We have been exploring a concept we often get asked about in this series of articles. Owners of businesses question whether selling a business is like selling real property investments, as many owners have experience with these transactions. In the previous installment of this series, Determining Fair Market Value: Three Approaches, we explored the different approaches and methods used to determine the value of a business and a piece of real estate. In this installment, we explore the major value-drivers of a privately held business as compared to real property investments.
Where is the Location?
Most of us have heard the phrase “Location/Location/Location” when referring to what drives the value of a piece of real property. The factors that should be considered with regards to location are visibility, proximity to growth, the potential for appreciation, and land use changes. While nothing can be done to change the location of a particular piece of real property, a change in the zoning could possibly have a dramatic impact. Location generally does not have a major impact on the value of a business unless the business is restricted to operating in and/or servicing a particular area, such as a retail location.
Cash Flow is Key
When it comes to the value of a privately held business, the most common phrase is “Cash Flow/Cash Flow/Cash Flow.” Cash flow drives the value of both a business and investment real property.
The cash flow of real property is driven by rental revenue and the quality of the cash flow is tied to the tenants and terms of the lease. Rental income could be increased by renovating the property to the extent that it would warrant a higher rental rate.
Business owners generally have more options to increase and/or improve the quality of the cash flow of a business. Cash flow could be increased by adding new products or services, expanding the geographic area served by the business, adding new customers or perhaps by reducing costs through automation or similar measures. The quality and predictability of the cash flow is a major issue when considering its impact on the value of a business.
The quality of the cash flow for businesses will be negatively impacted by items like:
- concentration of business in a small number of customers
- historically slow payment terms
- pricing pressures
- reliance on a concentrated number of suppliers
- excessive reliance on the owner
Business owners that make improvements in the quality and predictability of earnings prior to selling their business will generally be rewarded.
Curb appeal, age and condition all have an impactful effect on the value of real property, perhaps more so when compared to a business. Many owners of real property will “spruce up” the property prior to putting it on the market, such as a new coat of paint, taking care of deferred maintenance and updating the landscape. With regards to a business, value will be negatively impacted if its assets are not well maintained or need replacing, have an untidy appearance and/or suboptimal functionality. Business owners that have these conditions should also consider undertaking steps that could improve the “appeal” of the business.
It's the Economy
The state of the economy will impact values of both real estate and privately held businesses. However, the local economy will generally have a greater impact on real property (location) as compared to businesses, which in many cases have the option to operate in or serve multiple markets.
Additional Business Value Drivers
Attributes that play a significant role in driving the value of a business, but are generally not applicable to real property, are:
- growth potential
- strength and depth of management
- strategic or competitive advantages
A business owner can often take steps to excel in each of these value-driver areas and doing so will have a positive effect on the performance (cash flow) of a business and how buyers view the company. A common misconception that many businesses owners have is that buyers are willing to pay a premium if the company has “potential” in these areas. This is rarely the case as buyers generally pay based on past performance of the business and are reluctant to pay a business seller for the results that they, as a new owner, create with their efforts.
Factors that tend to have a greater impact on the value of a real property investment, when compared to a business, include supply and demand. This includes the number of investors/speculators or users attracted to a geographic area as compared to the number of properties that are available for purchase, coupled with the current cost to replicate the property. A recent example of this is supply chain issues that resulted in rising prices and scarcity of construction materials. Existing properties became more desirable than building a new property, thus driving their value higher.
While this recaps major value-drivers, there may be others that should be considered for each particular property, whether it is a business or a real property investment. And thus, seeking the advice of a professional that is experienced in marketing and selling businesses or real property will almost certainly lead to a better outcome for the owner when they have decided to monetize the asset.In upcoming articles, we will continue to compare selling investment real property and privately held businesses and the steps in the process. Next up, we will turn our attention to the ease and complexity of selling a business or investment real property. Please reach out if you have a question or topic you’d like to see covered in future articles.