How Much is Your Business Worth?
Once or twice a year I get a call from some contractor's accountant asking for guidance on evaluating the worth of his client's business. Usually, it's because the contractor is looking to sell the business either to retire or do something else. (Pardon this digression, but accountants aren't the best people to arrange the sale of your business. CPAs may be good at counting beans but most don't have a clue about selling anything. You wouldn't call your accountant to help sell your home, you'd go to a realtor. With a business, you'd be better off recruiting a business broker.)
Even when it comes to accounting, most accountants do not understand construction businesses. The financial structure of a construction firm is much different than that of companies that make things or sell merchandise, which is what you'll find in most accounting textbooks. A construction company typically doesn't have much in the way of tangible assets. The real value of the business is its intellectual property; that is, the know-how, along with know-who. There's also a considerable amount of what's known as "goodwill," which basically refers to the reputation of a business.
An accountant usually surmises that a contractor's skill, contacts and reputation ought to be worth a heck of a lot. So he sends out feelers to prospective buyers, and can't believe it when he hears that nobody seems very interested in paying more than a bargain-basement price for what seems to be a successful business. That's when he gets on the phone to call people like me.
"What am I missing?" the accountants ask.
I remember one call from an accountant who helped a client sell a plumbing shop with close to a million dollars in annual sales that had been a pillar of its community for more than 30 years. The owner got $50,000 for the business. The accountant thought he had failed his client. He told me a lot of his white-collar buddies make that much in annual bonus payments.
In a bad year
I congratulated the guy for doing so well by his client. Most plumbing businesses don't even sell for that much. The majority of owners hold a garage sale and walk away with a few thousand bucks.
The sad truth is that the backbone of the construction industry is formed by tens of thousands of small shops that, no matter how well they perform, have no real value to anyone except the immediate owners. Many of these companies are family firms that pass down to succeeding generations. This postpones the day of reckoning as the children continue to eke out a living from the family business, but it doesn't fill the void in underlying value.
Contractors deserve a better fate. The skill, toil and risk you put into the business ought to entitle you to a comfortable retirement after decades of hard work. Why aren't your businesses worth very much on the open market?
The first thing a prospective buyer looks at is the earnings potential of a business. With a privately-held business, it's a matter of deciphering what the owner and his family take out of the business in salaries and perks. Some contractors operate at little more than a subsistence level, earning maybe $40,000 to $50,000 in income. Those contractors do not own a business as much as they own a job. No buyer is going to be interested in paying anything more than pocket change for that type of business.
But even if you run a successful company that provides an elevated lifestyle for you and your family, it still may not be an attractive acquisition candidate unless its know-how, know-who and goodwill are transferable to the new owner. This can be a problem if the owner is looking to exit the business. Supplier and client relationships are the most valuable assets of many construction businesses. A buyer wants to be sure these relationships will last if the owner doesn't stick around. It helps if there's a strong number two person in the organization, or a team of managers in a larger company, who would lend continuity to the business if the owner departs. Without this, your client list isn't worth much more than a direct mail list that can be obtained from any list broker.
That's why most acquisitions involve continued employment for the former owner. In addition to the payout for buying your company, the buyer will want to hire the former owner or key managers to a management or consulting contract for at least a couple of years. Some of these end up being sweet consulting deals in which the owner collects a large paycheck for doing little more than giving advice when asked and lending his name and prestige to the business. If it's a full-fledged management contract, the owner will continue overseeing operations, except as an employee rather than the owner.
There are exceptions, but most often these arrangements prove disappointing. The owner's abilities remain the same, but his entrepreneurial drive is bound to slack off. Things can get downright ugly if the former owner doesn't see eye to eye with the manager who's now his boss.
Laying the groundworkIt seems counterintuitive, but the best thing an owner can do to lay the groundwork for selling his business in the future is to minimize his own importance to the business. This requires developing a second tier of management, delegating authority and setting up job descriptions, policies and procedures so that the company can run in your absence. A good way to test this out is to take extended vacations without being in constant touch by phone and e-mail. If you don't feel confident doing this, why should anyone feel confident buying your business?
While you're on that vacation, take along a copy of Michael Gerber's book, "The E-Myth: Why Most Small Businesses Don't Work and What To Do About It." Gerber pulls no punches in describing the fallacies in small business thinking.
A couple of other points need to be made about selling your business. First, in most cases, the buyer will not seek to buy your business per se, but purchase the assets of your business. Buying the entire business means accepting responsibility for any liabilities that may exist. This means you would still be on the hook for any lawsuits arising from work done in the past. Depending on your track record and how confident you are that the work you've done will stand the test of time, you want to try to negotiate your way out of liabilities if possible, maybe even by accepting less in payment for your business. This is a complicated issue and many deals have broken off because of it.
Second, if your shop is located in a building you own, that adds a major tangible asset to your value. But real estate tends to be a side issue in acquisition negotiations. The prospective buyer may want to merge operations into those he already owns or move to someplace cheaper. If you own your building, you're in the commercial real estate business as well as contracting. You need to treat them as separate businesses to be evaluated on their own merits.