Know your Gaps

The Three Gaps: Wealth, Profit, And Value

Many business owners wonder how much their business is worth and how they stack up against their competitors. Take the traditional "country club valuation," for instance. A group of four business owners goes out on a Sunday to play a round of golf. One owner has just closed a deal and sold their manufacturing company for millions of dollars. A fellow golfer, who owns a business in the same manufacturing space, thinks, "I could probably sell my company for that." But what should the business owner sell their business for? What are the owner's personal and financial goals?

When talking about buying and selling companies, many business owners get caught up in the purchase price, when the real number they should be focused on is net proceeds. The "net proceeds" of the sale refers to the cash the owners get at the close after taking care of all expenses, such as investment banking and transaction fees, accounting and legal fees, debt from the business, holdbacks, and earnouts, seller financing, and, of course, taxes.

Although the net proceeds number is critical to determine what your business should sell for, it is only part of the equation. Net proceeds help establish the three financial gaps in your life. Those gaps dictate what your business must sell for in order to live a fulfilled life after exit.

The three gaps are the wealth gap, profit gap, and value gap. The first step is identifying the business owner's wealth gap.

Wealth Gap

Your wealth gap is the difference between your current wealth and the amount you need in order to live the life you want. To understand your wealth gap, you must investigate your personal goals and ambitions outside of the business. For example, an owner who wants to own a minor league baseball team in the next phase of their life will need more funds than an owner who wants to retire and live quietly on an old farm.

Your goals, family, extended family, and personal ambitions should all be considered. Once identified, you can determine your wealth gap. Your net worth outside of the business plus the value of your company today equals your goal. In other words, if your goal was $10 million and you had $2 million of assets outside of the business, your wealth gap would be $8 million.

Profit Gap

Using this example, the next step in the process is understanding if the business today is, in fact, worth $8 million. To get to the root of this, start by calculating your company's profit gap. At a very high level, a profit gap is calculated by understanding the best-in-class earnings before interest, taxes, depreciation, and amortization (known as EBITDA) of businesses in the same industry. Next, assess your current EBITDA performance.

The profit gap then is calculated by understanding how you can drive toward best-in-class performance by subtracting your company's current EBITDA performance from the best-in-class EBITDA performance. For example, if your company is currently valued at $1 million in EBITDA while the best-in-class companies are generating $3 million in EBITDA, your business currently has a $2 million profit gap.

Value Gap

Value Gap This EBITDA number is then applied to the sale price of the company. Small and lower middle-market companies sell in a range of industry multiples dictated by the private capital market. For example, upon research, a plastic manufacturing company could be selling in a range of multiples from one times the EBITDA to six times the EBITDA, with the best-in-class companies selling at the higher range.

Given the same industry research, you can now identify your company's value gap. The value gap takes into consideration the best-in-class performance and applies it to the current company. For example, if best in-class companies are performing at 15% EBITDA to revenue and the current business owner's company is performing at 10% EBITDA to revenue, the company could improve performance, even at the same level of revenue, and generate another 5% in EBITDA.

To illustrate this further, imagine a company currently generates $20 million in annual revenue. At 15% EBITDA, this company would generate $3 million in EBITDA, whereas, at 10% EBITDA, the company would generate $2 million in EBITDA. Given 15% EBITDA is best-in-class performance, these companies would sell at the best multiples. In this example, if best-in class companies are selling at six times the EBITDA, that would be an $18 million sale price. An "average" company performing at 10% EBITDA, on the other hand, would likely sell for an average multiple. Let's assume that multiple is 3.5 times the EBITDA, which would equate to a $7 million sale price. This would represent our existing example.

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