The Five Stages of Value Maturity
When I was a young man I can remember my brother, who owned a small business, telling me he was rich… “on paper”. I never really understood that until I became an owner myself. Most financial planners will tell you that many owners have 80-90% of their net worth tied up in their business. Yet, many times this is only a number. Beyond the working capital and asset value which lies in the business, owners cannot really get their hands on most of what their business is worth unless they can monetize that value.
The fact is most owners don’t even know the true value of the business. In EPI’s State of Owner Readiness Survey, 56% of owners indicated the felt they had a “good idea” of what their business was worth, yet only 18% had completed a formal valuation of the business within the previous two years. In another survey by the Alliance of Mergers and Acquisitions Advisors (AM&AA), 95% of M&A professionals indicated the value gap between what the business was worth versus what owners thought it was worth was the number one factor to why businesses don’t sell.
Most business owners did not start their business with the end in mind – the idea of selling it at a premium someday. Most started or purchased their businesses for reasons of personal growth, for what they thought would give them independence, to be the “their own boss”. Some were forced to start or buy because they lost their job or could not find a job. Some felt like they had a rare idea that could be developed into a business. Some felt that owning their own business was the only way to secure income. Only a few actually started or purchased a business with the idea of building it and selling it some day with the hopes that it would make them rich.
How Much of Total Net Worth is Dependent on Business?
How important is the business to the owner’s wealth plan? My friend Sean Hutchinson does a compelling presentation which illustrates the significance of the business in the owner’s portfolio of assets and wealth by displaying two circles. It is an effective way to see the impact of a business on the owner’s net worth. Let’s look at an actual past client of mine to explore this importance. The first circle displays the owner’s wealth without the value of their business included:
This is a common view of net worth without the business reflected in the statement.
As you can see without considering the business this owner has most their net worth in real estate (34%) and retirement plans (36%) with all other being made up of cash, life insurance cash value, a few non-retirement investments, their residence, and personal property.
Now let’s explore the circle with their business value included…
That large dark area is the value of their business and it accounts for nearly 70% of their net worth (assuming they can monetize it). Including the business’ market value increased their net worth by 229% or more than 3x their present net worth.
As an owner, really ask yourself:
- Will cashing in this asset make a difference to your lifestyle at some point?
- Do you have a system which is built to continuously focus your team on maximizing the value of your most significant financial asset?
In this actual case the value of the business accounted for 70% of the owner’s net worth. That’s not 80-90% as many financial planners indicate is normal – but does it matter? Whether you calculate this number to be 70%, 80% or 90% – it doesn’t matter cause any way you slice it, it’s big! Of course, it will make a difference. Imagine if this owner cannot liquidate the asset at some point.
Of course, the opposite point to that is – why liquidate, right? After all, the business is producing a very nice lifestyle.
Let’s look at another scenario. This business was generating roughly $1.7 million per year in recasted EBITDA supplying the owner with a very nice annual income. In fact, given the amount of cash this business was kicking off, wouldn’t you expect his net worth portfolio without the business to look stronger? Let’s face it, this owner was spending a lot of what they earned. But that’s a discussion for another time.
Regardless, this business was providing a very nice lifestyle for the owner. Let’s look at life-after the business. Let’s say he was actually able to sell the business for what it is worth – $8.5 million. Perhaps he clears $5 million after the sale. If he invested safely and earned 4% on the post-sale value, he is now earning $200,000 per year on that investment. That’s a far cry from the $1.7 million he was earning on the asset pre-sale. He just took an 88% pay cut!
Is it any wonder why owners don’t want to exit – this what we call the “income trap”. If the owners have not invested to build a portfolio outside the business when they had the chance, instead of spending it, they will be quite reluctant to sell it. But that’s a story for another day too.
How long can this business owner continue to operate the asset? How long will it be before he runs out of the energy needed to run it? This owner was in his 60’s. Maybe another 10 years? So maybe if you were the owner you are thinking, ok – I get it. I’m 60 so I’ll keep the business for another 10 years and start putting more of that $1.7 million away. On the surface that’s not a bad idea. However, it’s going to affect your lifestyle and you run the risk of under-capitalizing the business potentially stunting its growth.
Clearly this owner was spending a lot of that $1.7 million in recasted EBITDA. Yes, some of it was going back into the business. But a lot of it was simply being spent on a lavish lifestyle. Now really, it would be great to start tucking some of that excess cash away over the next 10 years. But will you really do it? That means you must change your lifestyle and perhaps the amount you are investing back into the business today – not just potentially AFTER you exit.
If you decide to pull back on what you are investing into the business, you run the risk of under-capitalizing it which will potentially undermine the value of the business – which you don’t want to do. A growing business needs to be fed, continuously. You don’t want to undermine that and risk losing value.
So, if you were the owner and your plan was to hold the business, I might ask you a couple more questions:
- Do you need the business to remain profitable after you are gone?
- Can the business run without you?
Okay, so let’s look at another option. Let’s say the owners decide to sell it or gift it to the children, management or employees. They likely will not receive a big payout on transfer under those circumstances. Now the business needs to operate as well or even better without the owner operating it.
So, what does all this have to do with the topic of this post (The 5 Stages of Value Maturity)? Well, the most mature stage of the Value Maturity Index is Manage Value. Manage Value represents the most mature stage of the 5 Stages of Value Maturity because if you achieve that stage you have managed value throughout the entire process of Value Acceleration – meaning BEFORE, DURING, and AFTER you exit the business. Do you see the importance of a strong financial plan BEFORE you decide to exit the business?
We definitely want to actively manage the value of our business – our largest financial asset by far. But just as important, maybe even more holistically, is managing total value which includes your investments outside the business by making yourself business independent financially, which starts with making your business owner independent. If you can achieve that, you will have lots of exit options available to you.
I will break down each individual stage over the coming weeks so stay tuned for deeper dives into the Five Stages: Identify, Protect, Build, Harvest, Manage.