The Endowment Principle
And Valuing Your Business
By John C. Stewart, Executive Director, NPRC
“The endowment principle suggests that an owner of an object tends to attribute a higher value to that object because he owns it. Consequently, the owner of a business may think that the business has a higher value than it actually does, merely because he or she started it, nurtured it, etc. You should take this into account if your valuation falls far below the owner’s asking price.” (From Print Shop for Sale, Chapter 1)
I would love to have $10 for every time I have heard an owner tell me that they would rather shut the doors, close the business and walk away before they would accept an offer they consider too low. It is amazing how many owners simply point to the many years they have worked building the business, the sacrifices they have made, and the “blood sweat and tears” they have invested to build their businesses to justify the value they have placed on their business.
Tell owners that they have made a major mistake loading up their small businesses with equipment that really isn’t need, or tell them that after all is said and done they have earned a decent salary over the years but they really haven’t generated any significant “excess earnings” and as a result their business is worth very, very little.
Sadly, many owners wait too late to sit down and attempt to value their business. To be blunt, some put this task off because they suspect the value will not be what they were dreaming of or counting on a few years ago. Other owners simply have little or no idea as to how to arrive at a value for their business, and they are unwilling to take the five or six hours it might take to get a better grasp on valuing a business.
Some make a half-hearted attempt by using some outdated multiplier, while others rely on advice offered by a well-meaning uncle or business broker, most of whom know little about valuations in the printing industry.
Valuations Based Upon Earnings
Most important of all, many of these owners simply do not understand the basic valuation principle that notes that, “for a business to have any real value to a potential buyer, it must be able to produce enough cash flow to pay the new owner a reasonable working salary and then produce enough ‘excess earnings’ for the buyer to be able to purchase the business from the seller over a 4-6 year period of time.”
“For a business to have any real value to a potential buyer, it must be able to produce enough cash flow to pay the new owner a reasonable working salary and then produce enough ‘excess earnings’ for the buyer to be able to purchase the business from the seller over a 4-6 year period of time.”
The biggest mistake made by many owners contemplating the sale of their business is to initially combine the salary and perks paid to both the husband and wife and look at that combined total as the “profit” generated by the business. Once combined, the owners then use some type of multiplier, add a value for assets, and arrive at a final selling price for the business. Oh, if were only that simple!
Let’s clear up something immediately. Combining your salary and perks with whatever is paid to your spouse and then claiming that represents the “net profit” or “net earnings” of the business is simply wrong, wrong, wrong!
Only If You Are Selling Your Spouse
Of course, the only exception to the discussion above would be in the event that you are actually including your spouse (husband or wife) along with the list of other assets that will convey when you sell the business. I know at least some readers are whispering to themselves,“Oh, if I could only do that I would…”
“Ok Mr. Stevens (the new buyer), here is the final paper work for the sale of the business, and you will notice that it includes a Ricoh digital printer, a state-of-the-art estimating system, a Heidelberg folder, padding rack, a Sakuri 40” cutter and my wife. She will stay on with the business until you decide to trade her in or sell her to another print shop.”
The point in the sarcasm noted above is that when a husband and wife sell their business to an individual buyer, it is typically assumed that the buyer will assume some or all of the responsibilities of the primary owner, AND if there is a “working” spouse involved in the business, the new buyer will also have to hire someone to replace that spouse or partner. So the money paid to the spouse that was initially classified, counted or included as part of “net profit” or “owner’s compensation” is really nothing more than payroll that must be assumed by the new buyer.
What about the value of the hard assets that are normally sold and conveyed with the sale of the business? Yes, the value of assets used in the business are also included in most valuations, but in the end, the value of assets are typically modest or minimal compared the value of the business when considering “excess earnings” or profits.
A Disgruntled Client
I once had a client who actually stopped communicating with me (he was acting like a small child) when I told him that his decision to purchase one piece of equipment after another, especially in the past 3-4 years had actually negatively impacted the value of his business. It seemed like he was bent on buying equipment and he bought and bought, using the argument that the more production capability he brought in-house the better and more productive he would be.
Sometimes it is better to broker than to invest in equipment that is only used two or three times a month. Just remember, the very last thing you want to do in the last few years before you sell your business is to start adding a bunch of new assets.
Assets never contribute on a $1 for $1 basis when it comes to valuing a business, but “excess earnings” can easily end up being multiplied by a ratio of 3 to 5 in caluclating the final value of a business.
Buyers Like Profits, Not Assets
Newly acquired assets are quickly depreciated, oftentimes far faster than shown on the balance sheet. To consider the investment cost for a new piece of equipment can or will be recaptured at the time of sale is pure folly. Buyers are not interested in buying shiny new equipment. They can do that on their own without your help.
On the other hand, buyers are interested in buying businesses that produce real “excess earnings,” “cash flow” or “profit” above and beyond what required or necessary to pay a single working owner. The bottom line? Excess earnings are always far more valuable than even the best net assets, no matter all the bells and whistles.
Drop me a line with any of your questions at: email@example.com