is your sticky note material.

Hopefully, you re-listen to this podcast. But here's the first four, John. I'm going to write them down.

Owner dependence. If your business cannot function without you, you're multiple drops like a cinder block. Buyer is buying a business, not the privilege of having a job with overhead.

And also, if everything depends on you, it's extremely risky. And that lowers the multiple as well. Risk lowers the multiple every time.

So we've got to get the business running without you, and that will increase your multiple significantly. Second one is revenue concentration. If 30% of one or two clients is 30% of your revenue because you're doing a business with your cousins, there's a real risk there.

That's losing 30% of annual sales, which drags down your adjusted EBITDA. So one client leaves, the whole thing falls apart like a poorly assembled Ikea bookshelf. The third thing is recurring or contractual revenue.

So in construction, that would be called a backlog. But also, making sure that we have recurring, you can set your watch to it, revenue. And if 70% of the revenue lives there, you're on a different planet.

But if you're starting at zero every single January, the multiple is not going to be there. We need to have a backlog. We need to have predictability.

So anything that is boring, predictable, low risk, that's going to help increase your multiple. The fourth thing, these high-earning projects where you have to bid via RFP and you're going through that process over and over and over again, that creates uncertainty in terms of income. Sometimes a business model where it's simplified and it's regular and recurring, that demonstrates the consistency you're talking about.

Dave It does, right. But some of those RFPs might be for a five-year duration. So then it becomes recurring revenue.

So there is some good to that, folks. But if you're constantly having to go out and get the next sale and get the next sale and get the next sale, you're absolutely right, John. It's going to lower your multiple.

The fourth thing is cashflow consistency. Go ahead. John One more point there because that goes back to the owner as well.

A lot of the time, it's the owner going out and winning that business, either handshake deals or they're the ones with the relationships and the locale. So you got to think about that a little bit in terms of if you're removing yourself from the equation, how does a buyer coming in understand that, oh, we can count on that sales flow for continual ongoing revenue. So just obviously things to think about as people are preparing.

Dave Absolutely. We worked with one client who was very much owner-dependent and we actually increased expenses by bringing in people to take away a lot of the tasks that that owner was doing. So now, we were reducing the owner dependency.

We also made it a point to diversify the customer base. And so when the person sold, it sold for 1.5x more than it would have just two years previous before doing that. John Right.

So worth the cash hit. Dave Absolutely. Absolutely.

Yeah. The return on investment was 1,000% or 10,000% or something like that. It was crazy.

So I think the fourth thing is cashflow consistency. So we want to make sure that there's no seasonal panic, that payroll isn't a magic trick in the offseason, those kinds of things. We want to try to smooth out cashflow as much as possible.

We want to make it boring, predictable, on-time cashflow using profit-first methodology. So if you are seasonal, you've already saved up all your money and now it's predictable cashflow coming in. You have enough money to pay your bills because you've seen it, those kinds of things.

And so I cannot stress this enough, the market pays a premium for boring. It always has, it always will. John Awesome.

Okay, that's four. What are the others? Let's keep rolling. Dave Clean financials, John.

If the books need a guided tour and an interpreter, it ain't going to happen. I've seen it where books were a mess, tax returns didn't tie out to the financial statements, and it costs somebody a multiple of two. I also saw it the other way where you can hand the potential buyer everything on a platter, everything's clean, everything's wonderful, and they paid an extra three, multiple.

Because it was gift-wrapped. So think of it as being, I hate to use this term, but audit-ready books. They're ready, they're good, and that's what's really going to give you a leg up on your competition.

Numero seis, number six, team depth. Do we have a real management layer? Do we have a visionary, an integrator, department heads? Are they helping us make decisions? Now where I have a leadership team structure, that's what we need. Or is your leadership team you, your spouse, and your cousin Jerry? That's the difference.

We are looking for turnkey, turnkey is premium. So we want to make sure that we have a team that can make those decisions. And a great way to think about that is if you left and went on a trip for four weeks, would your company run without you? And if your company would run better without you, then that's what's going to get a great potential buyer that's going to pay for a huge multiple.

Seven is growth trajectory. So revenue is not the underlying factor, but we want to see that the curve is going from left to right in an upward type of direction. That also means that we need to make sure our profitability is increasing as well.

A lot of people, and that's in the episode of revenue, is that they will sacrifice their bottom line to increase their sales. Don't do it. We want to make sure that we are doing, we are scaling things profitably.

That's the key. We see a lot of businesses on that point. We see a lot of businesses that suddenly have a great year and think, oh, I'm going to sell.

And so maybe they're doing 500 one year, 550 the next year, then 900 the following year. And then they use evaluation and EBITDA, SDE, whatever. And then they're using that 900 as the multiple.

Would a seller look at it that way? Because they're suddenly having a great year. They think the valuation has gone up and they're going to get more. That's not necessarily the case though, is it? No, John.

So a seller will look at that that way. Hey, we'll take our best year ever. And then give me a multiple of four off of that one.

A sophisticated buyer will take the last three years. What's your run rate? Is it an abnormality? They might wait it a little bit more towards that 900,000. Especially if you're forecasting it's 1.2 million.

And we're four months into it and you're hitting your targets. That's something that you can go to as well. But yeah, the seller, the broker will tell you, base it on the 900,000 year.

And a buyer will come in and say, not so fast. And the last thing, numero ocho, is industry and market dynamics. SAS, for example, goes to 8 to 12x, whereas landscaping is 2 to 3x.

You can't change your industry and you can't change your height either. And so that's just the way it is. And it's also the eye of the beholder, right? So the market is what the market is, right? And sometimes markets get crazy and sometimes markets are cold.

Right. Gotcha. So yeah, and that makes a ton of sense.

A lot of what you just described, I mean, it sounds like years of work. If an owner is like three years, say, from wanting to sell, is that enough time to put all that in place? We typically say it takes three to seven years to get ready to be sellable, right? But three years is doable, right? It's not comfortable, but it's enough. So year one, I like to call that the unsexy year, right? Where you're going to clean your books, you're going to restructure your owner's compensation, you've got to have profit first running, document the processes that currently live in your head and would die with you in a car accident, right? That's what we need to do.

Start getting out of owner dependence, right? Nothing really changes outside. Everything changes underneath. We want to make it boring, but life-changing.

And that's what the first year is. Year two is the team year, right? We're going to hire or promote the people who run the business when you're not in the building, right? We want to build up a leadership team so that we can remove you and have business decisions made for you. And that's really going to show that a potential buyer that, hey, I want to just buy for the cash flow.

I just want to buy for the ATM. I don't want to run this business. I want to have a team that's going to run it for me, right? And they know what they're doing.

And so they're going to get reps under their belt, right? By doing it that way. But the problem is, is that owners have a really tough time delegating. They have a really tough time knowing what to do and allowing their teams to make mistakes or to figure things out on their own, right? But this is going to be probably the biggest factor in you getting a higher multiple is by allowing your team to do that, right? And then year three is the proof year, right? You had two years of clean data, consistent growing financials, right? The leadership team now has gone into their move, right? And it really will demonstrate that the business operates without you, right? You want to diversify your revenue and you're really starting to build the buyer's narrative, right? What do buyers want to see? Well, I've got predictable cash flow.

I've got recurring revenue. I have a backlog, those things, right? And you're not even selling a pitch, right? You're selling proof that this works, that your business is a viable thing for a potential buyer, right? And so if this happens, that's when you can start talking about four to five X, right? If you're not prepared, you're going to be stuck at your two X. This segment is brought to you by Backyard Barbecue Capital Partners. Brian, have you heard of them? Unfortunately, yes.

I read their pitch deck. Very impressive. Was it on a paper plate? Nope.

It was on the back of a placemat from a steakhouse. That tracks. Their motto is your business is worth what you say it's worth.

That is the entire problem with this episode in one sentence. They quoted me seven times revenue for a line. Marketing agencies trade at one to two X. But they said I was special.

Of course they did. They also offered to handle the diligence themselves to keep things efficient. That is called fraud.

They called it streamlined. Don, walk. No, run away.

They said you'd say that. They said you were jealous. Of what? Of their methodology.

Their methodology is asking Steve. That's what I said. They said exactly that.

Backyard Barbecue Capital Partners. If your fractional CFO tells you not to use them as the first informed opinion you receive in the entire process. So I shouldn't sign? John.

Right. Right. Okay.

Gotcha. It makes sense. I think a little bonus information for for sellers too.

Most most buyers will have what's called a buy box where they sit down and they they're because they'll be looking and someone will be looking for years to purchase the right business. And so they create a buy box with all the right criteria. And it's a number of things you mentioned.

Right. What is the SD? How many employees? How many years in business? What vertical is it in contracts in certain or customer concentration? They'll even go into the price they're going to pay. How much to pay a deposit? How quickly do they pay that deposit back? And they put that generally in some sort of spreadsheet.

And they have this buy box that they sit there waiting to to make their call based on all those different criteria. Is there anything that a business can do just to kind of shape things beyond what we just said? Obviously, you've gone through all the different mechanics of how those multiples are created. But, you know, with a three year plan, understanding all the factors of multiple, is there anything else that can be done? Like just thinking through how things are transferable, how the business is sold, you know, asset sale versus, you know, an outright purchase of the business.

Anything like that people can can do to prepare as well? Well, I think you need to start assembling your advisors. Right. You need personal advisors, business advisors, so that you know exactly you need outside perspective on things that you can improve.

Right. And what you're going to do with that money once you sell. Right.

Right. So, yeah, businesses have a buy box and it's you want to be the bell of the ball. Right.

You don't even want it to be a question when you when you put your listing out there or when word gets around that you're, you know, you're looking to start the next chapter of your life. Right. You want to have everything ready to go, have your due diligence ready to go.

You have all your ducks in a row. And that way you can make a nice, clean exit. And if you have a nice, clean exit, you're going to get top dollar for it.

Yeah. And if you do view it from the lens of a buyer's buy box, I think you get extra insight. One example is, you know, we're looking all the time and you dig in.

A lot of people want an asset sale versus a share sale because, you know, you don't want to buy liabilities in the company. You don't want to buy any potential legal issues with an asset sale. Somebody's just coming in and buying the assets.

But when owners and sellers are creating contracts, they don't necessarily think that their contracts need to be transferable. So that's something you can plan for. Right.

Like if you have transferable contracts when you make all your deals, then somebody coming in and making an asset purchase, those contract transferable contacts then go with the business that's purchasing their organization. So that can help. I mean, that's one of the things that we look at, because if the contracts aren't transferable and then you have to go in and have conversations with people that you've sold work to, there's a risk there that you don't get the revenue that there is on the books or in the forecast.

So, yeah, just some thinking as they go through and all this is great for people who knowingly, thoughtfully are preparing and want to sell their business. What about owners who say, well, I'm not selling this, so it really doesn't apply to me? Exit planning is good business. OK, yeah, it applies to you most of all if you don't want to sell.

Exit planning is about having options. Right. If I have a job with overhead, I don't have a lot of options at exit.

Right. Usually I'm just going to shut down, shut down the garage, shut down the company. And that's it because it was it was a great job for me.

I provided for my family, other families. But, you know, it's all owner dependent, so nobody else is going to buy it. Right.

So when you have when you're doing these things, here's what's here's what's really nice about is that, you know, if you have lower owner dependence, you get your weekends back. Right. If you have a great team depth, there's no meltdown when you leave to take your kid to the orthodontist or or go to Italy for three weeks.

Right. If you have clean financials, you're making decisions based on data, not vibes. Right.

If you have consistent cash flow, you can sleep at night without a stomachache. You know, building a sellable business isn't about selling. It's about building a business that doesn't need you to survive.

Right. So what happens if one of the five D's happens to you where, God forbid, you were to get into an accident? If you have a sellable business, something that runs without you, that's still going to provide money for your family for years to come. Whereas if it's all on you.

Right. That thing could collapse immediately. And then now not only do you have insurance and medical bills and all that kind of stuff, but you have no income coming in.

Right. So every owner will exit eventually. Right.

When it's voluntarily, accidentally, medically or in a wooden box. Right. Everyone exit.

I'm not selling is not a plan. Right. It's a postponement.

So the universe doesn't care about your plan. It'll exit you on its own schedule if you don't pick one first. Right.

Awesome. So if somebody's listening, they realize they've got no idea what their business is actually worth, what's the first move? What do they do? Get a real number. Right.

Not a guess. Not what your buddy got.