Like many Wealthpreneurs, you have probably wondered how much your business is worth. Beyond that, you may have considered how your company stacks up against similar businesses. When a fellow business owner in the same industry tells you he just sold his company for millions of dollars, you wonder, Could I sell my business for that much? The answer might not be what you think.
Forget the price tag
When considering selling your business, you might assume the most important number is the sale price. But in reality, you need to focus on the net proceeds: the cash you receive after considering all transaction expenses and other adjustments. These cash reductions can accumulate between investment banking and transaction fees, accounting and legal fees, business debt repayment, holdbacks and earn outs, seller financing, and (of course) taxes.
The net proceeds number is important because it is a key factor in calculating the three financial gaps in your life. These gaps dictate the price your business must sell for so you can live a fulfilled life after your exit. The Three Gaps are Profit, Value, and Wealth.
Winner earns all
The Profit Gap is the amount of profit your company could have earned, but did not due to below best-in-class profitability. (For this discussion, profit is often defined as earnings before interest, taxes, depreciation, and amortization [EBITDA]). The Profit Gap compares the best-in-class EBITDA of businesses in your industry with a similar sales level to your current EBITDA performance. The money that makes up your Profit Gap is simply cash left on the table!
Adjust That EBITDA!
To calculate your Profit Gap, your profit (defined as your EBITDA) should be adjusted for an apples-to-apples comparison with the best-in-class EBITDA. To prepare your EBIDTA for this calculation, adjust it for:
- Extraordinary or one-time events
- Discretionary expenses tied to the owner
- Expenses that are currently above or below market rates (such as rent or compensation)
Do you measure up?
The Value Gap represents the difference in business value between your business value and the value of best-in-class companies in your industry with a similar sales level. The value of small and lower middle-market companies is also impacted by private capital market conditions. The Value Gap takes these conditions into account as it measures the best-in-class business value performance against your own. As with the Profit Gap, the Value Gap is created when your operations are not up to best-in-class levels.
Money can buy this kind of happiness
Perhaps the most important of the Three Gaps, your Wealth Gap is the additional wealth you need to meet your wealth goal. It is equal to your net worth goal minus your current actual net worth (not including your business value). Your business value is not included because it cannot be easily converted to cash. Additionally, depending on what you decide to do with your business, you may not convert it to cash at all! Much of your Wealth Gap is determined by how you want to live after your exit. Some Wealthpreneursneed more funds to live their post-exit dream life than others.
Wealthpreneur Lesson
Just Get Started
“The way to get started is to quit talking and begin doing.”
– Walt Disney
The king of the gaps
Fictional Wealthpreneur Charles Waldorf is ready to retire. His Certified Exit Planning Advisor (CEPA) advises him to consider his Three Gaps before he sells Waldorf Industries, his manufacturing company.
Charles’s CEPA begins by calculating Charles’s Profit Gap. She compares Waldorf Industries’s EBITDA to the EBITDA generated by similar best-in-class manufacturing companies. She and Charles discover that Waldorf Industries generates an annual EBITDA of $1 million, but best-in-class manufacturing companies generate $3 million in annual EBITDA! This means Charles has a Profit Gap of $2 million.
To calculate Charles’s Value Gap, his CEPA begins with a business valuation of Waldorf Industries prepared using leading edge software. When Charles first received this valuation, he was thrilled to hear his business was worth $3 million! But that number sounds less promising when his CEPA compares it to the value of similar best-in-class manufacturing companies. These companies are worth up to $8 million, which means Charles has a Value Gap of $5 million!
Finally, Charles’s CEPA evaluates his Wealth Gap. After conversations with his family and friends, Charles decides he would like to retire in sunny Florida and watch his grandchildren grow up. His CEPA estimates he will need $10 million to achieve this dream life. Outside of his business value, Charles has a net worth of $2 million. This means he has a Wealth Gap of $8 million.
When his CEPA explains this, Charles is understandably shell-shocked. “So my Profit Gap is $2 million, my Value Gap is $5 million, and my Wealth Gap is $8 million,” he says. “How am I ever going to close these gaps?”
“It’s not a one-and-done process, but all three of your gaps can be significantly reduced. To start, we can optimize your operations to increase your profitability. That will help close your Profit Gap. There are also many strategies we can use to increase your business value, which will reduce your Value Gap. If your business sells at a higher valuation multiple, the additional net proceeds you receive will go toward closing your Wealth Gap,” his CEPA explains.
“So it’s not a lost cause after all,” Charles realizes. “When can we start?”
Leap across the chasm
Without knowledge of the type and size of your Three Gaps, you may struggle to reach your wealth goals. But identifying and reducing them is a key step in your journey to achieving your dream post-exit life! Before you get started with a Three Gaps analysis, it is important to know the value of your business and how its profitability and operations compare to other companies in the industry.
