The Basics of Monetizing Your Business
Monetization --- our favorite word that no one understands. We have a saying that helps describe our client’s feelings, “I don’t know what that is, but I want some.” The real concept of monetization is probably something you can relate to, especially if you own a business.
As a business owner, you have an amount of money tied up in a business and you would like to turn some or all that money into cash that you can spend. Not too bad, right? Unfortunately, this is where it gets complicated. In order to monetize a business, first we must establish that a business has value.
Let’s take a step back, so we can detail some concepts of business financials. Please forgive us if the following information is over simplified. Don't worry though, monetization can get plenty complex for even the most analytical.
Every business on the planet has a few things in common. First, it sells a product or service for money. The amount of money it makes is called revenue. In order to offer that product or service, there are expenses. When you take all the expenses from the revenue, you are left with net income.
For example, a business has $15,000,000 of revenue and $12,000,000 of expenses. That would leave $3,000,000 of net income. The net income is the only amount of money that belongs to the owner. The good news for the owner, however, is that the value of the business is not just limited to $3,000,000.
Now that we have established the income generated for the owner, we move into the concept of value. Let’s make some assumptions about our business. Let’s assume that our business has revenue in multiple years instead of just one year. In this case, we would be able to establish an idea of how much the net income is growing. For the owner, having a $3,000,000 check in one year is nice, but an annual $3,000,000 income that grows has real value.
Think of it this way, how much would someone have to pay you to give up a growing income of $3,000,000? Would you accept $3,000,000? Obviously, no one would accept that trade. By the second year, you would have lost money. What about $20,000,000? Ok, now we are closer. Maybe some would take that deal, maybe some wouldn’t, but what we have done is given you some idea of the value of this specific business. The value is defined by the price a buyer is willing to pay and a seller is willing to accept.
Let’s return to the concept of monetization. Monetization can be the outright sale of a business to a third party for cash. In our example, the business owner would accept a payment of $20,000,000 and transfer the ownership of the business to the buyer. The outright sale of stock or assets of a business has its own complexities, but for our purposes it’s the most straight forward.
For the business owner, often the company founder, this solves only one issue regarding monetizing their asset. Many owners are emotionally tied to the business and its continued success. Often, they are incredibly dedicated to their employees and their clients.
An outright sale removes the owner from all aspects of the business and the people there within. This may not be an acceptable option for the owner. Also, outright sales can be unpalatable because it removes the owner from their comfort zone.
If we were to break-down the asset allocation of most small business owners, it would look something like this: 10% in cash or short-term investments, 5% in market-based investments from their 401k/IRA, and 85% in a speculative single small business. Although having so much money in a single asset is highly risky, this is where business owners are most comfortable. If you were to survey them, you would likely hear comments along the lines that it “feels” less risky because they are in control.
Now, take that business owner from where they are most comfortable and place 100% of their assets in a fully diversified portfolio of investments. The risk has been reduced, but the owner’s anxiety is raised due to the lack of control. We need to explore other options that may meet the needs of the business owner better than an outright sale.
Another common situation involves bringing in fresh eyes and fresh feet to help drive the business to higher levels. Often successful businesses take a lifetime or more to mature. Owners of successful business are, quite often, presented with ideas and opportunities that can take their business to a whole other level. In their earlier days, maybe they would have jumped at an opportunity, but for many reasons they now pass.
This risk aversion is often due to having something to lose or families to support. It can also be due to mental bandwidth, or they are more interested in the fly-fishing spot they found in Montana than extra revenue growth. Whatever the reason, passing on these potentially lucrative deals may not be in the best interest of the business and, in turn, the best interest of the largest shareholder.
Bringing in a new partner might be just the shot in the arm the business needs. A fresh person that has the energy to take on new opportunities and the drive to work the hours it would take to make it a success. In this scenario, the owner would not sell the business outright. They would keep some level of ownership at a lower percentage then before the partnership.
Let’s assume the business owner has $1 million in short term investments and $500,000 in a 401k with the business value of $3.5 million. To say that in percentages the owner is 20% cash, 10% market based, and 70% speculative. By selling half of their company, the owner rebalances their risk to 25% cash, 40% market based, and 35% speculative. The best part is that the owner has monetized a portion of the business asset if the partnership doesn’t work out and stands to benefit greatly if it does. If the plan works and the business value doubles in size, the owner’s net worth would go from $5 million to $7,426,451.00 (assuming 6% return on market assets over five years.)
That is a huge 48.5% cumulative return over a five-year period, all while reducing the workload of the owner and the risk profile of their net worth. This can be a very lucrative option, if a partnership can be found with a partner that has both the ability to drive the business and the cash to buy into fifty percent of the value.
The final situation that we will cover in this paper is the transfer of assets to an employee or family member. This scenario happens when the owner wants to transfer the business to someone that cannot afford to buy the business.
For example, let’s create a fictitious scenario of an employer and their most trusted employee. They have worked hand in glove for twenty years. In this scenario, the employee comes from a wealthy family and has money set aside to purchase a business. There is no complexity here. The owner knows them, trusts them, and the employee has the money.
The issue comes when the person the owner trusts most with her clients and employees does not have the funds to purchase the business. This is one of the most complicated ways to monetize the value of a business because it involves debt financing.
For many small business owners, this may be the first interaction with commercial lending. It is unlike residential mortgage or credit card financing in a few key ways. First, the institution that lends the money will use the future revenues of the business to pay back the loan. Meaning there must be enough excess revenue to cover the payment. Most banking standards require a business to have enough excess to cover three times the monthly payment.
Second, the lending institution is going to look for collateral, personal guarantees, and detailed business financials. Although we cannot cover all topics here, we should consider that the lender will require the excess revenue to be adequate after the business owner leaves the business.
This brings up a common issue for most small businesses; the owner drives most of or all the business revenue. To illustrate, think of a surgeon. There is no revenue without the surgeon’s hands in the operating room. In sales and service organizations, the owner is often the driving force behind the revenue. As part of that monetization process, the business owner must work to promote management and other key employees, so the business can persist without the owner physically being there. If the owner has successfully transitioned his duties to others, the bank and lending institution can feel comfortable that the income will continue and the risk of not getting a return on their money is reduced.
Many of these issues come up after it is too late to address them. At RCG Valuation & Monetization, we offer many services to help business owners who find themselves in these scenarios and we encourage them to work on these issues as soon as possible.
It’s never too early to start planning for a transition. Please reach out to us if you have questions or if you find yourself having some of these planning issues.
For more information on how we can help, please contact us at:
RCG Valuation & Monetization, Inc.
O: (480) 404-7521
T: (833) 851-8045