Jane and John each own their own small accounting practice and are each getting ready to retire.
They have equivalent staff costs, rent, and other overhead. Further, they each generate approximately $250,000 in annual owner earnings, and have done so consistently for many years. However, the similarities stop here.
Jane has three long-tenured employees with significant responsibilities. John has five interns and makes all the big decisions himself.
Jane has a steady book of recurring annual clients. John focuses on walk-in clients and has relatively high turnover.
Jane’s landlord is willing to sign a new extended lease with a new business owner after typical due diligence. John’s landlord will agree to assign his existing lease until end of term, but will not discuss renewal until later.
Two businesses with identical financial performances – but very different values.
Business Buyers Are Purchasing the Future
In many ways, buying a business is no different from buying a car. Two cars may be identical and both run perfectly. Yet the car with higher mileage is going to be worth less because the risk of unforeseen maintenance and repairs increases along with mileage.
The past performance of the car is an important indicator of its future performance, but not a guarantee. The car with the better chance of continuing its past performance – the car with the lower purchase risk – is the car which sells for more.
The same principles apply to business purchases.
In the opening example, Jane and John’s historical performance is identical. Each owner has generated the same amount of owner earnings consistently. However, their chances of continued performance are very different!
Jane has:
- More experienced employees.
- More recurring revenue.
- Safer tenancy arrangement.
Because of these risk-mitigating factors, Jane’s past earnings of $250,000 per year seem likely to continue for the next owner.
John has:- Heavy reliance on himself.
- Non-recurring customers.
- Uncertain future tenancy.
The next owner would be essentially gambling that they could navigate each of these situations successfully in order to continue John’s past earnings.
Business buyers are not interested in what Jane and John have achieved in the past. They are buying the ability and probability of achieving the same results in the future.
Despite their identical past financial performance, the risk of continuing performance is very different for Jane and John! Jane's business is more likely to continue performing at its current level; therefore it is worth more than John's.
What Makes a Business More Risky?
Every business owner holds a unique package of advantages and risks. However, most professional business valuations consider similar broad factors which may affect the future performance of a company.
Some common examples include:
- Customer concentration: is your performance heavily dependent on a small number of individual relationships?
- Owner reliance: could the business operate successfully without the current owner’s daily involvement?
- Employee retention: will key managers and skilled practitioners remain with the business post-acquisition?
- Declining or competitive markets: are your margins getting squeezed due to economic or industry trends?
- Earnings consistency: is recent performance the norm, or has the business benefited from unusually favorable conditions which may not continue?
- Overdue expenses: will the new owner be saddled by deferred maintenance, equipment replacement, building repairs, or obsolete software?
- Skeletons in the closet: are there any pending litigation or regulatory issues for which a new owner may be responsible?
A business valuator will consider the entire picture of risks and advantages when developing a business valuation. Business buyers may not use the same methodological approach as a business valuator, but they instinctively consider many of these same factors and will adjust their purchase offers accordingly.
Risk Does Not Mean Something Is Wrong
Every business investment carries some level of risk. The opportunity to earn a financial return exists because there is a chance that the investment will not perform as expected. In general, investments with lower risk offer lower returns, while higher-risk investments must offer the possibility of greater returns to attract buyers.
For example, U.S. Treasury securities are considered among the safest available investments. The risk of losing money is relatively low, but so is the potential return.
Commercial real estate generally carries greater risk because future returns depend on occupancy, maintenance costs, financing, and local market conditions. Investors accept those uncertainties because they expect higher returns.
By comparison, small privately held businesses are generally considered to be among the highest-risk income-producing asset classes.
Regardless of the industry, every business depends on customers, employees, competition, economic conditions, and countless other factors that cannot be fully controlled. Even well-managed businesses with long operating histories face uncertainty about future performance.
But these risks are balanced by the opportunity for exceptional returns. A successful small business may produce financial returns far exceeding those available from safer investments. Many businesses can be started with relatively little capital investment. Many of today's largest companies began in the founder’s basement or garage.
Therefore, business owners should not expect to eliminate every risk. Risk is an unavoidable part of owning and operating a business. Instead, owners should focus on identifying unnecessary risks, reducing them where practical, and demonstrating to prospective buyers why the business is well positioned to succeed despite the uncertainties inherent in ownership.
Understanding Risk Helps Owners Make Better Decisions
Reducing risk does not guarantee a higher business value, but reducing unnecessary uncertainty generally makes a business more attractive to potential buyers.
Business owners often focus solely on current revenue and profitability, which are certainly important drivers of value. Owners who take the extra steps to mitigate performance risk will strengthen their company's marketability and increase business value potential.
A professional business valuation considers both financial performance and the risks associated with future earnings. Understanding how those factors work together can help owners make more informed decisions when planning for a sale or transition of any type.