Issue #294: Value a Business

Welcome back to the 51,000 investopreneurs joining us for today’s issue.

Picking up on our last message, we’re trying to get back to our original roots by discussing a topic you care about + a template you can utilize to get to value fast.

For topics, we’re going to keep running the weekly polls to let you decide where we focus & then share the results + dive deep where the interest lives.

Last week we asked “As a business owner, how often do you think about what your equity in your business is worth? How important is knowing the value of your equity?”

This week, we are curious:

Overview of Wedge Equity

What is Wedge Equity?
Wedge equity is a concept that focuses on adding incremental value to a business. It involves using specific strategies and frameworks to expand a business's profitability and reduce its operational risks. Essentially, it means viewing your business through the lens of an investor and methodically improving its worth.

It’s pretty much how we do every deal at Bootstrapper Capital and how we improve companies for our own portfolio.

Assessing Your Business

Starting Point:
The first step in leveraging wedge equity is to conduct a thorough evaluation of your business's current worth.

Strategic Considerations

Operational and Brand Equity:

• Operational Equity: This strategy focuses on refining your business’s internal processes to enhance efficiency and decrease the risk ratio (or discount) on your business.

• Brand Equity: This aspect targets factors that impact your overall monies multiple. Things like customer acquisition, retention, and diversification.

Goal of Wedge Equity

Enhancing Business Value:

When valuing a business using the wedge equity approach, we focus on a comprehensive analysis that not only considers the business’s current performance but also its potential for growth and efficiency. This involves calculating Seller's Discretionary Earnings (SDE), using the monies multiple, and assessing the risk ratio based on various business pillars.

Seller's Discretionary Earnings (SDE)

What is SDE?
Seller's Discretionary Earnings represent the total economic benefit that an owner-operator derives from the business on an annual basis. It includes not only the business's profit but also the owner's salary, benefits, and any personal expenses run through the business. To calculate SDE, we start with the business’s net profit, then add back these expenses, as they are considered personal to the current owner and might not necessarily continue under new ownership.

The Monies Multiple

Calculating the Monies Multiple:
Once we determine the SDE, it is multiplied by a factor known as the monies multiple to estimate the business's value. This multiple is derived from industry standards, comparable company sales, and adjusted based on the business’s growth trajectory, market position, and unique advantages. It reflects how many times the SDE buyers are willing to pay for the business, taking into consideration its profitability and stability.

Risk Ratio Assessment

Deep Dive into Risk Assessment:
To refine the valuation, we assess the risk ratio, which involves a detailed evaluation of potential gaps or risks in four key areas:

1. Customer Acquisition: We examine the effectiveness and efficiency of the strategies in place for acquiring new customers, considering the cost, conversion rates, and scalability of these strategies.

2. 9-Cs of Customer Retention: This includes checking for consistency in customer satisfaction, the completeness of customer service, and the continuity of relationships, among other factors.

3. Diversification of Customer Profile: We analyze the spread of the customer base to ensure that the business isn’t overly dependent on a small number of clients which could represent a higher risk.

4. Business Operating System: The robustness of the internal systems for operations management is scrutinized to ensure that they are capable of supporting current and future business activities without significant additional investment.

Applying the Risk Ratio

Adjusting the Monies Multiple:
Based on the assessment of these areas, we adjust the monies multiple by applying a risk ratio or discount rate. This adjustment reflects the level of risk associated with the business's future cash flows. A higher risk found in any of the pillars leads to a higher discount rate, thereby lowering the monies multiple. Conversely, lower risk strengthens the multiplier, suggesting a more stable and promising investment.

Risk Ratio Calculation:
The risk ratio is quantitatively determined by evaluating historical data, industry benchmarks, and projected business performance. Factors such as market volatility, customer retention rates, and the strength of the business’s operational processes play a crucial role in this calculation.

Implementation of Valuation Techniques

By integrating these valuation methods into the wedge equity framework, business owners can obtain a nuanced understanding of their company’s worth. This process not only provides a clear picture of where the business stands financially but also highlights areas where strategic interventions can significantly enhance value. With this approach, the business valuation becomes not just an estimate of worth but a roadmap for future growth and risk management, allowing owners to make informed decisions about selling, investing, or continuing to grow the business.

Over Simplified Business Valuation Template Using SDE

Step 1: Gather Financial Information

• Annual Net Profit: $_____

• Owner's Salary and Benefits: $_____

• Non-recurring Expenses: $_____

• Non-operational Expenses: $_____

• Any Personal Expenses run through the Business: $_____

Step 2: Calculate SDE

Use the formula to calculate Seller's Discretionary Earnings: SDE=Net Profit+Owner’s Salary+Benefits+Non-recurring Expenses+Non-operational Expenses+Personal Expenses

SDE Calculation: SDE=SDE= $_____

Step 3: Determine Appropriate Monies Multiple

• Industry Average Multiple: _____

• Adjust for Growth Prospects: _____

• Adjust for Market Position: _____

• Adjust for Customer Diversification: _____

• Adjust for Operational Efficiency: _____

Adjusted Monies Multiple: _____ times

Step 4: Business Valuation

Calculate the estimated business value by multiplying the SDE by the adjusted monies multiple. Business Value=SDE×Adjusted Monies MultipleBusiness Value=SDE×Adjusted Monies Multiple

Estimated Business Value: Estimated Business Value=Estimated Business Value= $_____

Additional Considerations

• Risk Factors: List any significant risks that might affect the monies multiple, such as customer concentration, market volatility, or operational inefficiencies.

• Opportunities: Outline any potential opportunities that could enhance the business’s value in the future, such as expansion into new markets or the introduction of new products/services.

This template provides a systematic approach to valuing a business based on its discretionary earnings, adjusted for its unique factors and market conditions. It allows the owner or prospective buyer to see the financial benefits of the business operation clearly and assess its worth based on more than just the bottom line.