Submitted by John Brown on Mon, 06/27/2016 – 5:00am

Today’s Quiz:

What is the most important element in an owner’s successful exit?

A. A business with great cash flow

B. An owner with a comprehensive Exit Plan

C. An advisor skilled in Exit Planning

D. Transferable value

If you picked D (without looking at the title of this article), you are smarter than I was 25 years ago. It only took me 25 years of creating Exit Plans for business owners to understand and appreciate its significance. If you disagree, consider the following story of one Exit Planner’s interaction with “Lester,” the owner of a consulting company with clients across the globe.

Several years ago Lester walked into my office to ask me how much I thought he could sell his business for.  By way of introduction, he told me two things:

  1. He made (between salary and S distributions) over $1,000,000 per year.
  2. He was burned-out and ready to leave his business as soon as he could sell it.

“So John,” Lester started, “I’m thinking it will sell for at least five times earnings or $5,000,000.”

Not knowing enough to formulate an answer I asked him to tell me more about his business and his role in it.

  1. Lester Enterprises (LE) was a well-known management consulting firm that designed and implemented management systems for international companies worldwide.
  2. Lester’s only role was to secure the consulting engagements while approximately 25 consultants (working in different locations across the globe) performed the actual consulting.

At first glance Lester Enterprises was a valuable company—consistent cash flow, great customers, capable consultants. But when I asked Lester who currently managed the consultants and would stay after he left? Lester just looked at me.

Lester explained that LE’s consultants were not employees but independent contractors. LE not only had no management team, it had only one part-time employee—a bookkeeper/receptionist. “There’s no way I’m sticking around long enough to find and train someone to replace me!”

It was my turn to do some explaining, “Lester, without you, there is no one to oversee projects or obtain them. Without you, your business is worthless.”

The price Lester paid for not having developed transferable value was steep.  As soon as the last engagement was complete, he shut down the company. With no transferable value, there were no buyers and Lester’s income plummeted from $1 million+ to $0 overnight.

Is this an extreme example? Maybe. But it is entirely accurate in illustrating how a company with consistent annual cash flow/EBITDA of $1,000,000 has absolutely no transferable value when no management team exists to replace the departing owner.

Can You Define Transferable Value?

Let’s skip the multiple-choice quiz: Transferable value is what a business is worth, to someone else, without its current owner.  

No matter which exit path an owner chooses, transferable value is the common denominator of a successful exit. Think about it:

  • Why would insiders be willing to acquire a company (pledging personal assets) if they can’t run the business without the current owner?
  • If children are not capable of continuing a business successfully, passing it on to them is a recipe for disaster.
  • Third-party buyers know that owners will be leaving the company when they sell it so exactly what are they buying if the business is the owner?

Transferable value also has a huge impact an owner’s goals and family:

  • If the owner dies today, they cannot expect a business with no transferable value to provide their families any income.
  • Without the ability to prosper without its owner, a business cannot help owners to achieve any of their values-based goals (e.g. preserving their legacies, maintaining their company’s culture, and benefitting their communities).

Determining Transferable Value: Don’t Take My Word For It

Owners have their view of transferable value but it is buyers—specifically Private Equity Groups (PEGs)—who are the arbiters of value. That applies even if an owner plans to transfer a business to insiders or a sell to a strategic buyer.  PEGs (generally financial buyers) remain the gold standard of valuators because, unlike insiders, PEGs buy companies based on their experience, competition with other experienced buyers, and a thorough examination of a potential acquisition.

Before you dismiss the idea that PEGs determine value because your clients’ companies are too small, remember that every buyer, big or small, wants the same qualities in a business that professional buyers require.

Elements of Transferable Value

BEI advisors refer to the characteristics buyers require as “value drivers.” It is the strength of a company’s value drivers that determines, in large measure, the value of a company. When they are present and functioning well, buyers will pay top dollar for a company because value drivers contribute to increased cash flow.

A company with strong value drivers can demand (and receive) a higher multiple on the same amount of EBITDA than can a company with average value drivers.

Before listing the drivers, remember that if owners are vital to the success of their companies in any one of these areas, they haven’t built transferable value. As an Exit Planning advisor, you must lead them to re-examine that aspect of their role in their company.

 Top Nine Value Drivers 

  1. Next-Level Management
  2. Operating Systems Demonstrated to Increase Sustainability of Cash Flows
  3. Diversified Customer Base
  4. Proven Growth Strategy
  5. Recurring Revenue That Is Sustainable and Resistant to “Commoditization”
  6. Good and Improving Cash Flow
  7. Demonstrated Scalability
  8. Competitive Advantage
  9. Financial Foresight and Controls

In the next article in this series, we will explain why next-level management is the most important value driver. The others appear in the order that BEI members have found to be the most likely to affect transferable value.

Can This Wait?

Given that the sooner owners begin to improve their companies’ value drivers, the more they benefit, why would you wait? If you wait to help owners to begin building transferable value until they tell you that they are emotionally prepared to leave, there are several problems.

First, they (and you!) still have to do all the same work necessary to build value. That work will take just as much time as if you start today, but once owners reach their I’m-ready-point, there’s a high probability that the passion and drive they had before that point has evaporated.

Second, owners who wait to build transferable value, forfeit years of increased cash flow.

Third, waiting owners also forfeit a better ownership experience. Why? Because the heart of increasing transferable value is making the owner replaceable while increasing cash flow. Ask owners which tasks they find uninteresting or unpleasant and if at all possible, transfer those to others first.

Finally, waiting to build transferable value until owners feel ready to leave limits their exit path options and increases the difficulty of the obstacles they will encounter because they don’t have the time for you to initiate alternative growth strategies (e.g. replacing non-performing management).

Perhaps your clients aren’t like Lester, the sole creators of value in their companies. I’d be surprised, however, if they all have companies that can run smoothly—permanently—without them. Installing and enhancing value drivers creates a company that can be transferred to another—without the owner—with minimal disruption to its cash flow. You can’t create successful Exit Plans for owners unless you help them to create companies with transferable value.