What, How & Art of Identifying and Improving A Business’s Value: The “Value Drivers”
The most critical step in both valuing and selling a business is to know how much it is worth. The first question is usually, just what is fair market value to a buyer?
Fair Market Value is defined as:
“The price a willing seller and a willing buyer, both possessing complete information, agree on; when there is no undue pressure to act on either side.”
The reality is your business will be valued by how much the new owner thinks he can make from operating it, today and in the future. NOT what you think he should be making! So a ‘text book’ definition maybe nice, a real world perspective is oftentimes different.
So what makes a buyer pay more? The better the performance of your business in the following areas called the “Value Drivers” will engender a higher multiple application and therefore a higher price for the business.
A buyer’s evaluation of these following areas is the “art form”, an individual’s or company’s subjective assessment, in the valuation process. The more you can improve each “Value Driver” to the eyes of that buyer, the higher the multiple and more valuable and desirable the business. There are different types of buyers, an individual entrepreneur, a Strategic or Synergistic buyer, or an investment group. Each values a business differently, because the acquisition provides value to each differently.
Finally, remember that even if you are currently not considering to sell your business, or are just starting one – the better developed and managed each of the following “Value Drivers” – the more successful, more profitable and more valuable your business will become.
The following are the ten most common value drivers, not necessarily in order of importance, but each is critical.
The Value Drivers:
1. Clean, Reliable Financial Information:
The valuation process and a company’s critical daily management practice starts here – the Financial Statements. This is used as the foundation for all buyers to begin determining value. The ability to see clearly from an accurate statement all revenues and owner economic benefits. Financial statements validate the business’s profitability and demonstrate the Seller’s Discretionary Cash Flow (“SDCF”) – to which a multiple is applied. The SDCF is also known as “adjusted EBITDA.
The buyer needs to see and understand the stated numbers. If a owner/seller says he generates total financial benefits of $1M, $2M, or $3+ million, he must prove it! How does it happen? Where does it come from? Where does it go?
Sellers should attempt to understate should there be doubts concerning the amounts of their personal financial benefits. Experienced buyers know how to review financial statements and Tax Returns. If a mistake or over-statement occurs, chances are the buyer, or one of his advisors, will find it, will have questions – and may begin to doubt everything stated from that experience on out. And from that point, if enough doubt emerges and remains, you usually have lost your buyer.
If there is an oversight or miss-statement discovered, much rather it be a pleasant surprise for the buyer.
The lack of integrity in the production of the financial records is the single most common downfall and deal killer of the transaction process.
2. Sustainable and Increasing Year to Year Cash Flows:
When buyers research business listings, the first thing they usually look for is the Seller’s Discretionary Cash Flow, “adjusted EBITDA”. The higher and more reliable the business cash flow – the greater the attraction. This is the attention grabber. A business with a historically proven and growing cash flow will attract many buyers and bring a premium price when it is sold. The price associated with acquiring the cash flow is directly related to risk through time. The lower the risk of losing that cash flow (post transfer of ownership and the years going forward) the higher the multiple and therefore the higher a valuation and price.
Buyers are willing to pay a premium when their perception of a business’s cash flow is – predictable, sustainable and scalable into the future.
3. Market and Growth Potential:
Is there a there – tomorrow? Is the company sustainable and the cash flow scalable after it is acquired?
Buyers will apply a go-forward strategic plan that, if implemented and successfully executed, will lead to a business’s higher future value. Buyers will look at and question the following areas of the opportunity:
- Is the business in a growth industry?
- Are there new markets that management could pursue?
- Are there new products or services that existing customers may need?
- Will new distribution channels spur growth opportunities?
- Is there available pricing elasticity to expand profit margins?
- Will new, refreshed marketing campaigns and sales efforts increase growth?
- What is the possibility of developing new products and reaching new customer bases?
- Can growth come from expanding reach to new territories or countries?
- Are there operational redundancies that an acquisition’s assimilation will eliminate?
The more positively a buyer translates these questions into the acquisition, the higher the price a business will bring. Simply, this is why someone is buying the business. The buyer understands today’s market situation, but wants prosperity in the future and if he/she senses it, or better yet, sees it, – they will pay for it!
4. Quality of Management and Workforce Infrastructure: The Company’s people
Buyers will look closely at who in the company possesses the know-how and talent to both operate and help grow the business. The more dependent the business is on an owner’s day to day involvement, the more challenging it will be to sell.
Key employees are invaluable assets and can be critical to the sale of a company. Never underestimate their significance or the intrinsic value they bring to a business.
The employee’s length of employment, their expertise, age and commitment to the success of the business are factors all buyers will value. Employment agreements for the critical performers and strong incentive programs only go to enhance a buyer’s comfort level with an acquisition post transaction.
5. Customer Diversity:
A broad customer base in which no single client accounts for more than five to ten percent of total sales revenue helps to insulate a company from the loss of any single customer. It reduces the risk of serious cash flow distortions if one or more customers do not continue with new ownership.
6. Operating Systems and Procedures:
The “how to” operate your business through the creation and documentation of a company’s procedures and systems only reinforces the buyer’s comfort level with maintaining the profitability post sale.
Once the buyer and the seller begin serious discussions regarding ownership transition, this always comes up, one way or another – “How do you operate this business”?
Documentation: Prepare internal systems that include computerized records and manual detailed procedures/protocols (particularly for staff) used in the day to day operation of the business. Emphasis on customer identification, how products and services are delivered and clients’ history are greatly valued.
7. High Barriers to Competitive Entry: Your position in the market space.
This oftentimes is the most influential value driver of them all. It is about what advantages your company has over the market; the strength of your strategic position versus your competitor or a possible future market entrant. The larger the breadth and depth of your company’s separation from a possible competitor (the bigger a moat around your castle – the business) the more value it brings to a suitor.
Examples of competitive barriers would be:
- Copyrights (and their maintenance)
- Proprietary Designs, Know-how, Databases
- Brand and/or Trade Names
- Customized or Proprietary Software Programs
- Hard to acquire licenses, zoning, regulatory approvals
- Contracts with customer bases in difficult-to-penetrate businesses and entities (governments – Federal, State, Local)
- Special accredited skills or experience or education
8. Product Diversity:
The more limited your product or service mix the more exposure to risk and the lower the valuation by a prospective buyer. An expansive product and/or service mix, a broad reach of multiple markets, the elasticity of pricing opportunities will only increase the entity’s value to a buyer.
9. Technology, Facility and Equipment Condition:
The maintenance of technology compared to industry competitors is critical to the health of the business. All too often, as a business owner approaches the horizon of ownership, the less and less of capital assets are devoted to technology. The market is changing so rapidly that without “best in class” technology the more vulnerable a company is to a competitor or a disruptor in the market space.
In addition, business equipment and facilities need to be well maintained to be viewed as assets rather than a future liability that will require re-investment. A buyer will not pay a premium, and may very well discount an offer, for a run-down, disorganized warehouse, office or building. Seeing poorly maintained facilities and equipment may cause the buyer to perceive that other aspects of the business may be similarly disorganized (employee records, financial records, system processes and procedures, compliance records, etc.). Owners should be sure that facilities and equipment are maintained in peak condition before beginning the sale process.
10. The Ability of an Owner to Take a Vacation – At Any Time!
That’s right, the ability to leave at any time. The more dependent a business is on the involvement of the owner, the less valuable it is to a potential buyer. Why? Owner operational dominance only limits the universe of potential buyers. So learn to take more vacations and develop a company infrastructure that supports it. Your family and friends will appreciate the new found lifestyle.
Whether you are just starting a business or have reached the horizon of ownership – when these value drivers are developed, nurtured and improved – the more successful and valuable the business will be, the higher a price the business will command, and the easier it will be – – – to successfully sell!