Kerry Pulliam, CFP®, AEP®, CEPA®
Valuing Business: Revenue, Profits, and Sustainable Cash Flow
It is a truism in business that a company’s value extends far beyond its immediate financial metrics. Yet, in valuing a business for succession, acquisition, growth, or exit planning, an undue focus tends to be placed on the immediate figures of top-line revenue and bottom- line profits. The saying goes that “revenue is vanity, profits are sanity, but cash flow is king.” In this light, sustainable cash flow for the highest valuations tends to be sidelined due to the omnipresent impact of risk and its effect on the sustainability and stability of future cash flows.
Risk Mitigation: A Closer Look at Tangible and Intangible Assets
When we discuss risk, we often think about the insurance on tangible assets, such as property, plant, and equipment. It’s not unusual for businesses to spend hundreds of thousands, if not millions, annually to safeguard against potential losses of these assets. However, an examination of business transitions reveals a telling pattern: tangible assets comprise on average only about 30% of a business’s value. The lion’s share of value, nearly 70%, is attributed to intangible assets.
While some of these intangibles, like patents, trademarks, or copyrights, can be relatively straightforward to value and transition, others are trickier. These include specialized knowledge, skills, and relationships typically held by key people within the business.
For instance, consider the case of a trucking company owned by two individuals, ages 68 and 61. When health issues arose, they agreed to sell the company. The terms negotiated with a competitor were generous, but when the selling plan was shared with key employees, it triggered an unexpected response. A key person with strong customer and driver relationships quit, starting his own trucking company. The buyer, unwilling to compete, backed out. Collaborative planning with a team specializing in tax, legal, and financial aspects might have mitigated such an outcome.
Navigating the 5Ds in Business Transition
This scenario underscores the critical nature of the ‘5Ds’ of transition risk – disagreement, distress, divorce, disability, and death, as outlined by the Exit Planning Institute. These dynamics can trigger threats not only to businesses but families as well.
Early in my career, I had a telling conversation with an owner of an HVAC contractor business regarding the importance of buy-sell agreements. A few years after our conversation, the older partner suffered a heart attack and did not survive. Their verbal “understanding” failed to stand under the strain of actual events. The surviving partner was forced to use more company reserves to purchase shares, negatively impacting their ability to obtain bonding for jobs, and leading to the company’s sale at liquidation value.
Planning for the Unforeseen: Lessons Pandemic from the COVID-19 Pandemic
Human nature often has us planning for the last crisis, not the next, with the rearview mirror a poor predictor of the future. Converting business income into personal savings in a tax-efficient manner that protects from business creditors, predators, crashes, and taxes, while retaining access to the business in times of financial distress, is essential. When the world was shutting down at the onset of Covid-19, a sales organization was able to access over $5 million in tax free cash within days thanks to a decade of forward planning. This money bridged the gap until a PPP loan became available, helping the business to thrive in a post-Covid world.
The Legacy of Multi-generational Businesses: Planning as the Key to Success
Fourth and fifth-generation family businesses are rare gems, typically borne out of thorough planning. These families understand the importance of creating value for the community, employees, and stakeholders, rather than merely accumulating wealth. One risk, however, is inescapable – death. Business owners either have a ‘vertical’ plan to retire someday or a ‘horizontal’ plan that sees them carried out. Without planning, 40-50% of the wealth could be lost to estate taxes. These successful multigenerational businesses typically have coordinated business transition and estate plans developed by collaborating with tax, legal, and financial teams.
In conclusion, in succession, acquisition, growth, and exit planning, the importance of risk mitigation cannot be overstated. Collaborative planning can unlock business value, improve sustainability, and prevent devastating losses, while ensuring that the torch of entrepreneurship continues to burn bright across generations.
