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In order to maximize enterprise value, a business must not only prove that it makes money, wins clients and closes deals, but must demonstrate that it is bigger than just the owner – that it won’t falter in his or her absence.

Industry trends

Succession Planning: Optimizing Enterprise Value

  • Darrel Mullenbach
  • 1/13/2020

There comes a time for most entrepreneurs and business owners to face a critical decision: when to sell their business. The reasons for selling can vary, though often it’s with an eye toward retirement. When you consider that baby boomers own almost half of privately held businesses in the United States, and that 10,000 boomers reach the age of 65 every single day, it becomes apparent there’s a growing urgency for entrepreneurs to prepare for the future.

Despite these facts, more than 85% of business owners don’t have a succession plan in place. This could help explain why increasing numbers of owners can’t find a buyer for their businesses once they’re ready to sell. Statistics show only 20-30% of businesses that hit the market actually find a buyer. Part of the reason is that a lack of succession planning limits an enterprise’s value. Add to the equation that many business owners have 80-90% of their personal financial assets based in their businesses, and alarm bells should be ringing for those who haven’t begun preparing their businesses for the day they step away.

Whether its retirement or some other reason you might want to sell your business, it’s vital to have an exit strategy. Moreover, it’s important to start planning that exit strategy long before you actually expect to put it into action. Many owners fail to understand the timeframe and steps required to adequately prepare a business for takeover, which in turn can limit the enterprise value and prevent them from getting acceptable return on the investment they’ve put so much of themselves into building.

Enterprise Value: Understanding It

Businesses can be valued in a number of different ways. When it comes to preparing a business for sale, enterprise value becomes the operative metric, as opposed to equity or market capitalization. Whereas market capitalization leaves out debt and cash reserves, those are both factored into enterprise value.

At its core, enterprise value represents the organization’s fair market value – what your business is worth to someone from the outside. Importantly, enterprise value realistically lies deeper than numbers and figures. One critical aspect entrepreneurs can overlook is how much of that enterprise value actually lies with the owners themselves. In other words, is the business itself that valuable, or is most of the value in the knowledge, skills and relationships of the owner(s)? Could that business continue to exist and function with similar profitability without the presence of the owner?

If less than 15% of businesses have succession plans in place, as noted above, it’s not hard to understand why so few businesses are sold if potential buyers can’t find enterprise value, beyond the current ownership, that the owners are asking. This illustrates why developing and maintaining long-term a succession plan to build enterprise value is essential to earning top dollar when selling a business.

Enterprise Value: Optimizing It

It’s one thing to understand the definition of enterprise value; it’s another to understand what optimizes that value. Given the purchase of a business is a financial transaction, it shouldn’t need stating that –– foremost –– complete and accurate financial statements are necessary. If any of the financial reporting appears to be unreliable, the value of the entire enterprise comes into question. With confidence in the accounting, a buyer is often willing to offer a higher price – confidence in the numbers allows more confidence it what is being acquired.

But as we already noted, numbers aren’t the only factor. The goal when preparing a business for sale is to make it equally or even more valuable without the owner. That is accomplished by moving key decision making away from just one person.

A transfer of value must take place from the owner, ideally to a management team as opposed to another individual. Distributing key decisions and operations across a team of departments adds value to the enterprise because it’s decreasingly dependent on one or a handful people. Coordinated and cooperating departments, such as sales and marketing and HR, can carry out their specialized operations more efficiently than under the direction of a single figurehead.

In order to optimize enterprise value, a business must not only prove that it makes money, wins clients and closes deals, but must demonstrate that it is bigger than just the owner – that it won’t falter in his or her absence. It must prove sustainability and growth potential under new leadership. Unfortunately, the time and complexity mandatory to establish that assurance is commonly overlooked and underestimated. Building optimal enterprise value requires considerable planning.

Enterprise Value: Planning for It

Ideally, a business owner maintains prudent financial planning that always keeps the future in mind. In best cases, he or she sets a target date for retirement and works backward to build a timeline to get there. But even the best of plans can encounter bumps in the road, so it makes sense to understand how much planning is involved in establishing and growing enterprise value before selling a business.

It’s logical to expect that preparing to sell a business – especially one in which much of the enterprise value has been with the owner(s) – can take five to seven years. Naturally, variables may shift the timeline, but this general timeframe attests to it being a long-term process.

Many business owners have years’ or even decades’ worth of personal knowledge about their business and industry that was gained from the proverbial school of hard knocks. It takes time to transfer this knowledge. Furthermore, it’s rarely as simple as choosing a successor, passing along a list of contacts and saying, “This is how it’s done.”

In fact, in many cases, a business owner must embark on a soul-searching mission to determine if the future leaders of the business are already in-house, or if they need to come from outside. Just because a person has been around the business a long time, or has an applicable skill set, it doesn’t necessarily make them a good fit to take the reins. In these times, entrepreneurs must make some honest and tough choices, which may also lead to some difficult conversations. But ultimately these choices must be made in the best interest of the company and its enterprise value.

Bringing in new staff from the outside might be warranted. It might step on some toes. It might also be an expense. But ensuring the right people are in place will pay off in the long run through enterprise value.

As a brief example, consider a company with messy books. Perhaps the office manager (or even the owner) handles the books but isn’t a CPA by trade. The business has managed to get by in this manner, but potential buyers will demand more than messy books. Bringing in a trained accountant who stabilizes and frames the business finances adds to the enterprise value both short and long term.

The key for an owner is getting the right people in place. Once you feel confident those people in place, begin the knowledge transfer and start the transition of decision making. Slowly let the new leaders take on more responsibility and groom them to the point you can simply weigh in before important decisions are made. Once the business can operate in absence of the owner, it’s ready for a potential transfer of ownership – and for drawing its best possible sales multiple.

Bear in mind that, while the sale and transfer of a business is a financial transaction, it’s impossible to ignore the potential role of emotions. Many private businesses are the literal blood, sweat and tears of their owners. It’s understandable for entrepreneurs to be tentative or uneasy about some or much of the process in preparing to sell these enterprises they have built. This reinforces how important it is for owners to begin the process of transition as far in advance as possible, to ensure they’re comfortable before signing off on such a major decision.

Enterprise Value in Construction

Though the definition of enterprise value might be the same across industries, there exists nuances within certain industries that have an impact on how enterprise value is viewed. Such is the case with construction.

It’s a reality of the construction business that much of the work is based on and won through bids. This matters because in many cases contract work is awarded to the lowest bid. This can create questions about enterprise value when lowest price is winning the work instead of a reliable name or brand that’s winning contracts on that name or brand value. In other words, just securing work by making low bids doesn’t necessarily equate to real value.

Understanding this concept, it’s important for construction companies to help build their enterprise value through the type of work they do. Service contracts or annuity-based projects – those that demonstrate repeat customers – can help establish greater value in the brand and business.

Getting Everything You Deserve

Few people start a business thinking about the day they’re going to sell it. But there’s comes a time when every business owner may be ready for retirement or perhaps just ready to take on a different challenge in life. Regardless of why they choose to sell, owners want to get the best possible return on the businesses they worked so hard to create.

In order to accomplish this, owners must make a realistic assessment of where the enterprise value lies within the business, and make sure it’s in the business itself. Only then can the company be of the largest valuable to a potential buyer. The steps and processes necessary to ensure enterprise value can be challenging and emotional. Getting the right team on your side that has experience in succession planning as well as the specialized industry knowledge will lead to a positive outcome – both financially and emotionally.

The information contained herein is general in nature and is not intended, and should not be construed, as legal, medical, accounting, investment, or tax advice or opinion provided by CliftonLarsonAllen LLP (CliftonLarsonAllen) to the reader. For more information, visit CLAconnect.com/disclaimers.