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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Some make a half-hearted attempt by using some outdated multiplier, while others rely on advice offered by a well-meaning uncle or business broker, most of whom know little about valuations in the printing industry.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.
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Analysis Reveals Huge Disparities in Company Values Among Firms Reporting Almost Identical Sales!
By John Stewart
35 Valuations – Even the small portion of valuations excerpted above illustrate the huge variations in valuations for printing firms in this country. For explanations of the “headers” please visit the full chart at the end of this post. As to why the huge variances? Click here or the chart above to download a PDF of the above chart. Read further…
Rules of Thumb
In the old days, one of the most popular rules of thumb for determining what a printing business was worth or company valuations was based upon nothing more than a multiple of sales –one times annual sales was probably the most common.Sometimes that multiplier even exceeded one! The amazing thing about that rule was that it never took into account profitability or what a working owner was able to take out of the business.
Other valuation rules that are still floating around today may be a bit more logical in that they take profitability into account. Some rules rely on a multiple of excess earnings, and some modify that by adding in the value of net assets. Still other rules use a average of owner’s compensation over a period of time multiplied by a factor between 2-6.
Unfortunately, many owners don’t understand the term “excess earnings,” or give much thought to company valuations until they near retirement and suddenly realize that the business isn’t worth half what they thought it would be! Very few owners fully understand terms such as “owner’s compensation,” or “earnings multipliers” and thus have great difficulty determining the value of their own firm.
“Print Shop For Sale” Published
In 2007 Larry Hunt (a highly respected printing consultant) and I published a book titled, “Print Shop for Sale.” PSFS, a 280+ page publication, has been reprinted numerous times and at last count had sold more than 3,800 copies. At the time “Print Shop for Sale” was published it was the only book in the printing industry dedicated strictly to valuing printing firms. It continues to hold that distinction today. As noted on the cover of the book, it is intended to provide readers with, “A step-by-step guide for establishing a fair market value for your printing firm, or one you are looking to buy.”
Writing the book with Larry was a true labor of love. Neither of us imagined that it would eventually lead to numerous inquiries from printers around the country asking if we would value their firm. Naively, we assumed our $89 book would do the trick. We figured the book did a pretty good job at explaining the “Modified Excess Earnings” approach and how to use that to arrive at the value of a printing firm.
Wow, were we wrong! We began getting calls from both independents and franchises alike asking us if we would prepare a valuation for their firm. Larry decided he would prefer to retire early and play golf. I don’t play golf, but I do own an airplane which is very expensive to operate and maintain, thus I continue offering valuation services when asked. <g> (Interestingly enough, after we evacuated the plane during the last hurricane we returned to Melbourne only to discover that we had developed a crack in the engine block and we are now looking at a $37,500 cost for a re-built engine!)
When an independent or franchise owner would call about valuations one of the first things I would recommend is that they should buy the book and gather together the various forms suggested in the book and then provide answers to our valuation questionnaire. If they still had questions then they should call me.
Sometimes, you just have to do the “hard” work. There are no “rules of thumb” or shortcuts to valuing most firms.
Interestingly enough, many of the printers told me they had already bought to book but still wanted me to do the work. They wanted more than “Print Shop for Sale” had to offer.
Some owners, although telling me they had purchased the book, admitted they were not really into the “numbers” and wanted me to do the work. Some wanted a detailed valuation of their firm and were willing to pay the price. Other owners had found a business they were interested in buying but wanted my help in coming up with a “fair market” offering price.
Avoiding Valuation Pitfalls
Since that time, I have conducted more than 450 valuations and I continue to provide valuation services today. However, I am NOT trying to sell valuation services. What I would like to share with you are some general comments about valuations and why some owners are able to receive “top dollar” for their businesses, while other owners end up, even after 10-15 years of operation, with businesses with little if any value. The result, they work it to the very end and then close the doors.
For those of you who used to read my columns in Quick Printing magazine, or have read some of my recent articles posted on the National Printing Research Council website (www.printingresearch.org) you know that I tend to rant and rave sometimes just to make a point.
That’s what I am going to do with the column – Offering up some “rants” and “raves” about company valuations and what causes some to be valued extremely high, while others end up being shockingly low.
First, let me observe that in today’s world, it does strike me that many of the owners that I encounter are far more realistic than they were in the past as to what they think their business might be worth. Buyers also strike me as being better informed and more realistic as to what they are looking for and what they are willing to pay. You’re probably not going get away with the old, “Hey, this business is a goldmine and someone with some real marketing skills and who is a good sales person can easily take this business to the next level.”
Unfortunately, there is also a substantial number of owners who have worked more than half their life to build a business, only to discover that it is worth far less than they thought it was. They had put most of their eggs into one basket (the business), only to discover too late that they had been making poor decisions almost from day one – decisions that would really hurt them in the long run.
Low Valuations and Lost Friends
The sad thing is that I have actually lost a couple of friends along the way as the result of valuations that came in much lower than what they had expected, and they blamed me for the low valuations. They had been counting on a valuation of $$$ for the last few years, and then I prepare a valuation based upon the numbers they provided and I end up telling them their business was worth less than 50% of what they thought.
Another owner bragged about how much money he was able to take out under the table and thus avoid taxes. When I valued his firm, and told him we couldn’t use that “stolen cash” to value his business he was shocked!
Still another owner bragged to me about his excellent package of equipment and that he could produce 95% of all his work in house. What we discovered was that he was asset-rich and excess earnings poor. He had accumulated far more in equipment than he really needed to produce his annual sales.
Sure, the equipment was really neat, and worked extremely well, but a lot of it was only used 2-3 times a month and for the remainder of the time it sat in the corner collecting dust. Excessive amounts of hard assets, as a percent of sales, combined with low excess earnings, typically produce low company valuations. Most savvy buyers are not interested in buying all of your fancy assets, but rather what those assets can produce in terms of excess earnings!
The Worst Case of All!
Of course, the worst case of all is to put a fairly-valued firm up for sale hoping to get lots of offers only to hear dead silence. Even the best, most logical, common-sense valuation doesn’t guarantee and that that you are going to find qualified buyers in your market willing and able to pay your asking price. Bottom line, that unlike in the residential real estate market, there really isn’t much of a market in which to advertise, let alone sell printing businesses.
Special Editorial Note: Actually this entire article is an “editorial note” <g>, but I want to point out the values assigned to various businesses noted in this article are not meant to imply that these businesses sold for those prices, or in fact sold at all! Many businesses just never sell. Some are taken off the market by the business owner or broker and some never get even a nibble because of excessive value placed on the business by the owner, a business broker and yes, even a consultant.
“Despite the commonly held belief that markets are efficient, and efficient market does not exist for privately held businesses… unlike the NYSE or the NASDAQ, there is no place to buy and sell privately held businesses aside from the business brokerage community, which is small in scope. As a result, it is very difficult to determine what a privately held business is worth in the marketplace. This lack of an efficient market presents a critical need for valuation services.
This study is “worth its weight in gold,” say many of the profit leaders in the industry. Unfortunately, this may indeed be the last edition of this study to be published in the industry due to a lack of support by printers.
Let’s face it, this industry, taken as whole, is also a very mature industry. Sure, we’ve evolved in the products we produce and how we produce them, and we’ve added more services and products but it is difficult to argue against it being a mature industry. To claim that the printing industry offers up boundless opportunities for sales, growth and profits has to be taken with a grain of salt.
When it comes to valuations there is one thing you don’t want to do and that is to be caught with “your pants down” when you are are approached by a competitor asking, “Have you guys ever thought of selling your business, and if so what do you think it is worth?” That’s not the time to be scrambling around to come up with some value.
To be blunt, valuing your own firm ought to be done every couple of years, just like to update your statements of personal net worth – Of course you do that, don’t you? If the value of your firm has continued to grow over the years then congratulations! If it hasn’t, then do something about it. See my list of “Key Take-aways” near the end of this article.
35 Randomly Selected Printing Firms
Recently I was looking for a specific chart I prepared a few years listing and comparing company valuations but for the life of me I could not find it. So I went searching out some of hundreds of valuations I have conducted in the last 7-10 years and started opening up one folder after another, retrieving basic information from each valuation.
I extracted data for 35 firms. I could have easily extracted 50 or even 100! However, I know from experience that once I passed the 25 count or so, that the average and median data I was searching for would change little if any.
I assigned a fictional name to each company folder I opened, and then retrieved the following items: • Annual Sales • Calculated Excess Earnings • Value of Net Assets* (sold) • Excess Earnings Multiplier used in the valuation • Estimated Valuation of Firm
*NET ASSETS, as defined in the accompanying charts, is the true, market value of the essential assets (equipment, furniture and fixtures) transferred and sold to the buyer. This value is not necessarily “book” value, but rather the value that a savvy buyer would pay if he or she had to go out on the street and replace the equipment used to produce the sales in question. As a general observation, many owners want to assign a much higher value on their equipment package than would be warranted in the real-world marketplace!
For purposes of comparison and sorting, I also calculated the percent of net assets to annual sales as well as the value of the firm expressed as a percent of annual sales. Below is one of four charts I prepared. It illustrates, without sorting, the first 17 firms for which I recorded data. Note that we eliminated two “outlier” firms (#4 and #17) – One was worth 110% its annual sales (certainly possible but still a clear “outlier”) and one firm that actually had a negative value – that scenario is also quite possible, but it too was an outlier that would have otherwise distorted our average.
SPECIAL CAUTION: Be advised that the above company names are totally fictional and have no relationship whatsoever to firms that might coincidentally have the same name. You don’t know how hard it is to actually come up with a fictional name without a real firm name coming to mind.
Of the 35 companies for which we retrieved valuation data, the smallest firm we uncovered (Instant Copy) reported annual sales of $230,256 and was eventually valued at $114,905, or 49.9% of its annual sales.
The largest firm in our selection of 35 firms (Signature Offset) reported $4,199,105 in sales, and it was ultimately valued at $931,116, or 22.4% of its annual sales.
All Firms Ranked – Although the above chart reflects the remaining 18 firms we analyzed, we have included at the end of this article a single table ranking the above firm in terms of calculated value to annual sales.
As you examine the two tables above, you can’t help but notice the range of valuations based upon annual sales. Some firms are valued extremely low at 3-29% of annual sales, while other firms, those near the top, are valued at 52-75% (and some even higher) of annual sales.
Each of the valuations were subjected to the same valuation tests and formulas. You would like to think that the highest valued firms were those with the highest ratio of “Excess Earnings” to “value” but that is not always the case. The same expectation might be said for “Net Assets to Value” but that too cannot be said. What we can say is there are so many variables when it comes to preparing a valuation that it pretty much precludes the ability to offer up a neat “rule of thumb” that you could quickly apply to just two or three ratios.
Below is the entire list of 35 firms sorted by their value as a percent of annual sales:
Click image to download PDF of this chart
Partial Definitions of headers: Annual Sales – Self explantory Excess Earnings – Total owner’s compensation less “fair market salary” for working owner. Explained in detail in Print Shop for Sale. Net Assets – Hard assets (“real world” street market value of equipment, furniture & leasehold improvements) transferred free & clear at time of sales. Does not include cash, AR, etc. as those normally are retained by seller.) % Of Assets to Total Sales – A comparative ratio of Net Assets to Sales. Earnings Multiplier – Multiplier and score arrived when sellers complete valuation questionnaire as explained in Print Shop for Sale. Questionnaire is also available for inspection at our Valuation Services Page on our companion site. Estimated Valuation – This is the value (we sometimes determine a range rather than a specific figure) that we arrived at when applying and using the Modified Excess Earnings Approach. Value as a Percent of Sales – We divided estimated value by annual sales to arrive at this ratio.
Key Take-Aways for Increasing Value
While I cannot offer up hard “rules of thumb,” I can still rant a bit and offer up suggestions for improving the overall profitability of your firm and thus its value. Some are common sense, others are not as obvious:
1. Monthly Financial Statements – Generally speaking, the most troubled firms I have encountered over the years, including many of those with a low valuation as a percent of sales, are those that either don’t receive monthly financial statements, or if they do they don’t read them! Some owners just don’t seem to care too much about the “numbers” and it shows when it comes time to value their firm. It’s probably preaching the the choir, but my guess is a vast majority of the most troubled firms in this industry have never, never examined an Industry Financial Benchmarking Study and that is a tragedy. (This link directs you to our bookstore where this key study can be purchased) Hell, Larry Hunt’s Executive Summary is a treasure trove of suggestions for becoming a profit leader! Do I feel sorry for these folks? Not a bit. That’s a rant!
2. Properly Formatted Financial Statements – Of Course, you can get financial statements every month, but if they are not formatted properly you’re not going to be able to find the key info that you need to manage the business. At the very least, your financial statements need to breakout expenses into three basic categories – Total Payroll, Cost of Goods and Overhead Expenses. When it comes to payroll, you also need to be able to quickly distinguish payroll costs and benefits paid to a single owner as compared to what is paid for all other employees. This is critical info required for a valuation. P.S. If both husband and wife work the business, one of those salaries needs to be shifted to general payroll. By the way, it is up to you and not your CPA or bookkeeper to determine how your P&L should be formatted.
3. A Huge Mistake Made by Many – Far too many owners allow either their CPA or their internal bookkeeper to provide raw dollar figures without providing them with an adjacent column reflecting the the actual ratios or percent of annual sales that each cost item or category represents – These are critical ratios you need to commit to memory and if someone isn’t giving these ratios to you then fire them! These ratios, whether good or bad, can be used to compare to the ratios for profit leaders and laggards found in industry benchmarking studies.
4. Excess Earnings vs. Owner’s Compensation – “For a business to have any appreciable value to a potential buyer, it must produce a cash flow above and beyond what would be required to pay a fair market salary to the new owner or manager. It is this ‘excess cash flow’ or ‘excess earnings’ that is used to purchase the business from the former owner.” (Excerpt from Print Shop for Sale.) If you’re unfamiliar with this principle or don’t understand it you need to hit the books! If you think someone is going to buy your business and not take out a reasonable salary while he/she uses the profits of the business to pay you off you are sadly mistaken. That new buyer is entitled to pay himself/herself a fair market salary and still have enough money left over to pay you! Where is that money?
5. Truly Understanding Owner’s Compensation – Most owners don’t fully understand what is meant by the term “Owner’s Compensation.” “Owner’s Compensation” is defined as, “all the money that is left over in the business after covering all expenses of the business (cost of goods, payroll and overhead expenses) but before paying the primary working owner a salary or giving that owner any fringe benefits.” “Owner’s Compensation” DOES NOT include combined salaries or benefits paid to a spouse or partner. You should be able to calculate your owner’s compensation quickly and without trying to play games with the numbers.
6. Blood Sweat and Tears Don’t Count – Just because you and your spouse or partner have worked the business very hard for so many years plays little if any role in its value to others. In “Print Shop for Sale” we discuss the “Endowment Principle” – “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.” That principle is often the cause for the vast differences in valuations prepared by sellers as opposed to those prepared by potential buyers.
7. Whatever You Do, Clean-Up Your Balance Sheets – In 90% or more of sales involving small businesses, the seller typically keeps or retains all cash and AR and assumes responsibility for paying off all short and long-term accounts payable, including notes, loans, etc. (Operating Leases remain on the books as an expense) As for all those special liabilities or notes payable to owners or relatives forget about them! No buyer is going to pay-off those types of liabilities. If the company owes you money you better take care of it now because it won’t happen at the time of sale. The same is true for fictional entries like “amortization” or trade secrets or other ill-defined items listed as assets.
8. Increasing Value by Decreasing Costs – You may think you are running a tight ship. Chances are you’re not, certainly not when compared to the real “profit leaders” in this industry. For every $10,000 in annual expenses that can be trimmed means that the value of your business can increase by anywhere between $25,000 and $60,000!
9. Inability to Make Hard Choices – Sometimes, owners with the best of intentions fail to make decisions that would almost immediately enhance the value of their business. Terminating bad apples or at least apples that are starting to rot. Like it or not, almost every company with six or more employees has one of these employees. Failure to act on the obvious ultimately leads to lower excess earnings and lower valuations. It is also possible that you have a great team of long-term, very loyal employees, all of who are highly valued AND YET it is also quite possible that you may have one more employee than you really need. If you terminate just one $40,000 employee that could easily increase the value of your firm by $120,000 to $200,000! But you can’t do that at the very end and expect to benefit from that increased value!
10. Spending Too Much Time on Social Networks – While I rarely go out in the field these days, I can tell you that many owners I know spend an enormous amount of time on social networks. In many respects, I believe Facebook, Twitter, LinkedIn as well as various listservs can be tremendous time-wasters, preventing even the best-intentioned owners from really pursuing what needs to be done. What’s fun to do, is not the same as what needs to be done!
Thanks for Reading
Tired of my rants? I understand if you nod “yes.” If you spotted a couple of grammatical mistakes or missing words I am constantly reproofing so if you notice a mistake chances are good it will be corrected soon. On the other hand, if you find something wrong or unclear let me know ASAP and I will correct it. For those that finished this article I want to say thanks as well. I welcome your comments, although I can’t promise that I will be able to get back to all of them. You can email me at [email protected]
SPECIAL NOTE – Last week, we launched a special 22% Discount Sale on all NPRC publications. The offer was originally set to expire Sept. 26th, but that offer has now been extended until Sept. 29th! You must use “Irma2017” for your coupon code. “Print Shop For Sale” is excluded from this special offer.
Writing the book with Larry was a true labor of love. Neither of us imagined that it would eventually lead to numerous inquiries from printers around the country asking if we would value their firm. Naively, we assumed our $89 book would do the trick. We figured the book did a pretty good job at explaining the “Modified Excess Earnings” approach and how to use that to arrive at the value of a printing firm.
