Valuation Is Easy: The greater the perception of risk- the higher the reward.

facebooktwitterlinkedinby featherdouble-six-diceAt the last Winter NAMM (National Association of Music Merchants) I gave a talk on Succession Planning. And as usually the case, folks come up to speak to me after a talk. Here’s how a typical conversation goes.

Bob- Jaimie I enjoyed your talk on succession planning. My store grosses about $1,000,000 a year.What’s the most I can get for my store?

Jaimie-  Sounds like you built up a successful business. Congratulations but I believe you are asking the wrong question.

Bob- What do you mean?

Jaimie- I mean a much better question to ask is- under the right terms and conditions, assuming we get everything right regarding the running of our business, over the next # of years, with solid re-occurring cash flow & earnings, what’s the maximum value I can create for me and the new owner?

Now that is a more elegant question, is it not? Valuation is easy to understand if you look at it from the buyer’s perspective. The greater the perception of risk – the higher reward.

On February 5th, I posted a video interview with Alan Friedman, CPA, guru accountant for music retailers.

And I asked him to explain why some stores may receive a higher multiple than others.

Most music stores are bought on a multiple of earnings. If I can assure myself the business will throw off $200,000 a year, after I pay myself a reasonable officer salary or pay someone a salary to do a job the prior owner is doing, and I can generate $200,000 in cash, maybe I’d be inclined to offer $1,000,000 for the business, a 20% return on the buyers money.

The multiple is nothing more than a measure of risk. The potential buyer may be only willing to pay 3x or 4x earnings. Generally you don’t see multiples higher than 6X earnings on the top end of the range.

To see the whole video click http://bhwealth.com/succession-planning-interview-for-music-retailers/

Alan talks about “cash flow” and “earnings.”  Let me define these two terms.

An accountant will look at cash flow and earnings in two different ways. It has to do with the time difference between cash movements and business transactions. In other words it’s possible that the cash flow and earnings are the same number, or may not be the same.

Alan continues.

For example, you could be legitimately reporting $200,000 of net income (earnings) and have little or no money in your business checking account.  How does this happen?  It’s because at different points in your profitable year you actually did have cash…but then you did something with it.  You either bought more assets (like inventory or equipment) or paid off debt.  Either way, you took that cash and did something that indeed bettered the business…but it left you in a cash deficient position.  The opposite is true as well. You could be sitting with $200,000 of cash in your business checking account, but you’re losing your shirt….as evidenced by the $5000,000 of unpaid bills sitting in your drawer.

Everyone knows both “profitability” and “positive cash flow” are critical to the running of every business.  My favorite question to ask an audience of music retailers is “If you had to pick just one, which one is more important…profitability or cash flow?” I love asking the question because most of the audience will get it wrong by saying “cash flow”. Ultimately you can fix cash flow problems by borrowing or restructuring debt….as long as your profitable.  But when you’re not profitable, borrowing money is like feeding cocaine to a heroin addict. You’re merely prolonging the agony and assuring the eventual death of the business, instead of fixing the real problem…the lack of profitability.

As far as the multiple goes that Alan is referring to- here’s the simple math.

If you have a buyer offering you 4 X earnings, the person is requiring a 25% return on their investment.

On the other hand, if you have a buyer offering you 5 X earnings, the person sees less risk and is prepared to accept a 20% return.

You can see the relationship; the higher the multiple offered, the lower the perceived risk.

On the flip side, if a buyer is only offering you 2 X earnings, the person see significant risk and requires a 50% return on the investment.

So the holy grail, in maximizing the valuation is to improve cash flow/earnings as “Net Income”…. a.k.a. “bottom line.”

There will always be external factors which may also influence the selling price. These factors may include; interest rates, stock market prices, the availability of capital, and the availability of other music stores up for sale in your market area.

What are the primary valuation drivers for a music retailer or music school?

  • A diversified line of products & or services.
  •  Talented management which can run without the new owner,
  •  Positive cash flow and consistent net income .

To receive the highest possible price upon the sale of your business, you need to plan for and manage those factors the day you open your business. Build your business with your exit strategy in mind.

So what are you waiting for?

Please note that Alan Friedman is not affiliated with BH Wealth Management. 
This is a personal opinion and does not constitute or reflect an endorsement by First Allied 
Securities, Inc.

 

Written by Jaimie Blackman

Jaimie Blackman

Jaimie Blackman has created Sound Financial Decisions ™ powered by MoneyCapsules®, to help guide business owners through the complexities of succession planning.

Jaimie writes “Smart Succession”, a monthly column in Music Inc., and also writes a bimonthly column for Canadian Music Trades magazine. He has spoken at NAMM U Idea Center, and at Yamah’s Succession Advantage.

As a financial literacy educator he has taught at New York University and has lectured at the 92nd Street Y, Marymount Manhattan College, and CUNY.

As President of BH Wealth Management, Jaimie also helps his clients implement investment and insurance solutions which are aligned to their personal values. Visit bhwealth.com to learn more.

To subscribe to Jaimie’s Succession Success: Insights for Music Retailers, visit moneycapsules.com.

The purpose of this post is to educate. Our content should not be construed as advice. If legal, tax or other advice is required by the readers, professional advice should be sought.

2 Comments

  1. So a store that breaks even with no excessive principals remuneration is only worth the assets less liquidation costs?

    Reply
  2. So a store that breaks even with no excessive principals remuneration is only worth the assets less liquidation costs?

    Reply

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