Defining a lifestyle business and a value-creating business
All businesses share the common goal of selling a product or service, but their operational structures can differ significantly. Lifestyle businesses heavily rely on the owner-operator, making them less transferable and scalable. In contrast, value-creating businesses are built on a collective effort, making them more transferable and sustainable.
There are three main characteristics of a lifestyle business:
- Reliance on the Owner: Lifestyle businesses depend on the owner for relationships, sales, and operations, making the transferability of the business highly uncertain.
- Lack of Documentation: Processes and procedures are often undocumented and rely on customary practices rather than formal records.
- Interwoven Expenses: Personal and company expenses are intertwined, making it challenging to ascertain the company’s true financials.
The lifestyle business structure serves as a suitable model for numerous ventures. Within this framework, the owner can steadily nurture the business, potentially expanding by hiring a small team. Nonetheless, such businesses encounter a natural limitation—they can only grow to the extent of the owner’s available time and energy. Thus, the size and scope of lifestyle businesses are inherently constrained by the personal capacity of their owner.
In contrast to a lifestyle business, a value-creating business operates on a different paradigm. Rather than depending on a single individual, its success is driven by the collective efforts of the team. The business maintains clear and transparent records, ensuring accountability and efficiency. While owners may occasionally integrate personal expenses, these expenditures are insignificant and easily quantifiable. The true strength of a value-creating business lies in its potential for scalability and transferability. It possesses the inherent capability to grow and expand its operations, unhindered by the limitations imposed by a single person’s capacity. Excess cash flow is re-invested in the business for growth and efficiency, rather than being distributed back to the owner as seen in many lifestyle businesses. Additionally, the structure of such businesses allows for smooth transitions of ownership, making them attractive candidates for long-term growth and potential sales.
Valuing a lifestyle business and a value-creating business
It’s a common reality that small businesses often remain unaware of their true value until the point of sale arises. When they decide to enlist the services of a Business Broker to facilitate the sale, the initial step taken is to assess and determine the company’s worth. Through this valuation process, the Business Broker identifies whether the business falls under the category of a value-creating business or a lifestyle business.
This pivotal distinction in the valuation process sheds light on the business’s inherent nature, revealing whether it is built to create lasting value and scalability or if it primarily revolves around the lifestyle and personal involvement of its owner. Understanding this fundamental difference is crucial as it significantly impacts the business’s marketability and potential for long-term growth and profitability.
Unfortunately, many Business Brokers tend to avoid working with lifestyle businesses because of their limited marketability and relatively lower value compared to value-creating enterprises. This preference is grounded in the fact that value creators are more likely to attract buyers, given their potential for growth, scalability, and transferability. The lifestyle business is dependent on finding a buyer who is willing to step into the shoes of an exiting owner and requires a similar amount of capacity to work long hours, passion for the business, and ability to lead a team.
Indeed, the disparity between the value and marketability of value-creating businesses and lifestyle businesses is quite pronounced. A value creator consistently commands a higher selling price and is typically associated with a more favorable valuation multiple compared to a lifestyle business. The reason behind this discrepancy lies in the intrinsic characteristics of each type.
Valuing a lifestyle business is undoubtedly a complex and speculative undertaking. Business Brokers and valuation experts face significant challenges when attempting to determine the true expenses of such a company. In the valuation process, a crucial initial step involves recreating the income statement in a manner that explicitly segregates personal and one-time expenses from the business’s operational costs. The goal is to provide prospective buyers with a clear understanding of what expenses they can expect to incur after the acquisition, rather than solely relying on historical records.
For this recreated statement to be credible and effective, two key factors must be satisfied. Firstly, the mathematical calculations must align accurately, ensuring all aspects of the financials are consistent and reliable. Secondly, all excluded expenses in the recreated statement should be verifiable, meaning they can be substantiated through documentation and evidence.
The two primary approaches to value are the Income Approach and Market Approach. The Income Approach considers the cash flows generated by the business and adjusts for various risk factors in a discount rate and/or capitalization rate. The Market Approach uses recent, comparable transactions in the market as a method to determine business value. This involves sorting through a number of databases to find transactions that are similar in industry, size, and geography, among other characteristics. Then, a multiple of Revenue, EBITDA, or Seller Discretionary Earnings “SDE” is applied. Often SDE is used to value Lifestyle Businesses because it reflects the entire economic benefit to an owner (business and personal). EBITDA is often used for value-creating businesses that have a proper management team with minimal commingling of business and personal funds on behalf of the owner.
If a business’s valuation exceeds the fair value of its assets, it signifies intrinsic value, suggesting the company is expected to generate future cash flow to some extent. However, financial forecasting always entails risk, as various factors could impact projections. Competing vendors, new market entries, increased competition, buyer fluctuations, rising costs, and numerous other variables make forecasts speculative.
One significant reason why lifestyle businesses are valued lower than value-creating enterprises is their heavy reliance on the existing owner. When the owner-operator transitions out of the business, the purchasing owner faces the challenge of maintaining historic relationships to sustain sales. This transition of relationships is highly speculative, prompting buyers to seek a discount when acquiring a business heavily dependent on the departing owner’s relationships.
Why is it important to be a value creator?
Nearly all companies begin as lifestyle businesses. Transitioning from a lifestyle business to a value-creator holds three primary benefits:
- Scalability and Growth Potential: Lifestyle businesses are generally constrained by the capacity of a single owner. In order to grow beyond the capacity of a single individual, processes, and procedures need to be established and well-documented to facilitate the distribution of responsibilities. This means investing in staff to allow for the owner to step back and work on the business, rather than in the business.
- Increased Market Value: Value-creating businesses inherently command higher valuations in the market. Their focus on creating lasting value, transferability, and scalability makes them more attractive to potential buyers or investors. Consequently, such businesses have greater potential to yield substantial financial rewards during a sale or investment.
- Reduced Reliance on the Owner: In a Value-creating business, the company’s operations are not solely dependent on the owner’s direct involvement. This reduces the risk associated with the owner’s potential departure or change in roles. The business becomes less reliant on any one individual, making it more resilient and capable of sustaining growth even with changes in management.
Understanding the distinction between a lifestyle business and a value-creating business is vital for business owners and business brokers alike. Building a value-creating business not only enhances the company’s overall value but also ensures sustainability and ease of succession planning. By investing in well-documented processes, delegating responsibilities, clean bookkeeping, and reducing reliance on the owner-operator, businesses can unlock their true potential and become attractive propositions for prospective buyers. So, whether you’re a business owner looking to sell or a business broker assisting clients, transitioning to a value-creating enterprise should be a top priority.
This article was co-authored by Mark Ahern, founder and President of AMP Business Valuations, and George Wellmer, founder and CEO of Tupelo.
AMP Business Valuations is a leading valuation and advisory firm serving the small and medium-sized M&A market. AMP produces hundreds of valuation reports each year for SBA lenders, sellers, and buyers. For more information, visit the website or email email@example.com.
Tupelo is a CRM system designed for business brokers to streamline and organize operations. Through enhanced automation, embedded listings, and customer support, Tupelo gives more time back to brokers to focus on dealmaking.