BEGIN WITH THE END IN MIND
Adapted from: The 7 Habits of Highly Effective People, by Stephen Covey
Stephen Covey wrote, ‘Begin with the End in Mind’. (Seven Habits of Highly Effective People). He applied the idea to personal actions and projects by making it clear that any task is more apt to be completed successfully when the person doing the work can simultaneously focus on what he has to do (task list for the project) and the sought after result of his work. (The End in Mind).
We can apply this thinking to the work of the entrepreneur in a new business start up. Having the end in mind is uniquely important for the small business which in many cases does not survive the retirement of the original owner/manager. That is unless when we start a business we have the end in mind. In this case, the end refers to the retirement of the owner/manager. In this short article I will present a program of what I will call a beneficial exit strategy (BES) that can enable the retiring owner to realize the gains of his/her work in starting and building the business, even if the business itself does not continue operating under his management.
The BES program is based upon two points. They are 1) Valuation, and 2) Options. Valuation is the result of efforts expended to make the business as attractive as possible to a potential new owner/investor, either as a complete operating unit, or any part thereof. Options are the actions that the retiring owner might take to maximize his returns. It is a fundamental principle in developing options that the way in which any option is exercised has a profound effect on its value.
First let’s address valuation. The value of a business it basically its power to generate earnings in its present configuration and structure, or in another format. It is measured by what is called an earnings multiple based upon the company’s profit and loss statement as generated by an accountant working for the company. For example, if the company earned $50,000 (average per year based on at least 3 years of financial statements), and if an agreed earnings multiple is 5, then a starting point in terms of valuations is $250,000.
Thus if a business owner wants to retire at a certain point in the future with at least $250,000, he would have to achieve reported earnings of at least $50,000 per year for the last three years before his projected retirement date. There are other methods of valuation which could be used, as well as various ways in which any reported earnings figure can be either revised upward or downward. In small businesses, for example, the owner’s salary may be lower than a new owner would require thereby lowering the valuation of the earnings. Or the present owner may have encountered trader credit financing problems which interfered with production schedules and order fulfillment, which lowered the valuation of earnings to the present owner but could raise the valuation of earnings to a new owner assuming that he would not have those difficulties. Also the present owner can take steps to mitigate the effect of past credit problems and thereby increase earnings and subsequent valuation.
Another important source of valuation can be taken from the balance sheet, which is basically a statement of assets minus liabilities which equals the net worth of the organization (its valuation). An ideal situation would be for the combination of net worth and earnings to show a high return on investment, or ROI (calculated by the percentage relationship of earnings to net worth).
Next, let’s discuss options open to the seller (the buyer also has options).There are many options that could be available to a retiring owner by which he could realize the valuation of his business. They include sale as a going business, sale of parts of the business for example: (accounts receivable, inventory, land, buildings, equipment). The owner may allow payment over a period of time, or possibly be paid as a consultant to the new owner (a further source of incremental value), or tie the cost of the business to its future earning power under new ownership (as opposed to determining valuation based upon past history as in the case above).
A beneficial exit strategy for the retiring owner is based upon working from as high a valuation of the business as possible, and by structuring the process of transfer to a new owner through the use of creative options to maximize payment in as short a period as possible. This can be achieved by thinking through both the timing of retirement and the valuation/options mix that will maximize the return to the retiring owner. But it should be thought of at the start up of a new business. Always remembering what Stephen Covey said: ‘Begin With the End in Mind’. Careful planning can produce an optimal BES (Beneficial Exit Strategy).