“We’ve been granted legal custody of my daughter’s two children, and we’re about to move them here from Chattanooga. I’ve got to sell my company because my wife can’t handle this on her own.”
Bart (not his real name) is one of the nicest guys I’ve ever met. I could tell he had a heart of gold to do the right thing for his two grandchildren. He told me the circumstances leading to his decision to take full time responsibility, it was not a happy story. But bless his heart, he and his wife were doing the right thing for his family, even if the timing to sell his company was not the best.
But before I accept an engagement to sell a company, I make sure the owner and I are in sync about valuation and timing. As Bart and I talked about his company, I got the sense we were not going to agree on valuation. “But we’ve got great potential” he said as he explained why the business hadn’t grown over the past few years. Sadly, I hear this logic all too often as he said, “All we need to grow is put more money into marketing,” to which I replied “OK, so why don’t you do that?” to which he said, “I can’t afford it.”
Interpretation: we cannot grow because the business does not produce sufficient cash flow to fund incremental growth.
There are many ways to value a business, but all the mechanics lead back to one core principle, the business must generate a return on investment sufficient to justify the risk required to buy the business. Whether the buyer is an individual, a sophisticated private equity fund, or a large strategic acquirer, valuation comes down to balancing reward and risk. A buyer might evaluate “potential” but only if there is real evidence that that risk-reward makes sense.
Bart’s business had annual revenue near $9 million with annual EBITDA of about $1.2 million. He wanted to value the company based on its potential. He said his revenue could increase 25% a year if he added 2 or 3 new salespeople. But he couldn’t afford to make that investment, so all he had to rely on to justify this forecast was his confidence. But I had to tell Bart that, in the absence of substantive verification of his confidence, a buyer would not likely pay more based on his representation of potential.
Now, I think I know what you’re thinking; Bart is making more than $1 million a year, he can afford to reinvest in company growth. In theory, you’d be right, except Bart is paying himself almost every penny of profits and his lifestyle is built on that kind of income. Meaning, he literally can’t afford to reinvest in growth.
If there’s any “comfort” to this story, it is that I see this phenomenon all the time. Founder-led business are often growth constrained because the founder has built his/her lifestyle around the success of the company.
There are two morals to this story: #1 If you want your company valuation to be based on potential, you must bring more than confidence to the negotiating table. #2 If you drain your company profits in personal income, don’t be surprised if you aren’t growing to your full potential.
Tennessee Valley Group
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