Entrances and exits are the most memorable moments. What happens in the middle is a blur of dedication, effort, confusion, and re-dedication. Parenthood taught me this life lesson in the most indelible way, but I am convinced it holds true in all aspects of life. It is a constant circle. No matter how hard I try, I cannot remember everything that happened in the middle, but I can remember with great clarity each beginning and each departure. In business, entrances and exits are guided by the upside downside ratio. For small businesses, the upside downside ratio can be difficult to cipher.
The Juno Group
I first learned of the upside downside ratio through membership in Juno Group. Juno was a 1990’s investment club comprised of neighborhood and church friends. We operated under the guidance and platform of Investment Club of America (ICA), managing a portfolio of equities funded through member contributions. Typically using Value Line research, members would perform analysis and make presentations at monthly meetings. We enjoyed lively debate about the stock’s upside downside ratio as the final gate to purchase.
ICA offered a clean framework for upside downside analysis. Take the prior 12-month history (longer if you like) of the stock’s price/earnings ratios (P/E). Find the high and low, then mark the current P/E in the range. Then, hit the earnings per share (EPS) forecasts hard, establishing the range from institutional investors. The club would then challenge economic and competitive trends to arrive at its own EPS estimate. The central question: based on the positioning of the P/E ratio within historical ranges and the consensus for EPS growth, did the stock price have more upside than downside potential for the club? Similarly, portfolio management required ongoing discipline with the upside downside ratio for timely exits in holdings. The calculation seems like simple math, but it was rarely that clean. Perceptions and expectations vary across personality types.
Small Business Entrances and Exits
Entrances and exits are just as defining for small business owners, but often lacking in quantitative support. Data is not nearly as clean, nor even available. Most small business owners I know, at least the ones not backed by some form of private equity, never considered enterprise valuation when starting. It was an adrenaline rush around revenue generation and personal income that drove the entry.
Exits by small business owners are also driven by non-financial considerations such as fatigue, health issues, or lack of apparent successors. With respect to the exit, I suspect that one of the primary reasons for delay or inattention to an upside/downside ratio is the lack of readily available information. The metrics are also a bit different from publicly traded companies, with some accounting vagaries that can be frustrating in establishing the valuation.
P/E Ratios Versus Multiples
Publicly traded companies inherently have richer and more readily available data available to trend and analyze. Each company has quarterly reporting requirements, and the stock exchanges capture daily stock pricing information. Anyone with a decent spreadsheet package could do the calculations, but no need! All the online trading services give it to you, and several versions.
Privately held companies are, well private. Banks may get annual or quarterly profit information, but that information is not generally available. Additionally, the only valuation information that can be captured is upon closing a sale. But there are companies that compile company sale data and express the sale price in the form of various multiples for guidance to future sellers. Sale price as: multiple of sales, multiple of EBITDA, multiple of EBIT, multiple of gross margin. It can be confusing, but, just like real estate, multiple valuation methods can help you hone in on a range of values. The EBITDA multiple seems to be the valuation most often used.
Potential buyers rely upon EBITDA to evaluate the cash-flow generation capacity of a company. Yet, these are privately held companies. Owners are typically zealous about reducing taxes, so they find interesting ways to expense cash out of the business. Not illegal, but creative. Put multiple family members on the payroll. Make improvements to real property owned by shareholders but leased back to the firm. Establish generous vendor contracts with friends and family members. When it comes time to sell and the calculators start whirring, you hear the urgency of the business owner, “But, but, but!!!!” OF COURSE that’s not the real profit number! Suddenly the pencils come out, adding back all kinds of expenses to increase the EBITDA number and aggressively multiply it. Unfortunately, often there is no specific record of the expense. Hard to make the case to a buyer without documentation.
Four Important Tasks for Small Business Owners
It is entirely possible that small business owners are just avoidant when it some to sales possibilities. I believe that inattention to the upside/downside ratios of their companies has more to do with lack of access to sale data and the lack of clarity around durable profit for future owners. Either way, small business owners’ inattention to the upside downside ratios of their businesses ultimately leaves money on the table just when it is needed most. Here are four suggestions to be vigilant of the upside/downside ratio and get what you deserve.
Set valuation expectations and tools from the very beginning
Any investor would take this approach, so do it for yourself! Future valuation is a key directional component for your company. Let it be a guiding light. The sale multiples are available, simply model your EBITDA over a multi-year period and you will begin defining a valuation mindset.
Find impartial purveyors of valuation statistics
You will find lots of people out there interested in selling your company. You will likely need their help. But establish checks and balances and make sure that you do not have a conflict of interest in your advisor team. Most CPAs have access to quality privately-held company valuation stats.
Catalog all unnecessary expenses every year
No need to keep two sets of books but keep meticulous information about discretionary expenses. If those are the numbers you would ultimately share with a buyer, you should use them consistently in your own internal evaluations.
Have upside/downside conversations consistently
Every publicly traded company for which I have ever worked has had a minimum of annual deliberations about remaining independent or selling. Do the same. You will most likely not have a team of investment bankers guiding you, but you should be able to assemble adequate information to calculate your upside/downside ratio and make the right decision.
Exits are never easy in any aspect of life, but do not compound your grief with the knowledge that you left money on the table because your timing was horrible.