Ira Friedman is the CEO of Bay Audio, a manufacturer of custom speaker solutions. He holds an MBA from the Harvard Business School. There’s a lot of talk about mergers and payout formulas in the CI business, with owners and buyers alike trying to nail down realistic valuations. There are a few tried-and-true formulas in the world of high finance, but none of these adequately capture the value of a typical CI business. Why? Because CI companies have present value–with measurable cash flow–but unpredictable and unmeasurable future value. Future value is what buyers are looking for, and a CI business is all but impossible to value, making the de facto value zero.
Two Common Valuation Methods
Companies with loads of assets, Dish Network for instance, can be valued on the strength of their balance sheet. Infrastructure has value, and it’s easy for a buyer to project the replacement cost of the company’s infrastructure. Throw in some projected subscription income and you’ve got a relatively stable company valuation. Even though Dish struggles to make a profit, it has a market valuation of more than 22 billion dollars. Its high value comes from its assets.
Now look at a company with limited assets, but lots of intellectual property, like Dolby Laboratories. The stock market values Dolby at more than three billion dollars. And rightly so, because its licensing income is easy to predict, and the company’s costs are well contained. No assets, no products for sale, just fantastic intellectual property driving the value of Dolby Labs.
Why CI Companies have Unpredictable Value
Unlike Dish Network, a CI company has no assets to speak of. And unlike Dolby Labs, the CI company has no intellectual property to leverage. Without assets and intellectual property, setting a valuation gets tricky.
A CI company has no assets to speak of and no intellectual property to leverage. Without assets and intellectual property, setting a valuation gets tricky. Looking at a CI company from another perspective, an acquirer will ask, “What will your next year’s sales and expenses look like?” In response, most CI owners will tell you that they’re fairly confident that next year will be as good as, if not better, than this year. But then the acquirer asks the owner, “And what will the business look like if you leave?” To which the owner replies, “I don’t know.” That’s because the owner of a CI business is the business. He is most likely the greatest generator of sales, the most attentive to labor costs, efficiency, and productivity, and the most likely to influence the disciplines that the company undertakes. That’s a lot of responsibility placed on one individual, and it makes the owner’s departure a critical change in the health of the business. So, unfortunately the honest answer to, “What is the company worth without the owner?” is, “Probably nothing.”
Think Like a Dentist
CI companies look and feel much like dental practices. Dentists don’t sell their practices when they choose to retire. They ease out of the business by taking on a junior partner and slowly, methodically, turning over the patient load to the younger dentist.
During the first year of the partnership, Dentist the Elder enjoys vacationing a week each month while still drawing her same salary. Within a few years, she’s taking off half the year, with no salary decrease. And five years later, she’s living full time in Maui, drawing a salary for several more years until Dentist the Younger owns 100 percent of the practice.
This is called a planned transfer of ownership, and it works precisely because the dental practice has no assets and no intellectual property. Instead, like the CI dealer, the dental practice has a database of clients that are introduced to the new partner and choose to remain patients of the practice, even as it undergoes managerial change.
The Real Value of the Dental Practice
Dentists learn, through financial planning seminars, to live on 75 percent of their income. That means for every $100,000 that they take home, they live on $75,000, and put $25,000 into long-term, stable, consistent investments. Like tax-free municipal bonds.
Dental practices and CI businesses have the benefit of ongoing cash flow. Socking away money for retirement every month is ingrained in the field of dentistry. (Not so in the CI world, and the reasons are too many to discuss here.) Dentists plan for retirement by capturing day-to-day cash flow in the early years and ceding the business to a junior partner as they near retirement.
This is the only valuation model that I see working in the CI world. Not mergers. Not selling to a wealthy client. Simply saving for retirement today, living on 75-percent of cash flow, and planning for top management to slowly ease the owner out of the business as he reaches retirement age. Which puts a tremendous onus on improving cash flow, driving efficiencies, and building a competent managerial team.