considerations for valuing a service business

A common problem occurs when an entrepreneur, who has been building a business for a period of time, decides to take on a new partner. What are the factors that determine the price that the new partner buys into? What piece of the company is a fair piece?

In public companies, where the shares in the company are traded on a stock exchange, the price of the shares reflects a consensus value determined by the interest level of all parties aware of the stock. If there are many shares trading hands on a frequent basis and the company is publishing its progress and successes through the press and the public is paying attention and the company is generating earnings, the price of the shares is a multiple of these earnings (say a multiple of ten times earnings). The public believes that the stream of earnings from the operations of the company will likely increase through time and they collectively reward the company with a high future value that it trades on.

In private companies, there are many difficulties. First the shares are not as liquid: someone who buys shares cannot easily sell them. Private companies pay back the investors only through dividend income or when the company goes public itself or is bought by another company in the space. With a growing company that is constantly cash-hungry, income that could go to dividends has to go back into growing the company. The other exit strategies of going public or merging with or selling to another company is a risky and difficult proposition.

In the case of a founding entrepreneur bringing on another partner, these issues are less of a consideration. Someone who is considering entering a business as a partner is there to contribute their talents and skills to the growth of the business and share ownership is a way to acknowledge this investment and compensate a partner from drawing less than their market value out of the business while it grows.

There is a natural conflict that exists between the founding partner(s) and the new partner(s). The founders have invested their time (sweat equity), cash and other assets to get the venture to its current level of success. The rationale of bringing on a new partner is this: the business will be more successful and will be worth more through the combined efforts of the original and new partners.

Private companies are typically bought and sold using a number of valuation methods:

1. multiple (1 to 4 times) of cashflow or EBITDA (earnings before interest, taxes, depreciation and amortization)

2. multiple of sales (50% to 150% of trailing revenue, as a moving average for 1 to 5 years of history)

3. the book values of hard assets (goodwill, intellectual property, machinery and realestate)

4. discounted value of future cashflow (the sum of 1 to 5 years of estimated EBITDA discounted for risk and uncertainty)

When a private company has not yet broken out and realized the escalating value that the original partners believed it had, sales and earnings may be low or negative (particularly if the founders are taking draws or salaries that are lower than the market rates for the roles that they are performing). Many service-based companies have no assets or goodwill or intellectual property that is unproven. Looking forward into the future, there are many risks and factors that positively and negatively affect sales and EBITDA. These factors make the value of the company ambiguous and easily contested.

The original founders tend to over-value the company based on the immense sacrifices and investments of time, energy and money they have made to get the business to its current state.

New partners tend to under-value the company based on the future value of their contributions and the amount of financial value that has not and might not materialize. Additionally the value of future cashflow is based in part to the assumption that they will succeed in contributing to the company: the company is less likely to become financially valuable if they do not join the partnership. If this was not true, they would not be good partner candidates in the first place.

Other factors to consider are the salaries of the new partners, how much of a discount these salaries are from market rates for their roles and any human, intellectual and financial capital they might bring.

The way ultimately to frame these negotiations is to arrive at a deal that is fair and that everyone can live with, remembering that great partnerships have great synergy and that a team of people can create much greater value together than apart.

the five love languages

I just read Gary Chapman's classic relationship book on the five languages of love.  He's come up with a very simple concept to help married people get the spark back.  The five love languages are:  physical touch, words of affirmation, gifts, acts of service and quality time.  The way my wife Tania tends to express her love for me (like baking things she knows I like and generally taking care of me) is her preferred way of receiving love as well.  She is an "acts of service" gal.  One of the things that is a great stress to her is anything that is broken down.  I can easily show her love in a very meaningful way by picking something and fixing it, whether that is taking a dog into his physio appointment or getting the leaking eavestrough fixed.  As her love tanks gets filled, she more naturally gives me the quality time I seek.  Where the system takes some faith is this:  love is an action and a gift, something I give to my spouse with the expectation of return.  But what of course makes this work and sustainable over the long term is that it becomes reciprocal in time.  Check out Chapman's work at http://www.fivelovelanguages.com/.  Happy Romancin'.

why change is hard to do

I think most people by now have figured out that making a change is hard.  It seems reasonable that if I want to change my results–say lose that last stubborn 10 pounds or earn that last stubborn $100K–I need to do something differently.  My results are a derivative of my habits:  spending habits, selling habits, eating habits, exercizing habits.  These are hard to change because, well, they're habits.  My behaviours are frozen in place by a complex web of emotions.  And will power is at best a short-term solution.  Even though I know what I should be doing, I don't always know why I'm not doing it.  Just do it?  A nice sentiment but not very useful.  I think Gandhi had it right when he suggested that we be the change we want to see in the world.  Being before feeling.  Feeling before doing.  Doing before getting.  So here is a great clue to what the key to the change is:  what trait do I most admire in other people?  For me, it's passion.  When I'm passionate, I'm not over-eating, over-spending, under-selling and under-exercizing.  I've been studying passionate people for a few months now.  They tend to do what they love and that energy is so enticing that it spreads and other people want a piece of it, ie, customers bringing money.  They also tend to keep active doing what they love and they seem to stay fit and healthy as a result.  And because they feel so great about themselves they don't need comfort spending and comfort eating and comfort laying-around-watching-television.  Passion.  It works.

what high level entrepreneurs think great coaching is about

I recently held two focus groups with some of the successful, high networth entrepreneurs I coach.  The primary value a coach delivers is calling them on their bullshit or "illuminating blindspots" in coaching parlance.  A great coach they said is willing to be the person that says the things that no one else in the entrepreneurs personal life or business is willing to say–things that are too risky because they carry the risk of termination or retribution in some way.  A great coach is willing to put his or her job on the line to say the hard things that need to be said.  The irony of course is this:  it might seem risky for the coach to make these tough communications, but they made it clear that it is more risky not to.  An entrepreneur's life is full of "yes" men, full of people who want something.