The Secret to Why Building a Business Can Make You Wealthy
Have you ever wondered how the wealthiest people in the world originally built their fortunes? If you analyzed the Forbes 400 list of richest people in the United States, you’d find that more than 325 of them got on the list by applying a simple formula (or being the heir of someone who applied this formula).
What is this formula?
It’s called a “business multiplier,” and it’s one of the greatest wealth leverage points of all time.
Let’s explore the business multiplier concept by walking through the value of a fictitious business we’ll call Star Biz, Inc. as it progresses through the normal stages and levels of a business’s development.
Level One: Business Start-Up
You probably already know that a business start-up is nothing more than an idea and a plan; as such, it has no value in the market. The only exception to this might be if the plan has intellectual property attached to it such as a patent that will be applied or a trade secret process that will be leveraged. So at Level One, the business value of our imaginary business, Star Biz, Inc., is zero.
Early Stage Level Two: Business Scrambling for Its Survival
Value: Very Little
At Early Stage Level Two, this business has few paying customers. It’s desperately trying to secure more clients and fulfill its promises to them long enough to establish a secure base for the business.
At this stage, Star Biz, Inc. still has no real value other than that of its tangible assets, including its equipment, inventory, and fixtures (and even those won’t be valued at more than a fraction of original cost), or some deeply discounted value of its current annual sales.
The valuation of most Early Stage Level Two businesses is the liquidation value of its hard assets.
Middle Stage Level Two: A Successful Business that Revolves Around the Owner
Gross Sales: $500,000
Net Profit: $150,000
Once Star Biz, Inc. has a consistent track record of generating profits, it gains value. But that value will be limited because the business depends on the owner being present and involved.
While every business has different valuation formulas, most owner-reliant Middle Stage Level Two businesses end up valued in the $50,000 to $500,000 range. The actual value will depend on the industry, the length of operating history, the value of its hard assets (e.g., inventory, equipment, etc.), and the sales volume of the business. But the biggest limitation to selling a Middle Stage Level Two business is its limited pool of buyers. Usually only mom-and-pop buyers will step into the owner’s shoes and “own” their own jobs. Plus they have very little access to any large capital sources which limits what they can afford to pay.
With Star Biz, Inc., let’s make these two assumptions: (1) It’s a service business with a profit margin of 30 percent, meaning 30 cents out of every dollar of sales ends up as net profit. (2) Its gross sales are $500,000, which means the business nets $150,000 per year.
So in this hypothetical example, we’re pegging the value of Star Biz, Inc. at $150,000, which is one times its annual net income.
Advanced Stage Level Two: A Successful Business Much Less Reliant on the Owner’s Presence to Function
Gross Sales: $3.4 million
Net Profit: $1 million
Value: $3 million
Once Star Biz, Inc. hits Advanced Stage Level Two, it has key leaders employed in three of its core pillars. The business still benefits from the owner’s leadership, but the company is becoming more systems-reliant every day. Sales are climbing fast. In fact, gross sales are $3.4 million dollars and net profit is $1 million per year.
While that $1 million profit sure feels good, even better is being an Advanced Stage Level Two business. At this stage, Star Biz, Inc. is now valued by a special formula called a business multiplier. The company is now valued at a multiple of its operating profit, which is a simplification but an accurate one. Every industry has its own range of business multipliers used in valuing a business in that industry.
Here’s the best part. As you progress to Level Three, not only is your business more valuable because you’re increasing both gross sales and operating profits, but you’re also increasing the business multiplier that your business can command. For example, your business at Advanced Stage Level Two might only command a three or four times (3-4x) multiplier, but when you hit Level Three, you might command an eight or ten times (8-10x) multiplier.
In our example, at Advanced Stage Level Two we valued Star Biz, Inc. at three times (3x) its net profit, or $3 million. Let’s see what happens when Star Biz, Inc. reaches Level Three.
Level Three: A Systems-Reliant Business with Winning Management Team in Place
Gross Sales: $10 million
Net Profit: $3 million
Value: $21 million
By this point, your Level Three business operates like a well-oiled machine. Your winning management team is in place, and your business controls and systems allow you to scale the business.
In our example, Star Biz, Inc. has grown its gross sales to $10 million, providing $3 million per year of net profit. As a Level Three business, Star Biz, Inc. now commands a seven times (7x) business multiplier, pegging its value at seven times (7x) its net earnings, or $21 million.
Notice that sales at Star Biz, Inc. have grown by only 300 percent from when the business was an Advanced Stage Level Two business, but it’s now worth seven times more. This demonstrates the multiplying power of leveraging a higher business multiplier. This is how business owners can build significant net worth fast.
Here’s an example of how this all works in the real world. We were coaching Jennifer, the owner of a niche software company that serviced “middleware” to hospitals and laboratories.
When we started working together, her company was an owner-reliant Middle Stage Level Two business with annual sales of $1.2 million. Twelve months later, she had not only increased her sales to $2 million, but in the process, she had grown her business to Advanced Stage Level Two.
Let’s look at how this maturation of her business radically increased its value.
As a Middle Stage Level Two business, the pool of potential buyers for Jennifer’s company was much smaller. That means fewer people want and can afford to pay for the business. Assuming she could get two times (2x) operating profit for her business at that stage (a realistic amount for this type of business at Middle Stage Level Two), the boost in sales by itself increased the value of her business from $750,000 to $1.5 million.
But she didn’t only increase sales and profits. Jennifer took her business to Advanced Stage Level Two, reduced its reliance on her, created more durable systems, and began to scale her company. This likely doubled her business multiplier from two times (2x) her operating profit to four times (4x). This meant that 12 months after she won the contest, her company was worth $3 million.
Think about it. Her $800,000 increase in sales along with maturing the business to Advanced Stage Level Two added $2 million of enterprise equity!
How else can you earn $2 million in 12 months starting with an asset like hers?
But Jennifer’s story doesn’t finish there. Since that time she’s grown her sales by several million dollars per year more. And she’s taken it very close to, if not reached, Level Three. Today her company is likely worth $18 to $20 million, which is 1,000 percent more than it was just seven years earlier.
Today, seven years after first working with Jennifer, she shares, “Last year my business generated 9 times the operating profit than it did since the contest,” Jennifer shared in a recent email to David. “I have more time off, am more relaxed, and a much better quality of life.”
If you want to learn more about how to systematize your company and introduce sound internal controls, I’m about to teach a new webinar that will focus in large part how you can do both so you build a scalable business.
If you’d like to join me on this special webinar training, please just click here to learn the details and to register. (It’s free.)