Business Owners Special Series No. 27
When business owners begin to prepare for an exit from their company, there are three important numbers they must know: the wealth gap, the value gap and the profit gap. These numbers will help you determine what your business is worth and where you will need to grow your business in order to support your lifestyle for the years to come after exiting your business.
- The first number to know is your wealth gap. This is the difference between your current net worth and the amount of money you will need to support your post-exit lifestyle.
- The second number is your value gap. This is the difference between the current value of your company and the value of a best-in-class company within your industry.
- The third and final number to know is your profit gap. Your profit gap is the difference between your current EBITDA (earnings before income tax, depreciation and amortization) and the EBITDA of a best-in-class company within your industry.
Your Certified Exit Planning Advisor can help you identify these gaps that may exist in both your business and personal financial goals. Understanding these gaps will help prepare you and the rest of your loved ones for a comfortable exit from your business when the time comes.
Before meeting with your financial planner or wealth advisor, you should think through what you want your post-business life to look like. Some questions to consider include:
- What goals would you like to accomplish?
- How will you spend your time?
- What do these new ventures (or hobbies or other activities) cost?
- How long you will need your financial resources to last?
Once you have a good idea of what your post-exit life will look like, the next step is to meet with your financial advisor to determine your current net worth. The difference between your current net worth and the number you arrived at to fund your post-business life is your wealth gap. An effective way to help close your wealth gap is to sell your business for its highest value at the best-in-class price.
Once you have determined your wealth gap, you will need to determine your value gap. The value gap is the difference between the current value of your business and the value of a best-in-class business of a comparable nature within your industry. To determine your current value and the value of the best-in-class business that compare to yours, you will need to get a business valuation. Your CEPA will introduce you to a valuation expert to help in this process. Even if you have had a business valuation in the past, it is important to conduct one on a regular basis to insure you have the most up-to-date data on your business. If your business performance has small-scale fluctuations over time, you should do this every two or three years. If your business or industry is more dynamic, you should consider having it done annually. In addition to a valuation of your own business, you will also benefit from benchmarking data against other businesses within your industry. This information will allow you to identify the value gap between your company and the best-in-class company within the industry. Once the value gap is identified, your exit planning advisor can help you identify opportunities within your business to help bridge that gap.
Often, one of the main ways you help close your value gap is by closing the profit pap. The profit gap is the difference between your current EBITDA and the EBITDA of a best-in-class company within your industry. To calculate your EBITDA, take your net Income and add your income tax, depreciation, and amortization expenses. You can determine the EBITDA of the best-in-class company through the benchmarking data you received from your CEPA or valuation advisor. There are a lot of ways to influence EBITDA, most commonly through increasing sales and reducing expenses. A major way a business owner can increase EBITDA is by ensuring that only necessary business expenses are occurring in the business. Sometimes business owners use their company as a funnel for lifestyle expenses, such as car leases, salaries for family members that do not contribute to the business, and other “discretionary” expenses.
Another common way to impact your business’s profit and value gaps are by de-risking your business. Your CEPA can help you asses the risks within your company so they can be mitigated. Some ways to de-risk are to clearly document all policies and procedures, train and empower senior management to run things without you there, eliminate customer concentration, and eliminate any potential liabilities of the company.
Having a solid understanding of your wealth, value and profit gaps is crucial to planning your exit from your business. Once you understand these gaps, you can set forth plans to improve them in order to sell your business at its highest value. This will ascertain that whenever and however you decide to exit your business, you are reaching its highest value, and ultimately, the value that will allow you to achieve and maintain the lifestyle you desire in your post-business life.
This article is No. 27 in the Business Ownership Succession Series (B.O.S.S.), an ongoing cycle of informational guides from BPM designed for business owners who are proactively seeking guidance from experts on how to implement value acceleration in their business, delivered each month straight to your inbox. For more insights, download our e-book, “Value-Focused Business Planning,” and check out the rest of our B.O.S.S. articles.