Your Business Will Change Hands:
Important Valuation Concepts to Understand
In this article, we provide a broad overview of business value and why understanding basic valuation concepts is critical for business owners. Why is this valuation knowledge important? Because businesses change hands much more frequently than one might think. In fact, every business changes hands at least every generation, even if control is maintained by a single family unit.
Business Press Focuses on Public Companies
According to statistics about business size from the U.S. Census Bureau, there are about six million businesses with payrolls (meaning these businesses employ people) in the United States.1 A little more than three and a half million U.S. businesses have sales of less than $500 thousand. Without any disrespect, these businesses are often referred to as “mom and pop” operations because their basic function is to provide jobs for the owner(s) and sometimes a few other people.
About two million businesses have annual sales between $500 thousand and $10 million.2 This segment of the business community is generally given credit for the majority of job growth. Only about 200 thousand businesses have annual sales exceeding $10 million.3
At the top of the business pyramid are public companies. Of these, as of 2012, only about four thousand have active public markets for their shares with regular stock pricing and volume information available.4 Because of their size and visibility, this relatively small group of public companies gets the lion’s share of coverage in the business press. As a result, most of the popular business press coverage of valuation issues relates to public companies.
Most Companies are Privately Owned
But most of the businesses in corporate America are closely held, or private corporations. This means that most of the business owners in corporate America are not in public companies, but in generally smaller entities owned by a single, or a small number of shareholders. Therefore, it’s important for these business owners and their advisors to have an understanding of the nature of value in these businesses.
Private Businesses Change Hands Frequently
Most business owners, and, quite often, their advisors, have inaccurate conceptions of the value of their businesses. This is not surprising, because there is no such thing as “the value” of any business. Value changes, often rapidly, over time. Yet it is important for business owners to have current and reasonable estimates of the values of their businesses for numerous reasons, including ownership transfer.
There are many reasons for ownership transfer, including:
- The death of the primary owner. At this point, it is clear that control of a business will pass to someone else.
- The departure of a key employee. This departure may trigger the necessity to sell a business if he or she takes away the key contacts or critical energy that keep things going and growing.
- The owner gets “tired” and decides to sell. This is an unbelievably frequent reason why business ownership transfers. Unfortunately, if a business owner waits until he or she is tired, they are already on the down side of the value curve. Tired owners almost unavoidably transmit their “tiredness” to employees and customers in many subtle and not so subtle ways. In the process, their businesses lose a vital life force critical for ongoing growth and success.
- An unexpected offer. Occasionally, a business owner will receive an unexpected offer to purchase the business and will, quite suddenly, sell out to take advantage of the situation.