June 9, 2018 | Financial Targets
When you dream about how much money you could get by selling your business, many different ideas may pop in your head. It’s pretty common for owners to build up an assumption that their company is worth a certain amount, only later to be disappointed when they learn that amount is much more than market will realistically pay. Why?
It’s perfectly natural to see your business in the best possible light, but in many cases the buyers just aren’t going to see things your way. Every private company is underperforming in some way – no company is perfect — and that will reduce the size of the check that buyer will write. After all, a buyer is taking on plenty of risk.
So it’s important to keep an open mind and examine things you can do to increase your company’s value before you go about selling it. You should always be looking at your company in the eyes of a buyer.
We will provide you with ideas and tools to actually get your business to higher valuations so you can get the most money when it’s time to sell.
Often owners think there’s some direct correlation between their annual sales and the price their business can fetch. That is, if we sell $10 million in widgets annually, we must be worth $10 million. Unfortunately that is not the way buyers (or well informed sellers) look at value. Revenue is just one of many factors that determine a company’s value, and it’s less important than others like profits and cash flow.
Let’s use an example from the real estate industry to illustrate this. Revenue is just one part of the value of a business the same way that square footage is just one part of the value of a house.
To illustrate this, let’s use a real estate analogy. Imagine two houses with identical square footage, located in the same neighborhood, and with the same size yard. On paper, these similarities might suggest they are worth the same. However, one house could be significantly more valuable because it has features that attract buyers, such as modern amenities, updated interiors, and well-maintained landscaping. In contrast, the other house might need extensive repairs and upgrades before anyone would consider it move-in ready.
Just as a house’s market value depends on factors beyond square footage, a business’s value depends on more than just revenue. Features like profitability, efficient operations, and reduced risks are like the modern upgrades that make a house more appealing. If your business lacks these elements, its value to buyers can suffer, regardless of your revenue numbers.
Of course it’s important to remember that real estate is very different than business. A buyer can write a $200,000 check for the house on the left and within a reasonable timeframe, tackle renovations to make it move-in ready. Some enterprising types in the fix-and-flip industry can perform renovations, bring it to the market, and re-sell it for a profit.
However for a business, buyers are a different animal. There are not very many “flippers” who would take on a problem business and do all the heavy lifting to make it “move-in ready.” That would probably present too many risks for the buyer. If you want your company to be more like that house on the right – attractive to the market and sellable at its highest possible value – then you have to focus on two main ideas:
In this guide we are going to get into the nitty-gritty so you really understand how to increase the value, and potential transferability of the value, of your business. The goals include:
If you spent the money to have a formal valuation of your business prepared by, say, an accounting firm, you’d probably come away with evidence that your business is worth “X” dollars. A formal valuation would probably take a few different looks at the business, for example by conducting a “net present value” calculation of the future projected cash flow of the business; or an analysis of the value of comparative businesses and a multiple of EBITDA. The accounting firm would look at these different ways of valuing a company and then drive to a single dollar figure.
A formal valuation like that is a nice benchmark, but it would not address a fundamental point: How much a buyer is willing to pay for your company depends on the goals and strategy of the buyer, not just what YOU think the value is.
Let’s go back to a real estate example to illustrate the different tiers of buyers. When selling your house, you’d get the highest offer from a buyer who needs to move in right away – say a family relocating from another city due to a job transfer. This top tier of buyers wants a “move-in ready” house and will pay a higher price.
Your next best tier of potential buyers may be professional landlords who want to buy your property and hold it for a long time to make income off it as a rental. They have a longer-term horizon to earn a steady return on the investment property. But they’re not willing to pay as high a price as will the relocating family — even though it’s for the identical piece of property.
Your lowest tier is composed of professional flippers who trawl your market for bargains. Flippers want a bargain—sometimes at the expense of someone’s situation or lack of knowledge—because they have the resources, capital, and expertise to implement the necessary repairs and updates to sell it at a higher price and profit.
The type of buyer also dictates the price for a company. Think through which tier your business would most appeal to today:
Strategic Buyers represent the top tier who will pay the most among all types of buyers, (like the relocating family in our real estate example). They:
Financial Buyers are next in terms of how high a multiple they will pay, like the landlords in our real estate example. They are:
Lifestyle Buyers, Management Buyout, and Family Buyers are the lowest tier of buyers in terms of the price they will pay, analogous to our house flippers.
So when we say beauty is in the eye of the beholder, we’re addressing a fundamental truth that certain buyers will pay more.
How do you attract those higher tier buyers, like a strategic company? That’s for you to figure out, and if you rigorously examine (and implement) all the ways you can boost value as laid out in the rest of this guide, you’ll definitely increase the odds that a strategic will know about and want to own your company.
Beauty is in the eye of the beholder, so make your company attractive to the strategic buyers in your industry that would benefit the most from your company’s value.
We talked above about how revenue is only one component of the value of a business. Remember other factors may be more important than topline sales – like operating profits and cash flow, for starters. But even within revenue, you can peel back the onion. Different kinds of revenue have different levels of value to a potential buyer.
Why is this? Because not all revenue is the same.
Consider this:
Which company faces more risk that it’s revenue could decline next year, or the year after? Easy answer.
When a buyer is considering acquiring your company, the kind of revenue you have – where it comes from – is a big component of the value equation. The buyer thinks about how likely it is that the company is going to continue generating the same amount of sales, or grow, after the transaction. She’ll naturally worry that some customers won’t keep buying at the same level as they did before the sale of the company. For every company, whether it gets sold or not, there’s some level of risk to the future revenue. So different kinds of revenue have different levels of risk!
Would you pay as much for a company in the “More Risky” column as you would for the same-size company in the “Less Risky” column? Nope.
Think about the kind of revenue in your business. How risky does it look today for a buyer? Questions to ask yourself:
Stay on top of questions like this, and more. You can’t be perfect, but you can get closer to it.
Think through the quality of your revenue and make changes now to reduce risks and make your revenue more attractive to potential buyers.
When we looked at the two-houses example in the section above, remember how the differences between the houses included a bunch of stuff. The one with the higher value had a nice paint job, new kitchen and bath, and so on.
With businesses, there are also a ton of other factors that can impact the value. Some are easily measured like sales (tangible), and others are not easily measured but still quite important to the value (intangible).
For businesses, such other factors include:
Imagine the two businesses have identical revenue and identical assets, margins, profits and free cash flow. Now, can their values really be all that different just because of the intangible factors?
Yes. You still have to take into account those other factors outside of the income statement and balance sheet.
If you were the buyer, which company would you want to take out a 10-year loan to purchase? Remember their sales, assets and profits are identical. How would you feel handing over that big check to the grinning owner of Company B, knowing that he and his cellphone would soon be relaxing on a beach somewhere leaving you with whatever’s left?
Of course you’d want Company A. In fact, you’d pay more for Company A than B. Company A is worth more, because it has a lower risk of you losing money (the current cash flow) after the sale.
Intangibles can have a direct impact on your valuation, so get them right to get the most money you can when you go to sell.
The sustainability, transferability and predictability of cash flow are the main influencers of a business’s value.
Got it? A truly committed business owner will have this tattooed somewhere on their body to keep it top of mind.
Here’s what we’re talking about: You can have two nearly identical businesses doing the same revenue, profits and cash flow. Company A and Company B both have $5 million sales, and 10% pre tax profit, of $500,000. They can even be in the same industry and region. Yet, as we already discussed, it’s completely possible for one to be valued at a substantially higher multiple than the other.
In our example Company A is valued at 3 times its earnings, while B is valued at 6 times. The reason for this difference in valuation? You guessed it: sustainability, transferability, and predictability.
Let’s break these down into more detail:
This is a very basic premise. Your business’s outlook has to be convincing that future sales will continue and enough profit margin is there to cover its expenses and service the debt from the buyer’s acquisition cost. If your company isn’t sustainable, it isn’t valuable—period. No one wants a company that will run out of cash! You can’t sell it and you can’t upkeep it. And at what point do you, the owner, stop funneling funds into something that won’t give you a positive return on investment in the long run?
Longevity is a bigger reflection of sustainability and ability to survive, change and adapt – giving buyers more confidence. Only 48.5% of businesses survive their 5th year in business and about 30% make it to 10 years. Check out the full infographic from the SBA HERE.
Say there is an unexpected 10 percent loss of revenue next year. The company doing $10 million sales can better absorb a 10 percent loss of sales than a company doing just $1 million revenue.
The financial health of a company’s largest customers can be a risk. If you have half your business coming from a Fortune 500 company, what happens if they cancel? A large mix of customers is more sustainable than a company where all the eggs are in one or two baskets.
Are products or solutions close to obsolete, or are they up to date? Blockbuster vs. Netflix. Need I say much more?
Are there any regulatory or legal challenges that could kill the business? Would a different political environment cause problems for the business? Is there adequate insurance for ordinary risks? For extraordinary but possible risks?
To think about transferability of value, imagine a crane reaching into a company, lifting out the current owner, plopping them out in the parking lot, and then dropping in an independent operator who doesn’t know the business very well into the owner’s chair. Now that all of the expertise is sitting in the parking lot, what will happen to the business?
Are the customers going to walk away because their buddy is out in the parking lot, and he or she was the main reason why they did business? Is there a management team the new owner can rely on for experienced advice, or just a bunch of yes-men who fail to even offer recommendations because the old owner used to make every decision?
If the management team is good, are there employee contracts in place and incentives to keep them in their seats, or are the talented people likely to head out the door? Will the new owner find a comprehensive enterprise management system and dashboard that gives her an instant handle on the business, or will she be wading through some spreadsheets and emails to guess what next quarter’s sales will look like?
To demonstrate value to a potential buyer, you as an owner must structure your operations in such a way it is a self running machine; that reduces the risk of a transferability problem – thus increasing its value.
For example, even if the owner is the face of the company’s sale team, getting customers into long term contracts reduces the risk of customers leaving after the company is sold.
Owners can reduce transferability risk with the management team too. Ensure you have good people in place, with clearly defined roles and responsibilities. Yes, you can even put pen to paper and compose job descriptions. Train your team to make decisions responsibly and hold themselves accountable for results. Then get them under employment agreements and provide long-term incentives so that they are committed to staying after you sell the company.
Think through any other intangible aspect of your business where you leaving might cause future cash flow to suffer. Or at a minimum, would make a future buyer worry that might be the case.
Then, come up with a plan to mitigate that risk, document it, and put it into action. If all of the expertise is now out in the parking lot, there is not a lot of value to that company to someone other that YOU! In essence, you have a glorified job that comes with a lot of risk and headaches.
But if you take transferability risk seriously and reduce those risks in a systematic way, then potential buyers are going to see more value to your operations and be willing to pay you more.
Predictability is a little trickier since markets can change rapidly and every industry has risk. However, this is still an excellent unit of measurement because it follows logically from sustainability: if your business is currently making you money, running well, and you have well grounded forecasts that suggest it should continue to do so for the foreseeable future, you can be fairly certain this business will continue to provide the necessary cash flow for the future owner.
How to you reinforce the predictability of your business? Certainly sales contracts with customers would help a lot, like with the transferability topic above. But there are other ways to manage this too, for example:
Run a normalized EBITDA, or at a minimum pre-tax earnings, for a clear current picture and benchmark going forward. This shows the historical data and trends that help explain the story of where you are today.
Think through the methodology by which sales forecasts are made. Is it just guesswork by the sales reps, or is it the outcome of detailed analysis by sales, marketing and finance? Is there a software tool to organize the information? Is there an annual strategic plan that captures insights and sets the vision for future success?
Have you identified the things that have to occur this month to drive sales in future months? For example, many companies employ a sales funnel methodology in which they track certain KPIs like number of customer contacts or meetings (at the top of the funnel) that lead to closed sales (bottom of funnel).
Do you know your ratios between KPIs and your sales? Or the average length of time to close a new sale? Having this data at your fingertips reduces the risk of poor predictability.
If your clear financials are a view into how you’ve done, KPIs are the way to predict and change the future before they become the past.
Businesses that have repeatable, analytically driven sales and marketing processes are better at essentially “creating their own future” sales and thus reducing risks. For example, many businesses employing Search Engine Marketing (SEM) understand the detailed relationship between their cost per digital ad and the click through rate for prospects opening it.
Furthermore, they can run the estimates straight through to calculate the number of downloads, phone calls, proposals, appointments and closed new business they can get with the ad campaign. With good analytics, they understand the total lifetime value of a customer, and the total acquisition costs to get them. Therefore they can predict with a high degree of confidence the impact of pumping incremental money into advertising to grow the business.
Don’t just focus on setting value based on the past. A buyer is really only acquiring a future stream of profits, so approach this with a different frame of mind. Make the case that the business is primed to expand. If you had a bigger checkbook or more resources what would be possible? Can it operate into a different market? Can you cross sale existing products and services to other markets? If you think so, find ways to test and expand this.
Imagine you were selling headphones before the iPod came to market. Suddenly with Apple’s new entry you begin selling a lot more headphones, as consumers want yours to go with their new iPod. A big change in the marketplace wound up boosting your business.
On the other hand imagine you were selling MP-3 players, and then iPod rolled out and your business tanked. In either case, having a close handle on what the market and competition are doing has a really big impact on predictability.
Implement profit-sharing with key executives and be very specific about what tenor of profits must be achieved for it to kick in. Look at putting any specialized employees under employment agreements for additional confidence for the buyer. Train your management team to be strategic and set direction, so that the company would run well even if you as the owner were absent.
If you have proprietary advantages to your product or services, you reduce the risk of competitors taking away business. On the other hand if you offer a commodity product or service, the business is more at risk from lower price substitutes. More competitive advantages means less risk of substitutes, which means more predictable future cash flows. Think of building moats or barriers around your business to reduce the competitive threat. They don’t have to be fool proof, but the more you have them the less risk you accept.
If possible, incorporate Patents to raise company’s value over and above the business profits and growth. This combination really boosts buyer confidence Even if you can’t patent something, you can protect it as a trade secret or intellectual property. Think of things that you do better than competition that they cannot readily find in the market. For example, having the best customer list in your segment or specific systems or processes can be a valuable trade secret. Spend time thinking of other things like this that can serve as a moat.
When a buyer looks at buying your company, strong customer satisfaction will give them more confidence that future revenue streams will be there. Sometimes financial buyers will go as far as calling clients to see how happy they are with your services.
It’s important to quantify customer satisfaction with some kind of empirical study. A Net Promoter Score is a benchmark widely used in the industry to show the likelihood that a customer would recommend your business to others.
Remember a new owner has to essentially write two checks. One to the seller, and one to the business to cover the cash it needs to operate in any given year. If a business needs less working capital to operate, that means the buyer has more cash to offer for it.
Find ways to cut down the amount of working capital needed:
When you consider sustainability, transferability, and predictability of your business’s cash flow, the goal is to build a machine — a machine that can run without you.
In the above sections we covered a lot of ground regarding what comes into play with a company’s value.
When you consider all the advice in the preceding paragraphs, it can be kind of overwhelming to start. But don’t be overwhelmed — for your business, just think about the first thing that you should focus on. What’s the most important project to start with that aligns with your ultimate goals and objectives? Start with the narrow focus, and once you have some accomplishments under your belt widen your focus to tackle other opportunities.
Remember, the entire purpose here is to help you get more money and give you more options for when you decide to sell your business.
Let’s examine these in a bit more detail:
You’ll want to build your strategic plan around the right time for you to sell the company. Take into account your plans for after the sale, whether you’re going to retire or find other ways to earn money, like starting a new business.
The decisions you make around your business should be impacted based on your ideal time range. For example, don’t start a new business model or service a year before selling to a buyer that doesn’t see any value in it – wasted time, capital, resources and time for zero (if not negative) value creation.
Spend the necessary time to think through who are the likely buyers that may be interested in acquiring your company. This will give you some serious insight into where you should spend your time and money. Give[RT1] particular focus to the strategic companies, since they are likely to support a higher valuation than other buyers. When you think through the potential buyers, evaluate what other things you could do in the company to position it for an easy sale or integration after the sale.
Be thoughtful about which projects you take on and why. For example:
We’ve identified a couple of tools you can use online to help you with your thinking. There are lots of different factors to take into account with building value. As we mentioned before, it can be more art that science. However, there are several “tried and true” value-building methodologies that have been proven in research to move the needle. These learnings come through various methods like surveys, market research, the valuations in deals that are made public, and in the public records of the tax recordings with the IRS.
Strategic Partner
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