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There are three “gaps” every business owner should know and track. They are:
Tracking these gaps can not only help you run a more efficient, valuable, and transferrable business, but it can also help you coordinate your business strategy with your personal financial goals.
According to the Exit Planning Institute’s 2023 National State of Owner Readiness Report, nearly half of today’s owners believe their business is “best in class” when it comes to its readiness to transition to a potential buyer. To be certain, business owners should look to understand these gaps if the expectation is to maximize business value and harvest the wealth that’s locked inside the business upon exit.
Profit gap
Your profit gap is the difference between your business’s profitability, typically measured in terms of its EBITDA (earnings before interest, taxes, depreciation, and amortization) and the EBITDA of a best-in-class company within your industry.
Every industry has benchmark profitability metrics. And every business within a given industry is compared against comparable companies that operate in the same industry. These benchmarks are key business metrics and practices that allow interested parties (e.g. potential buyers) to compare a particular business against its peers.
Where your business lands amongst these benchmarks helps determine where you need to improve to be a best-in-class business within your industry. Business owners need to understand their company’s EBITDA and how it compares with their industry benchmarks.
Value gap
Your value gap is the difference between the current value of your company and the value of a best-in-class company within your industry.
Like profitability, every industry has benchmarks in terms of the multiple of EBITDA a given business could sell for. When a business operates at peak efficiency and profitability, it will command a best-in-class multiple, which will yield a higher business value. The inverse is also true. When a business is not operating optimally and has not developed relevant intangible capital, it will receive a lower multiple of EBITDA and thus a lower valuation. (Related: Knowing the value of your business)
For example, a best-in-class manufacturing business may transact at five times its EBITDA, whereas a business that has some operational deficiencies may transact at only three times. Assuming the five times EBITDA is the best in class multiple, the difference between the value of the business selling at three times EBITDA versus selling at five times EBITDA is the value gap.
Basically, the value gap quantifies how much money is being left on the table if you exited your business today without strategically improving the operations inside your business.
Wealth gap
Your wealth gap is the difference between your current net worth and the amount of money you will need to support your lifestyle after you exit your business.
Many business owners have not calculated how much money they will need to maintain their current standard of living in retirement. In fact, according to MassMutual’s 2022 Business Owner Perspectives Study, only half of business owners have identified their future income needs as a component of their exit plan.
This value is called your income replacement value. The difference between your income replacement value and the actual value your business, plus the value of the assets you own outside your business (e.g., real estate, investments, and qualified plans) equals your wealth gap.
When your income replacement value is greater than the value of the assets you own, you need to make some decisions. You can either accept a lower standard of living in retirement or make plans to grow the value of the business and/or the value of your assets outside the business.
Now you can begin to see how these three gaps fit together. By knowing your profit and value gaps, you can get a sense for how much the business can realistically contribute to your wealth gap. In some cases, the business alone cannot close the gap and thus requires leveraging other assets outside the business to make up the difference.
Conclusion
Business owners should understand their position in the market compared with their competitors. Where do you fall on the benchmark ranges within your given industry? Best in class, worst in class, or somewhere in-between?
A business that is performing at peak levels of operational efficiency and profitability will be viewed as more sellable and command a higher valuation in the marketplace. If your goal is to create a company that can continue when you’ve decided to step away and provide wealth to you and your family as a reward for years of hard work and sacrifice, then tracking these gaps is an important first step.
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