Over the holidays, I did a deep dive into all things Exit Planning. After nerding out on everything from business planning to private equity, I noticed there was a consistent theme that kept coming up. Often, work “on the business” is avoided simply due to a lack of understanding or knowledge. It is not necessarily that we are running a bad business; it is more that they are run in isolation from what the rest of the market is doing. Working on the business feels like it takes too much time to figure out what the business is missing. Instead, if owners knew how their company compared to other similar companies, it could make the “on the business” work much easier and more effective.
Key Takeaways
- Understanding and tracking the Wealth Gap, Profit Gap, and Value Gap provides insight into the company’s financial health.
- The Wealth Gap is the difference between a business’s current value and the amount the owner needs to meet future financial or retirement goals. Identifying the Wealth Gap can meaningfully influence how the business is run.
- The Profit Gap measures the difference between a company’s current profit and the profit of best-in-class peers in the same industry and size, highlighting unrealized earnings potential and areas for improvement.
- The Value Gap builds on the Profit Gap by applying valuation multiples to compare a company’s current value with the potential value of a best-in-class peer. It allows owners to see how profit performance and valuation multiples together can create a substantial difference in overall business value.
Real Numbers
One of the most interesting concepts from my deep dive was all about valuations and how to figure them out without spending thousands of dollars each time. Trying to determine what the value of a business should be is very subjective, but doing so can still provide a lot of insight into how you should run the business. To add to that, I think most owners are curious as to how much their company is worth and how much similar companies are worth. Generally, when I have a conversation with an owner, very few actually know the range of multiples that are selling in their industry.
I recently wrote about the importance of knowing your numbers and the value of the company. For most owners, this will be the first step to determining how well your business is doing. It is important to track how sales, costs, overhead, profit, and personal expenses, among others, change from year-to-year. Doing so can lead to a decent valuation of the company. Once you have both of those, then you can go out and compare your company to others and see where it stands.
The Exit Planning Institute broke this problem down into 3 gaps: the Wealth Gap, Profit Gap, and Value Gap. Knowing your numbers will allow you to calculate these three gaps and identify where your business exists in the marketplace today.
Wealth Gap
After you get a realistic valuation, the next question to ask is what the value of the company should be. That is the goal of identifying the Wealth Gap. The answer is usually determined by the owner’s goals, both now and after the business. For example, if the business is currently worth $1 million, but an owner needs a $3 million exit for their retirement needs, then they just discovered the $2 million Wealth Gap in the business. Knowing the potential deficit between how much you need and how much you have can change the way you operate the business.
Identifying how much one person needs in retirement (or after this business) is not as simple as it sounds. Generally, a retirement plan is a part of a much larger personal financial plan to determine what is appropriate given the situation. After factoring in all the goals, incomes, assets, taxes, investments, etc., an advisor can help provide clarity on how much you may need in retirement. Especially for owners who look to their business for the income more so than owning an asset, determining the Wealth Gap could significantly change their perspective on the business.
Profit Gap
The second gap, the Profit Gap, compares the profit of your company with the profit of the “Best-In-Class” companies in your industry. Best-In-Class simply refers to the best company in your industry that is similar in size, relative to whatever measure you choose. For example, if you generally have about $300,000 in profit each year, and the Best-In-Class companies of comparable size are profiting $1,000,000, then your Profit Gap would be $700,000. Learning that the company is leaving $700,000 profit on the table each year can be very motivating to work on the business more!
This may be accomplished the easiest by bringing in an M&A advisor, Value Advisor, Valuation Expert, Business Coach, etc. One of these professionals can help you identify what the industry looks like more broadly and identify how those Best-In-Class companies are doing. Likely, you may get one of these professionals involved during the formal or informal valuation, so it could be a natural step to focus on those companies that get the best multiples in your industry.
Value Gap
That leads us straight into the final gap, the Value Gap. This gap essentially takes the Profit Gap and attaches multiples to it. Multiplying current profit by a realistic multiple should give you a rough value for the company, which was the essence of a baseline valuation mentioned above. Then take the Best-In-Class Profit from the Profit Gap, and multiply it by the top multiple in your industry.
If we continue the example, let’s say the industry multiples range from 3x-7x annual profit (SDE, EBITDA, etc.). A company with $300,000 in profit may have a 4x multiple for a value of $1,200,000. The Best-In-Class company with $1,000,000 in profit would get the 7x multiple for a $7,000,000 valuation. The difference between the two is $5,800,000!
Using the Gaps
Valuations are inherently subjective. Similar to real estate, you will not know the true value until after it’s sold. However, understanding the three gaps (even if rounded horribly) can provide insight into where the company is currently. If your Wealth Gap is larger than expected, and you’ve started talking about selling in the future, then focusing on growing the business could become a priority. Adding the fact that the Profit Gap may show that you are leaving 6-7 figures on the table each year can be enticing. At the end of the day, working on the business to understand where there is room for growth can be rewarding if done right. The goal should ultimately be for the business to serve you and your goals, not the other way around.
TC Falkner 