Owner-Dependent Business Model

When selling a small business, it is imperative to analyze the level of owner-dependency. The owner-dependency refers to the degree to which the owner is actively involved in running day to day business operations, fostering client relationships, and maintaining the competitive advantages that sets the business apart in the marketplace. A business model that is dependent to a large extent on the owner for its goodwill is significantly less valuable than a business model that is self-sustaining and not dependent on the owner. Business models less dependent on the owner have trained management in place as well as a customer base that frequents the business due to the infrastructure, products, services, and reputation of the business rather than its owner. Buyers of businesses with a low level of owner-dependency will pay a premium price since they are assured that the future cash flow of the business will remain intact after the closing.

Business Valuations Change Based on Role of Owner

Imagine two businesses in identical industries each with $500K of adjusted owner benefit or economic profit derived by its respective owners. The first business has an absentee owner along with an established management team in place. The second business has an active owner who works 60 hours per week in the business with no management team. Even though the profits of the two businesses appear to be the same, in reality the first business has higher real profits since its owner is absentee and does not incur costs (in sweat equity) of having to operate the business. Moreover, a buyer of the owner-dependent business would need to hire and pay staff or managers to replace the role of the owner after the sale (unless the buyer incurs sweat equity in replacing the owner’s role). Absentee-owned businesses are generally assigned a premium valuation multiple (3-5 x adjusted owner benefit) compared to average valuation multiples (1.5-3x) for owner-dependent businesses.

Assess Owner’s Role in Proper Context

Many business owners fall somewhere along the spectrum between an entirely absentee role and an active role.
A fully active role is where the majority of the goodwill, customer base, and reputation of the business is from the owner’s skills, personality, or know-how.
Business valuations are significantly affected when the owner’s role is far along either end of the spectrum.
Additionally, some businesses such as small restaurants, landscaping routes, or convenience stores seldom have absentee owners.
The industry and size of the business must be put into the right context to determine if the business model and nature of the business allows for an absentee owner.
It is often simply impractical, for example, to expect a small landscaping route owned by an active operator to be operated as an absentee-owned business.
The profits may not be significant enough for an absentee owner after paying a manager, the nature of the business may require the personal touch of an active owner’s involvement, or trusting the right manager may be impossible for an absentee owner.
In such cases, the valuation should not be affected by the owner’s role since it is reasonable to expect the buyer to replace the seller’s active role.
A buyer looking to purchase an absentee-owned business must locate a business where it makes financial sense for the owner to be absentee, and where there already is a transferable management team in place.

Special Skills or Licenses of Owner

Some business owners have special skills or licenses needed to operate the business or service customers. Examples include a licensed physical therapist who owns a physical therapy center, a licensed general contractor who owns a construction company, or a highly skilled chef who owns a luxury catering company. When selling these businesses, it is imperative to recognize that the average buyer will not be able to replace the owner after the sale. Since the business model is predicated upon the owner’s non-transferable talent or license, the business valuation must be adjusted accordingly. The simplest way to do this is by estimating the reasonable costs of replacing the owner, and deducting such costs from the current level of profits or adjusted owner benefit. Then apply a valuation multiple based on industry multiples and the transferable goodwill and competitive advantages that remain without the owner’s involvement.

Create Transitional Plan Prior to Selling

Other than removing themselves from an active role in the business, the best way in which active owner-operators may strengthen the valuation of their business is by creating a transitional plan prior to selling. A transitional plan describes the responsibilities and relationships the current owner has within the company, and how best to train and assist the buyer in handing off the owner’s responsibilities and relationships. A detailed transitional plan works best to thoroughly convince a buyer that the goodwill of the business will remain intact after the closing. The transitional plan often suggests how current staff members may be elevated to subsume part of the owner’s role. If no such staff members may do so, then the transitional plan should suggest how to locate a replacement with their suggested salary. Relying solely on the buyer to replace an active owner-operator (especially with special skills) may result in an impaired business valuation.

In many business transactions, the role of the owner will affect the business valuation when it comes time to sell. The more removed an owner is from day to day responsibilities and customer relationships then the higher the business valuation. Businesses with a low degree of involvement by the owner usually signifies a strong and durable business model that can continue prospering even after the sale when the owner is no longer a part of the business.

Give Martin at Five Star Business Brokers of Palm Beach County a call today at 561-827-1181 for a FREE evaluation of your business.