Preparing for the future is as much about identifying market trends and understanding your customer base as it is about knowing where you’ve been. Healthy growth requires experience and a fundamental understanding of the nuances of your business. It’s your baby, after all, and is a reflection of your drive, passion and planning. You hope that each year, the business increases in value so that when it’s time to retire, your nest egg is secure. So then, what’s your business worth?
Knowing the value of your business is the cornerstone and first step in understanding the business’s past performance. An accurate valuation allows you to determine “Where am I today?” and “How do I get to where I want tomorrow?”. The tumultuous nature of the global economic environment is always a factor to consider, and has resonating effects around business operations. Over 170,000 small businesses permanently closed their doors as a result of the Great Recession, and trillions of dollars deteriorated from the US equity markets. One of the biggest hazards for small businesses during bear markets is what’s known as the “Stock Market Effect”. This describes the consumer behavior in response to equity market conditions. As stocks decline, people feel less wealthy and don’t spend as much. Just as this hurts the big companies it really hurts Main Street businesses as well. Without a proper plan in place, the next bear market may cause the destruction of many hundreds of thousands more businesses and foster an economic environment of stagnation that will have far greater and further reaching effects than the collapse we saw in 2008-2010. Furthermore, after taking into account inflation and the normalization in population growth, the overall market value recovered since 2008 is less than half of that lost. For the 75% of business owners who plan to fund their retirement with the sale of their business, a proper plan in place to preserve capital, protect against suits and promote growth, is absolutely vital or else they will not have the funds necessary to survive let alone thrive.
US equity markets have seen tremendous gains over the last seven years. It has been one of the strongest bull markets in history and has fostered immense global growth as well. But many argue that we are overextended the question remains, “Can the underlying assets support such lofty valuations?”
The S&P for example has a P/E of 25.22, a valuation not seen since the Credit Crisis in 2008, Tech Bubble in 2001 and The Panic of 1893.
April equity valuations were a 76% deviation from the mean. The month prior to the start of the Great Recession, they were 64%. If we experienced a “crash” next month, it would be the second highest deviation from the mean we have seen before a bear market.
Consumer confidence in April missed estimates, representing the steepest decline in sentiment in the last 12 months.
The first quarter of 2017 grew at the weakest pace in the last 3 years at 0.7%. Compare that to 2.1% in the last quarter in 2016 and 1.1% for the first quarter a year before.
Whether you agree the outlook is bearish or not, you can agree that a solid plan and adequate preparation are absolutely necessary to have in place for every business. Any proper plan includes liquidity, and cash is king.
A business needs cash to expand. In the public market, obtaining capital is not too challenging but middle markets and closely held companies often have a much more difficult time. Coupled with lingering fear in the banking industry, capital or loan acquisition can be immensely challenging. The catch 22 is that banks are more inclined to give loans to larger companies because it is less risky. Small businesses, however, need cash in order to grow into those middle market companies. Small businesses rely more heavily on bank loans for working capital, whereas bigger companies have a myriad of options to obtain loans from. (The acquisition of a SBA 7(a), or multi-purpose business loan, actually requires a valuation done before it is even considered.) Unnecessary acts of desperation are often taken when cash flow is under pressure. Roughly 16% of business owners have taken equity from their home and used it as collateral to finance their business. After the business value is understood, plans can be put in place to secure funds, prepare the business for a capital acquisition or simply save and build cash reserves for the future. Money buys freedom and gives you, the business owner, leverage when seeking a loan. The point is to always have a plan. Starting with the valuation, understanding what the value is today and laying out a business plan, builds value moving forward.
By identifying the value of the business before a bear market, we can identify what the business can withstand, but more importantly, what it cannot. Insurance coverage and capital preservation are two important areas to consider. A lawsuit even in prosperous times can be a big threat to a business. A lawsuit during a recession can be a knock-out punch. You can see where your business is lacking in coverage and fill those gaps before they become an issue. Mishandled Key Man and Buy/Sell agreements can cause shockwaves resonating throughout all facets of the business and operations. Often, such a disturbance permanently shifts the businesses ability to generate the desired benefit stream. Maintaining adequate coverage keeps operations running smoothly and protects against unforeseen circumstances.
Capital preservation is one of the most important aspects for a business to effectively manage. The secret to capital preservation is a lean business model, or one that creates the most value per dollar spent. A simple Google search yields a clear and concise definition: “Simply, lean means creating more value for customers with fewer resources. A lean organization understands customer value and focuses its key processes to continuously increase it. The ultimate goal is to provide perfect value to the customer through a perfect value creation process that has zero waste.” The key is efficiency and leverage, getting the process as smooth as possible while maximizing each dollar spent. Pooling for example, is a great way to lower inventory costs. Speak with competitors who purchase from the same supplier you do. Combine your purchasing power and agreeing to work with a supplier for a set period of time, can dramatically decrease your inventory costs. A full-time employee is valuable but only if they are effectively utilizing their time. Often when business is slow, salaries go toward idle time and not revenue creating activity. By contracting out certain work you make sure to pay only for time worked and often for high quality skillsets that contractors bring to the table. Finally, simple bottom line cognizance and responsibility will help run a lean business. By stressing the importance of cost cutting and waste to the team, along with encouraging the team to bring ideas to the table around how the business can run more cost effectively, waste can be removed leaving more cash in hand. These are just a couple ways to save money but are still vitally important. Frugality is key to making it through a recessionary period and can be the difference between a happy retirement and a boarded up storefront.
Some of the greatest buying opportunities occur when everyone else is running for the hills. As the markets decline, the smart money starts to look for opportunities and undervalued investments they can scoop up for cheap. Opportunities like these don’t come around often and to seize them requires great preparation and foresight. Periods of economic downturn are often some of the greatest periods of merger and acquisition activity and truly distinguish the strong businesses from the weak. Planning ahead and being able to make a position on a failing operation could pay dividends later on. The main purpose of an acquisition is execution of company strategy and to increase the strength of the core business.
I hope that this article has shed light on the importance of knowing your business’s value. It is the most important step in a business owners plan for the future. Deterioration in the US equity markets over the next two years is going to become a headwind for business owners. Without a solid plan in place to account for decreased profits, fewer capital infusions, increased credit risk and growth opportunities, it is unlikely the business will remain profitable and may even cease operations.