What happens when our expectations don’t line up with actual results? A gap occurs. A gap between one’s perception and reality. The impact of such gaps cause disappointment, frustration and concern. The goal of this article is to educate business owners of three important gaps: the profit gap, value gap and wealth gap.
The profit gap
Each business is part of an industry. A business typically has competitors or comparable companies that operate in the same industry. Businesses in that industry have benchmarks. Benchmarks are key business metrics and practices that allow interested parties (i.e. the market) to compare a particular business against its competitors, peers or other companies around the world. Where a given business lands among these benchmarks helps an organization understand how and where it needs to change in order to improve performance. In short, benchmarks can tell a business owner whether they are a best-in-class business within their industry or something else.
One important benchmark is profitability, more specifically the earnings before interest, taxes and depreciation and amortization (EBITDA). Business owners need to understand the company’s EBITDA and how it compares to their industry benchmarks.
The difference between the EBITDA of a best in class business within the industry compared to the actual EBITDA of a business owner’s company is the profit gap.
The value gap
The value gap takes the profit gap to the next level.
Every business has a value. Some are worth a significant amount, others very little, and then there is everything in between. A common method of calculating value in an industry is to take a multiple of a company’s EBITDA (i.e. 3 x EBITDA or 5 x EBITDA) and then apply enhancements or deteriorations of that calculation based on other intangibles or considerations.
When a business operates at optimum profitability, it will command a best in class multiple. A best-in-class multiple yields a higher value for one’s business in the market.
The inverse is also true. When a business is not operating at optimum profitability and has not developed relevant intangible, intellectual capital, it will receive a lower multiple on its EBITDA when being valued.
How would your business compare? Would you receive a best in class multiple? Where are you now as compared to what a best-in-class company would be? That differential is the value gap. It quantifies how much value is being left on the table if you exited the business today.
It is disconcerting when an owner realizes their business is worth less than they expected because the owner’s wealth takes a direct hit.
The wealth gap
A business owner typically has a dollar figure in mind that would allow them to exit the business and enter a retirement that aligns with their current or desired lifestyle. A business owner’s current savings and spending habits are shaped on the assumption that this hypothetical dollar figure is achievable in the marketplace. But what if it is not? What if the current profitability of the business does not command a multiple in order to achieve this hypothetical dollar figure?
When there is a disconnect in the amount of value an owner needs to harvest from their business in an exit as compared to what the market allows the owner to harvest, you get a wealth gap.
Typically, 80-90% of an owner’s wealth is in their business. Therefore, an unfavorable wealth gap is particularly concerning to a business owner.
Summary
A business owner needs to understand their position in the market compared to its competitors. Are they benchmarking as a best-in-class business, worst-in-class or somewhere in between? Are they as profitable as other players in their industry? A focus on profitability and the intangible, intellectual capital will drive the value of the business. If the business is operating at optimal levels, it will command a strong multiple in the market place. A strong multiple in the marketplace raises the value of the company, which positions the owner to maximize the amount of wealth harvested in an exit.
The three (profit, value and wealth) gaps are interdependent and support each other. They can be assessed, quantified and influenced by thoughtful strategies.
We encourage business owners to be aware of these gaps in the early stages of the company. A common theme for us at Baker Tilly is that exit planning is simply good business strategy. It is always the right time to understand the operating effectiveness of the business and implement strategies that further build value in the business in order to minimize a wealth gap for the owners by maximizing the amount of enterprise value harvested in an exit.
