Valuing Your Business – Your Most Important Investment

Valuing your business is more than preparing for a sale or attracting investors—it’s about unlocking hidden potential and recognizing your enterprise as a powerful high-yield investment. By adopting an investor’s mindset, you can make strategic decisions that significantly enhance profitability and spur sustainable growth.

Greg Crabtree, a seasoned financial expert, emphasizes the importance of this transformative approach. With his practical methodologies, you can turn your business into a wealth-building machine, maximizing returns and achieving exceptional success.

Viewing Your Business as a High-Yield Investment

“You get paid a salary for what you do; you get a return on what you own. Don’t confuse the two.”

Greg Crabtree wearing a black shirt, showcasing expertise and professionalism.
– Greg Crabtree

When you own a privately held business, you’re in a unique position; unlike publicly traded companies, there’s no stock market to shout out a daily valuation of your company. While it might seem like a disadvantage, this can actually be a blessing.

The stock market’s daily valuations are often swayed by emotions and lack the depth to truly understand a business’s worth. Instead, as a business owner, you have the power to set your business’s value based on its true financial health, future plans, and forecasts. This is especially crucial if you have partners, want to share equity with key team members, or have compensation plans linked to the growth of your business’s value.

Greg Crabtree advocates for this crucial mindset shift. He believes that when business owners start viewing their enterprises through the lens of an investor, they unlock opportunities for higher returns and sustainable growth. By treating your business as an investment, you not only enhance its value but also set the stage for long-term success.

Benefits of Adopting an Investment Mindset

  • Strategic Decision-Making: With an investment perspective, you make data-driven decisions that align with long-term goals.
  • Enhanced Profitability: Focus on strategies that boost profits and reduce unnecessary expenses.
  • Growth Opportunities: Identify scalable expansions that elevate your business.
  • Financial Clarity: Gain a deeper understanding of financial metrics crucial for valuing your business accurately.
  • Competitive Edge: Businesses viewed as high-value investments often outperform competitors.

Return on Invested Capital

“It is our belief that no business that is privately held in a developed first world economy should be less than 50% return.”

Greg Crabtree wearing a black shirt, showcasing expertise and professionalism.
– Greg Crabtree

To step into this role wisely, you need to understand the concept of return on investment (ROI) and, even more importantly, return on invested capital (ROIC). Think of ROIC as the real gauge of how well your business is leveraging its financial resources. Unlike public market investments, where returns are calculated based on market value at the time of investment, ROIC focuses on your invested capital—essentially the money you and other owners put into the business.

Invested capital can be a bit of a tricky concept. Simply put, it’s the funds you have directly funneled into the business. This doesn’t include borrowed money, because debt is a placeholder that must eventually be paid back. Sweat equity also counts here, as it’s an investment of time and effort that hasn’t been properly accounted for in financial terms.

When it comes to measuring returns, consider the example of a bond or a certificate of deposit: you earn a stated interest, providing a clear picture of your return on investment. For a business, your ROIC unveils how efficiently your invested capital is at generating profits. A high ROIC, normally 50% or more, suggests your business is not just sustainable but thriving. Greg Crabtree’s studies indicate that businesses with less than a 50% ROIC often struggle with cash flow and sustainability unless they hold excess cash reserves.

A healthy ROIC suggests a range of attractive possibilities, from demanding a premium sale price for your business to having the option to walk away comfortably, knowing your efforts bore fruit. For example, out of Crabtree’s clients, those with efficient business operations typically see a 75% ROIC. Larger businesses, especially those with revenues over $5 million, can experience averages nearing 90%.

Ultimately, viewing your business as an investment isn’t just about celebrating revenue growth. It’s about understanding and continuously monitoring your ROIC, which brings a deeper insight into how effectively your business is utilizing its capital to generate profits and sustain growth. By maintaining a high ROIC, you’re positioning your business for long-term success and flexibility in achieving your financial goals.

Understanding Business Valuation

To unlock your business’s hidden value, you need to understand how to measure it effectively. Valuing your business involves determining its economic worth by considering various financial metrics and market conditions.

Defining Business Valuation and Its Significance

Business valuation is the process of assessing the total economic value of your company. It’s essential not only when selling or attracting investors but also for strategic planning and growth. By valuing your business accurately, you can:

  • Make Informed Decisions: Identify where to invest resources for the best returns. Know when to sell your business or keep it.
  • Negotiate Effectively: Use accurate valuations during mergers, acquisitions, or financing negotiations.
  • Plan Strategically: Set realistic goals based on your company’s financial standing.
  • Attract Investors: Present a compelling case to potential investors with transparent valuations.

Key Elements of Value

There are 5 key elements that drive sales and gross margin which in turn establish the value of your business. They include:

  • Customers – Customers are the lifeblood of any business. Without them, there are no sales, no revenue, and ultimately, no business. Loyal and satisfied customers are likely to become repeat buyers and advocates for your brand, thus driving sustainable revenue growth.
  • Employees- Employees are another critical element as they directly influence productivity, efficiency, and the quality of customer service. Skilled and motivated employees contribute to higher service quality, innovative solutions, and efficient processes, leading to lower operational costs and higher gross margins.
  • Processes and know-how- Effective and efficient processes, along with organizational know-how, are essential for maintaining a competitive edge. This includes everything from operational workflows to customer relationship management. Well-defined processes ensure consistency, reduce errors, and improve overall efficiency.
  • Core capital- Core capital refers to the financial resources that a business needs to sustain its operations and growth. This includes both working capital for day-to-day operations and growth capital for expansion initiatives.
  • Intellectual property- Intellectual property (IP) is a valuable asset that includes patents, trademarks, copyrights, and proprietary technologies or methodologies. IP can drive value by enabling higher profit margins through differentiation and providing opportunities for additional revenue streams, such as licensing and partnerships. Additionally, a well-protected IP portfolio enhances the overall worth of the business in the eyes of potential buyers or investors.

Greg Crabtree’s Unique Approach to Business Valuation

What sets Greg Crabtree apart is his ability to simplify complex financial concepts. His methodologies for valuing your business emphasize clarity and practicality:

Economic Value

When it comes to valuing a business, one of the most reliable ways to determine its worth is through understanding its economic value. This approach takes into account both a business’s profit-making ability and its overall financial health or capitalization. Essentially, you’re looking at how well the business has performed in the past and how well it’s set up for future success.

To start, the economic value of a business is typically calculated using its earnings over a certain period and the equity it holds. Specifically, this means adding up the pretax profits over the last three years and then adding the net equity—which is the difference between what the business owns (its assets) and what it owes (its liabilities)—at the time of valuation. This method serves to provide a comprehensive picture by combining both the business’s profit potential and its financial stability.

Economic value business analysis with pretax profits and equity valuation metrics.

Knowing your economic value helps make decisions about whether to sell your business or pass it on to the next generation of your family. It paints a clear picture of the transferrable value of the business.

50/50 Shareholder Agreements

Here, one partner might decide to buy out or sell to the other. In such cases, the economic value approach ensures fairness and feasibility. For a smooth transaction, the aim is to structure the buyout so that it can be funded through the business’s after-tax earnings over a five-year period. This is a practical time frame compared to the ten years someone might ordinarily consider for getting a full return on investment in other business acquisition scenarios.

Now you might wonder why we use a three-year profit period rather than just the most recent year. The idea is to establish a stable and consistent measure of profitability, rather than relying on a possibly exceptional or uncharacteristically weak recent year. However, if profits have been declining, adjustments might be necessary to weigh more recent results more heavily.

This approach is particularly insightful for those potentially buying their partner’s 50% share without external cash funds. By using this method, it typically takes between four to six years to complete the buyout using all of the business’s after-tax profits, provided no additional financial injections are needed for the company’s operations or growth.

Market Value

When it comes to valuing a business, one concept that stands out is market value. Market value is essentially the price an investor might be willing to pay for your business. This number can sometimes be higher than what the business’s economic fundamentals would suggest. But why is that the case?

The primary reason an investor might pay a premium above the calculated economic value is that “money chases easy, while entrepreneurs overcome hard.” Investors are often looking for opportunities that offer better returns than traditional market investments, and a profitable private business can certainly provide that. Unlike entrepreneurs who have to deal with the challenges of building and growing a business, investors can simply inject capital and potentially realize attractive returns.

Additionally, there’s a significant amount of capital looking for viable investment opportunities. Because relatively few businesses are up for sale, prices tend to rise, driven by the principles of supply and demand.

The value of a private company can fluctuate based on the performance of public markets and prevailing economic conditions. When the stock market is thriving and offering great returns, private companies tend to be valued at around four to six times their net income. Public companies are more attractive during these times due to their liquidity, meaning investors can easily sell their shares if they choose to exit.

Conversely, during periods when the stock market is peaking, and fixed income returns are low, private companies might see their valuation multiples climb to between seven and ten times net income. Investors, in search of higher yields, start looking more favorably at private businesses.

Buy/Sell Agreements

It’s crucial to structure buy/sell agreements carefully to avoid pitfalls. Using a market value appraisal for valuation when selling part of the business can be a trap. For example, one partner looking to exit might end up forcing an early sale of the entire company if the market is paying a premium.

A more viable approach is to ensure the existing partner receives no more than their fair share of the economic value of the business. Overextending the company’s cash flow to fund a buyout at premium market values can jeopardize its financial health. The remaining partner needs sufficient working capital to continue operating and growing the business post-transaction.

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Other Valuation Methods

Valuing a business can be approached in various ways, each with its own set of advantages and disadvantages.

Strip Sale

A “strip sale” often emerges as the go-to strategy for buyers interested in acquiring a company’s operational strengths but not its overheads. The term “strip sale” originates from the practice of stripping out a company’s valuable activities and integrating them into the buyer’s existing enterprise. This method stands out for its efficiency and practical appeal, especially when the transaction is structured as an asset sale.

For businesses that are struggling or facing financial difficulties, a strip sale offers a fresh start and an appealing exit strategy. Rather than attempting to sell the entire business as a single entity—which might be challenging and yield a lower valuation—a strip sale allows sellers to achieve a better financial outcome by selling the more valuable components individually. There’s a saying in business that sometimes “the parts are worth more than the whole,” and this rings particularly true in strip sales.

Thorn in the Side

When valuing your business, it’s essential to understand the concept known as the “thorn in the side” effect. This term refers to situations where a company’s innovative product or service becomes a significant nuisance to established competitors. In these scenarios, established companies might go to great lengths, even paying exorbitant amounts, to eliminate the pesky new player disrupting their market.

Imagine you’ve developed a revolutionary new mousetrap – it’s not just better; it’s much better than what’s currently available. Your business starts gaining market share because your product is superior. However, this success can cause turmoil for existing companies. They may find that competing with your groundbreaking mousetrap would require drastic changes to their own product lines, possibly reducing their profit margins and destabilizing their market position.

For many well-established companies, the more convenient and profitable route is to acquire you early before your business gets big enough to pose a serious threat. They would rather buy you out and integrate or shelve your product than face the risks and costs associated with direct competition. This urgency can drive up the value of your business significantly.

Software as a Service & Recurring Revenue

Companies operating on a Software as a Service (SaaS) or recurring revenue model often receive a premium valuation, but it’s important to tread carefully to avoid common pitfalls.

Many believe that you should pour all profits—and perhaps even external funding—into growing such businesses as quickly as possible. Rapid growth is great, but only if you know what actually drives that growth. Blindly throwing money at development and marketing isn’t always the best strategy.

It’s crucial to be disciplined about where you invest your resources. Consider adopting a controlled experiment approach: invest a small amount to test whether a concept works before committing significant funds. This applies to both software development and marketing efforts.

If you’re looking to build or transition to a recurring revenue model, make sure it fits genuine market needs and attracts long-term customers. Simply reshaping a traditional business into a recurring model to get higher sale multiples can backfire if it reduces ongoing profitability.

Multiples of EBITDA

When it comes to valuing your business, one popular method that often comes up is the use of multiples of EBITDA. For those unfamiliar with the term, EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization.

EBITDA is favored because it provides a clearer picture of a company’s operational performance by stripping out non-operational expenses, like interest and taxes, as well as accounting decisions related to depreciation and amortization.

The challenges of using EBITDA Multiples include:

  • Lack of Earnings or Distorted Earnings– If your business has little to no pretax profit, or the profits are very inconsistent, relying on EBITDA multiples might not paint an attractive picture.
  • Owner Salaries– Misreporting owner salaries can also skew EBITDA calculations significantly.
  • Discretionary Expenses– Many small-business owners run personal expenses through the business. While this might be a common practice, it can distort the true earnings of your business.

Multiple of Sales

“A multiple of sales is probably the weakest of multiple measures.”

Greg Crabtree wearing a black shirt, showcasing expertise and professionalism.
– Greg Crabtree

This technique considers the stock value as a multiple of the company’s sales. It’s not uncommon to see companies trading at two, three, or even higher multiples of their annual sales.

While there are some mathematical justifications for using a sales multiple, it’s important to recognize that this method involves a significant leap of faith. The fundamental issue lies in the fact that not all sales are created equal. Different sales can have varying profit margins, meaning that the profitability of each dollar in sales can differ. In some businesses, this might not be the case, but it often is, so relying solely on sales multiples can be misleading.

Discounted Projected Cash Flows

“You know, it’s funny. We always make money on the spread-sheet, but at the end of the year it’s not in the bank account.”

– Anonymous

Quote: “You know, it’s funny. We always make money on the spread-sheet, but at the end of the year it’s not in the bank account.” – Anonymous

At its core, this valuation measure attempts to determine the present value of a business by forecasting its future cash flows and then discounting them to reflect their value in today’s terms. While the concept may sound straightforward, its application often reveals a common pitfall: overly optimistic projections. This inherent optimism can lead to inflated valuations that don’t pass the test of reality.

Adding a dose of pragmatism to the projections can provide a more accurate picture of a business’s true value, showing clients both the ups and downs they might face.

Book Value or Liquidation Value

The term “Book Value” refers to the net value of a business as recorded on its balance sheet. Essentially, this is calculated by subtracting the company’s liabilities from its assets. It gives you an idea of what the company’s assets are worth after all debts and liabilities have been paid off.

“Liquidation Value”, on the other hand, is the net amount that can be realized if the assets were sold off individually, outside of the context of ongoing business. This is particularly relevant when a business is failing and needs to be wound down, and the owner seeks to liquidate the firm’s assets to cover debts.

These valuation methods often come into play when a business is not profitable or is facing financial distress. If you’re considering buying such a business, your focus should be on what the company’s existing assets are worth and not on any anticipated profits, which may be non-existent or unreliable.

In a market where the business outlook is bleak, the most logical valuation scenario is based on these net assets. For the current owner, accepting an offer that covers receivables (money owed to the business) and takes care of payables (business debts and obligations) might be more financially sensible than attempting to liquidate the business themselves, which could incur additional losses.

Best Practices For Viewing Your Business as an Investment

A common pitfall for entrepreneurs is mixing personal income with business profits. This practice can severely distort the true financial health of your enterprise and hinder accurate valuation.

1.Understand Profit Engine

An entrepreneur should understand how they generate margin. Analyze to ensure everything action in the business is contributing to the contribution margin because contribution margin is the most important number on your P&L. It can be calculated:

  • Revenue- COGS =Gross Margin
  • Gross Margin – Direct Labor = Contribution Margin

The target gross margin and contribution margin goals should be set at the beginning of the month.

Calculate contribution margin with gross margin and direct labor considerations.

2. Management Labor

Measure the effectiveness of management labor. Management labor can either be too skinny or too fat.

When management labor is “too skinny,” it means the company is under-investing in its management team. There may be an insufficient number of managers, or the existing managers might be stretched too thin, leading to inadequate oversight, poor decision-making, and ultimately, lower productivity. This scarcity of managerial resources can hinder the company’s ability to grow and respond effectively to challenges or opportunities, as the workforce lacks the necessary guidance and support.

Conversely, when management labor is “too fat,” the company has an excess of managers relative to its operational needs. This over investment results in higher labor costs without a commensurate increase in productivity or gross margin. Too many managers can lead to inefficiencies, redundancies, and potential conflicts over responsibilities, which can bog down decision-making processes and slow the organization’s overall momentum.

When you measure management labor in relation to margin, you can make strategic decisions to balance the effectiveness of management labor.

3. Cash Flow

Understand the concept of trade capital. Trade capital is a more accurate metric than the common working capital. Working capital is defined as current assets minus current liabilities. Trade capital on the other hand strips out all term debt. It is the net of accounts receivable, inventory, work in progress, less accounts payable, accrued expenses and deferred revenue. Trade capital tells you how much recurring income you will have at the existing volume of sales. Greg Crabtree puts trade capital as its own item as a percentage of the rolling 12 revenue.

  • If trade capital percentage to revenue is lower than your net income percentage to revenue -> cash-free growth zone
  • If trade capital percentage to revenue is higher than your net income revenue -> use the base camp growth method

Next Steps For Business Valuation

Valuing your business as a high-yield investment unlocks its hidden potential and sets the stage for exceptional returns. By adopting an investor’s mindset and leveraging financial insights, you can transform your enterprise into a wealth-building machine.

Greg Crabtree’s practical methodologies offer a clear pathway to achieving these goals. His emphasis on simplicity, clarity, and strategic planning empowers business owners to make informed decisions that enhance value and profitability.

Take control of your business’s future. Contact Greg Crabtree today to unlock your company’s full potential and achieve unprecedented returns!

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The content provided on Greg Crabtree’s blog is for informational purposes only and is not intended to be construed as professional or financial advice. While we aim to present accurate and up-to-date information based on Greg Crabtree’s Simple Numbers concepts, we cannot guarantee its completeness, reliability, or suitability for your specific circumstances. Readers are encouraged to consult with their accountant or other qualified professionals before making any business decisions based on the information contained in this blog.