Almost every entrepreneur’s dream is to cash out and live financially free — to sustain their lifestyle without having to sell time for money.
In reality, when the time comes to retire, most entrepreneurs are bitterly disappointed. (That’s assuming their business lasts that long.) They realise too late that their company is not a company or it’s not worth an investor’s second look.
What do I mean by “not a company”? It’s not the legal definition that matters — you might have a company, partnership, or a franchise, but it might operate like a practice.
The dipstick test is to measure the company’s dependence on its owner. If you're easily replaceable, then you have a company. Can you take an uninterrupted 4-week holiday and come back to a business that’s in the same state you left it?
But if the work you do is a key driver of value to customers — e.g. your work is highly skilled, creative or personal in customer relationships — then you have a practice, not a company.
This applies to most professional services firms, like lawyers, architects, and plumbers. I’ve even seen some franchise contracts obliging franchisees to work regular hours. The only buyer who might be interested in your practice is another professional willing to trade places with you.
This is not what investors look for. Investors want to buy out the owners and replace them with a manager. They don’t want to be stuck in your role.
The owner-dependence test is a useful guide, but it’s often too subjective. For a more objective measure, especially for owner-managed small businesses, we prefer a more reliable method of assessing the owner’s discretionary earnings (ODE). This involves comparing the owner’s salary against fair market rates and adjusting for perks (like overseas “business” trips), dividends and a few other items. (For larger companies, we’d use other valuation methods.)
If your ODE is similar to a regular employee’s pay, then you own a job, not a company. Or if you earn less than fair market rates, you’re donating free labour to a charity — expect investors to cross the street to avoid this.
To appeal to any true investor, your ODE must not only show how a new owner can replace you with a professional manager, but also come out with enough, regular dividends payments that justify the risk attached to owning your specific business.
This is where most entrepreneurs fail to see how they’re not paying themselves enough. Accounting profits might all be positive, but in relation to the risk attached to your business, you might be making an economic loss.
For most small businesses, the dividends an investor earns should pay back their investment within 2 to 5 years. The higher the risk, the shorter the payback period.
In addition to ODE being too low, you might be subsidising your business in other ways. For example, if you’ve paid off your bakkie and use it for work, your company enjoys this free benefit. Profits might look reasonable, even healthy. But will you donate your bakkie to the new owner? I doubt it.
A new owner would have to replace it. So after normalising cash flow to present a budget where capital or depreciation (or any other free benefit) is paid, the company might actually be in a loss scenario. Good luck finding a buyer willing to take over a business that can’t sustain itself off the bat.
And there’s a myriad other reasons, usually unique to each industry and business conditions. Landing a major client might shine up the financials, but a concentrated customer base poses a big risk. Old assets or technology past their best-before dates need more capital to replace them than simply buying you out. Competitors threatening a price war — are your pockets deep enough?
It’s too late to discover your “company” is unsellable when you’re ready to sell. It takes years to turn around and build up an unsellable company that’s attractive enough to investors. And offloading in a hurry typically gets you barely the book value for the assets before winding down and de-registering.
As a business owner, your strategic planning process should never be limited to simply planning your business strategy. It should always start with your shareholder exit goals: what’s your price and when do you want it? Then work backwards so your business funds your financial freedom.