Are You Building Equity or Income in Your Business?

When considering an exit from your business, you need to ask yourself whether you are focused on building an income stream within your business, or whether you are building equity in the business.  The difference between these two opposing perspectives will reveal itself when your turn comes to exit your business.

An owner who builds their business for income has a job.  An owner who builds their business for equity has an investment.  One day someone other than yourself will be running your business.  Will that successor be purchasing a job from you or an enterprise?  Your eventual buyer or successor will likely be interested in knowing about the equity that you have built, not about the income that you have achieved within your business.  And, as the exiting owner, you want to speak in terms of equity and not in terms of income.  You see, income can vary according to the personal needs of the owner-operator.  However, equity can be expanded and value can be driven into your business once your focus moves to an 'equity driven' model.

Technically, 'equity' is a Balance Sheet term which is equal to your assets less your liabilities; this would reveal your owner's equity.  However, we are not discussing the financial reporting within your business, we are discussing the manner in which you make operational decisions to increase the value of your business.  

For example.  Jim owns a distribution company and spends most of his time focusing on building strategic relationships to increase sales, as well as increasing the capacity of his business to distribute more products.  Sounds simple enough.  However, Jim's mindset is towards conducting these activities so that he can take a larger salary and bonus at the end of the year.  Again, to most reading this newsletter, that sounds like a very reasonable objective.  But there is a problem, a very predictable and obvious problem once Jim is aware of it.

The problem is that Jim is not spending any time considering who would be doing his 'job' at the company in his absence.  True, the company can run for a week or two as Jim takes his vacations.  Perhaps the business could even sustain for a few months if Jim were to want time off or had a physical problem that prevented him from working - these instances alone would not materially affect Jim's income.  However Jim is not protecting the equity in his business with his decision making process.  Jim's equity, and hence his illiquid business wealth, is at risk because Jim has not focused on his business as an investment.

What Jim needs to do in this case is begin to ask the important and crystallizing questions that will define how he exits his business.  Jim needs to know 'who will run the business after him'.  But in order to get to that point, Jim needs to have some idea as to what his exit options are and which one is optimal for his situation. 

For example, Jim may want his management team to take over the business.  Well, Jim's succession plan will need to include specific action items and benchmarks for transferring responsibility within his firm.  The decisions that Jim makes in his business today, will need to be aligned with his choice of exit in order to maximize the equity within his business for his personal needs.  Jim should communicate with his management team his desire to transfer operational control and begin to put measures in place to start this shift.  Jim should take his future rain-maker to the meetings with his strategic partners, take his financial person to the meeting with the bank, and allow his operational person to set policies and speak with authority to others in the organization. 

When Jim begins to make these changes to his behavior and the manner in which the business is run, he starts to build on the equity in his business because he is treating the business more of an investment and less as a job.  Jim's role converts to that of an overseer of the activities within his organization, not the creator of those activities.  As a result, over time Jim's presence will no longer be critical to the proper running of the business.

 At this point in time, the focus on the business - as an entity separate and distinct from Jim's personal desire for more income - and the running of the business with a process in place- Jim is increasing the value of his business.  Jim's value is increased because all business valuation is a prophecy of future cash flows.  Now Jim can more confidently state that his future cash flows are more secure because his management team has decision-making authority and Jim has protected the ongoing streams of income and cash flow against his own short-comings and/or mortality.  As a consequence, the value of the business increases because a buyer or successor has a higher certainty as to the ability to achieve future cash flows in Jim's absence.

Owners who fail to make these important decisions leave the value of their business in a very uncertain state.  Unfortunately, far too many business owners today are in this position.  Also, compounding this problem is the fact that these changes can take time (often times many years) to occur within an organization.  Therefore, the time is NOW to begin this process.

© John M. Leonetti