For what it's worth: it's never too early to build your business's value

Entrepreneur, July, 1997 by Mark Henricks

"Establishing value in your business allows you to make sure that the thing you've worked on most of your life continues to pay you," explains Lakhani, currently the owner of consulting firm Direct Hit Marketing. Building value also allows him to sell at a profit when his skills and the needs of a changing business no longer match, or when he just feels the urge to move on.

Unfortunately, few entrepreneurs take the same attitude, according to Don Taylor, chairman of TD Inc., the Newport Beach, California, franchisor of VR Business Brokers, a national network of business brokers. "They don't care," says Taylor, "because they [figure] they're not going to sell it anyway."

But value can be valuable even when you're not selling your business. Being able to place a high valuation on a business may be critical to success when an entrepreneur is obtaining financing, negotiating with a potential partner or strategic ally, hiring a key employee, setting up an employee stock ownership plan or at myriad other points in the life of a business.

"As much as we believe we're going to be doing this for the rest of our natural lives, eventually we wake up and realize there's more to life than our business," says Lakhani. "Or we come to a state in life where our business outgrows us, and it's time to get someone else who has the vision to carry on. Or it's just time to retire."

* WHAT IS VALUE?

Value, like beauty, is in the eye of the beholder. There probably are as many ways of defining value as there are businesses. The basic one, which all or at least most others come back to, is how much money the business could sell for on the open market. But that, too, is dependent on what a hypothetical buyer is looking for, how the business has positioned itself and exactly who is doing the valuing.

"In finance, any asset is valued based upon its expected future cash flow," says Glen A. Larsen Jr., associate professor of finance at Indiana University in Indianapolis. "So in the purest sense of the word, you build value by building expectations of future cash flow to the holder of that asset."

Value doesn't necessarily equal net profits or even break-even performance. Soaring expectations of future positive cash flow are behind the extremely high valuations the stock market places on shares in companies such as Netscape Communications, maker of Netscape Navigator software for browsing the World Wide Web, even when such companies have little in the way of sales and no short-term prospect for any profits, explains Larsen.

Cash flow is usually more important than profit when valuing small businesses. Unlike publicly held firms, which seek to maximize reported profits to attract investors, entrepreneurs often seek to minimize profits for tax or other reasons, says Karl H. Vesper, a Seattle-based University of Washington management professor and author of New Venture Experience (Vector Books).

An entrepreneur may allocate a trip to a meeting in Hawaii as a business expense or keep a spouse or child on the company payroll when a publicly held company would not. To accurately assess the value of a business, values such as the ability to employ family members or mix business with pleasure must be accounted for. And, Vesper notes, these may have value beyond financial considerations.

"Aside from the dollar value of these things, there's the psychic value," Vesper says. "Would you take less pay to sleep later in the morning?"

Value may also come in other forms. Ownership of a patent, proprietary process or trade secret may, by promising exceptional future cash flow, increase the value of a business. Often companies that dominate a market, no matter how small, are sought out for purchase at premium prices by other firms that, for one reason or another, want to add that niche to their existing business. Says Taylor, "There are different kinds of value for different kinds of people."

Many businesses count their physical location as a primary component of value. That's especially true in the case of restaurants and other retail businesses and, again, is not necessarily connected to cash flow or profit. Some retailers make a practice of buying businesses only for their locations rather than how much or what they sell or who they sell it to, figuring that a high-traffic spot will eventually prove to be a winner for some business combination.

"The business may not be doing well," explains Taylor. "But if they got good terms and conditions on their lease and [the site] is in an excellent location, sometimes they can switch what they can sell there."

Location may also be a big part of value if a company is in a resort community with a lifestyle that is attractive to would-be business owners. Other businesses, such as bed and breakfasts and bookstores, may have higher values because they appear glamorous or simply interesting to potential buyers.

On the other hand, a business may also be worth more if the buyer never has to venture near it. "Certain types of businesses have higher value because the owner is not required to be there," explains Larsen.