If you’re one of the millions of fans who tune-in to a popular weekly network television show featuring new businesses soliciting funds from high-profile investors, you know “What’s your margin?” is one of the first questions asked. And you also know that the answer determines whether the investors continue the interview the business hopeful or pass on the opportunity.
Having good margins is important for all businesses, regardless of size and maturity. It becomes especially important when you’re preparing to sell a venture because part of the potential buyer’s due diligence will be studying the margins of your products, product lines, and your business as a whole. If you don’t know what your margins are, you’re in good company. Chuck Richards, chief executive officer of CoreValue, a leading business evaluation software company, said he’s continually surprised by how many owners of well-established businesses don’t give the correct answer when asked about their margins.
Two types of margins exist — gross and net — with the former being straightforward and easy to understand. Gross margin is the difference between sales revenue and the cost of goods sold. It’s considered to be the best gauge of operating performance and competitiveness relative to industry peers. In other words, if the playing field is level, the company with the highest gross margin will have the highest value.
While you should know your gross margin, you’ll rarely be asked to explain it. The opposite is true for your net margin.
Your net margin represents your sales minus both the cost of goods sold and all other direct and indirect business expenses. These expenses can include everything from meals, vehicles, and health insurance to research and development costs. It represents earnings before interest, taxes, depreciation, and amortization, which is referred to by the acronym EBITDA.
As a business owner — particularly if you are one who’s preparing to exit the business by selling it — you should be able to explain your net margin and justify your expenses. Typically, owners favor having their books show lower net margin to minimize taxes. You might think this lower number would be less desirable to a buyer than a high one, but Mr. Richards claims that’s not necessarily true.
“It depends what you’re spending money on,” he said. “If the expenses represent an investment in the business, such as R&D, then the resulting lower net margin may make your company more valuable.”
When a low net margin results from unnecessary expenditures, it could easily depress the company’s value. Less desirable companies typically sell for 3 times EBITDA, while the multiple can be as high as 7 for high quality businesses. In dollar terms, that’s can be an enormous difference.
Mr. Richards tells a story that illustrates the concept. He describes one business owner who enjoyed going out for nice lunches, treating everyone from clients, new business prospects, and valued employees to his family members. He estimated those lunches cost him an average of $100 each and justified the expense because it was tax-deductible. That’s when Mr. Richards took out a pen and notepad.
“I figured he bought at least 200 of those expensive lunches every year, at a cost of approximately $25,000.” Mr. Richards said. “When he deducted the expense, the business saved about $12,500 annually on taxes. But if he eliminated the lunches, the lost tax deduction paled in comparison to the company’s increased value.”
Making future-looking investments can also increase the value of a business. Owners are busy selling buyers on the past, while buyers are focused on the future. A prospective purchaser wants to be confident that the business will continue to thrive, which is why spending now to meet tomorrow’s challenges can offer a big payoff.
Taking the time to understand your net margin is a prerequisite for exiting your business on your terms and realizing its full value.
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