The Key Elements that Determine Value

To celebrate the simultaneous release of our BizValue Android app and update to our Business Value Calculator, we decided to write a newsletter dedicated to the art and science of valuations. After all, if there’s one thing that seems to constantly puzzle small business owners it’s their company’s value.

Agreeing on your company’s value will make or break a transaction – ultimately, a company is only worth what someone else is willing to pay for it. That said, there are four key elements that impact every valuation:

  1. The Buyer
  2. Cash Flow
  3. Risk
  4. You

The Buyer

Corporations have more money than individuals, but is that why they tend to pay more for companies? Yes, and no. Yes, because affordability is rarely a concern. More likely, however, is that the paradigm shifts.

When corporations buy small businesses they usually achieve economies of scale. They can realize stronger margins by controlling wholesale purchasing decisions, streamlining back office functions, expanding market share, or a number of other methods. As a result, they create enough value to their own enterprise to break even on the investment in 3-5 years.

Don’t go into the deal assuming that the corporate buyer pays more because “they have deep pockets”.  If you expect to hold them up, you’ll be the one left holding the bag.  Instead, take some time to understand how their valuation criteria differs from individuals.  This will help you better understand how to align your objectives with those of your potential buyers, and may help you to gain a better understanding of the differences between the buyer who will pay the most and the buyer who you may prefer to sell to.

Cash Flow

Cash is king, and at the end of each year after all expenses are paid, there is only so much left over – and buyers require a minimum return on their investment.  Therefore, cash flow dictates value more than any other component.  Your business needs to generate enough cash to cover all operating expenses, any debt required to complete the transaction  and a return for the buyer.  If cash flow cannot cover all three (at the price for which you expect to sell), then your pricing expectations are not aligned with your company’s profitability.

Even those of you in industries that value businesses based on multiples of revenue (e.g. “1 x Sales”), cash flow still weighs heavily on the valuation. If you’re not profitable and you don’t meet other criteria, you are likely to be valued at less than “1 x Sales”.  Furthermore, the buyer type is critical here.  ”1 x Sales”, or any revenue multiple, is only relevant for corporate/strategic buyers who are attempting to consolidate an industry and capitalize on economies of scale.  For those of you targeting individual buyers or private equity buyers (if you’re on the larger end of the small business scale), cash flow drives the valuation and revenue multiples are irrelevant.

Risk

What makes two otherwise identical companies worth very different amounts? In a word, risk.  Risk comes in all forms: the risk of losing key employees, customers, suppliers, or referral sources; the risk of an economic downturn or emergence of a disruptive technology; financial and legal risk; the risk of a departing owner.  Some of these are out of your control and apply to all businesses (anyone can get sued, regardless of whether the lawsuit has merit); others, however, are directly under your control.

Consider two companies with $1 million in revenue and $200,000 in EBITDA (Earnings Before Interest, Tax, Depreciation, and Amortization, a common measure of profitability).  The first has a very diverse customer and supplier mix; all key employees have been with the business for years, have signed non-competes, and perform at or above industry benchmarks for their position; and, the owner is not active in the daily operations.  The second relies primarily on two large customers (or, in healthcare, third-party payors), and the owner generates over half of the revenue.  Assuming the industry and market sizes are the same, the first company will capture a much stronger valuation due to the absence of many key risk factors.

You

As the owner and seller of the company, your actions and decisions can impact the transaction value significantly. If you are a key contributor to the business and therefore difficult to replace, the buyer has a key problem to solve – how do they maintain current sales volumes and cash flow when you leave?  You can choose to be a part of the solution, helping to facilitate a transition and/or agree to continued employment after the sale closes; by doing this, you help preserve value for the buyer, and as a result can achieve a stronger valuation.  If, however, you decide to be a part of the problem and ignore the issue (or refuse to help), then you can expect your valuation to take a hit (and certain buyers to walk away altogether).

Owners can also scare off buyers or negatively impact value by their actions during the sale process.  They can do this in many ways, with the three most common being window shopping, making unrealistic demands, and failing to present the business properly.

If you enter into the sale process without being 100% committed to selling, soliciting offers with no real intention of closing a transaction unless someone overpays for your business, then you run the risk of annoying and possibly offending buyers.  This is especially true in a consolidating industry, in which there is a limited pool of buyers offering strong valuations.  These buyers will stop taking you seriously, and when you finally decide to commit to selling they will remember their previous interactions with you and value the business accordingly (e.g. very conservatively and reluctant to make a fully valued offer).

If you give the impression of having unrealistic demands, related to price, deal terms, or anything else, then value will suffer because buyers will become less willing to negotiate with you.  A transaction is a courtship, and buyers have a tendency to push valuation limits when they like an owner and are excited about the deal but they will take the opposite approach when turned off.  Nothing is a bigger turnoff than a seller with unrealistic expectation.

If you present the business poorly, due to the inability to either produce clean and updated financial statements or to respond to questions in a timely fashion, buyers will view the transaction as a riskier investment.  Such a situation makes it very difficult for the buyer to truly understand what they are buying, and this ambiguity will cause them to lower the price they are willing to pay because they lack confidence in the accuracy and completeness of the information you have provided.

Conclusion

Numbers don’t lie, and nothing can improve your company’s value as much as revenue growth and strong margins.  That aside, since valuations are always expressed as ranges it is important to understand why companies skew to certain ends of the range.  Many of the differences between companies that achieve strong valuations and those on the lower end of the scale are factors under the owner’s control.  While you may not be able to control which buyers will be interested in the future, you can control your behaviors and actions and many of the key risk factors that impact valuations.  Focus on these to drive the necessary change, and you will be rewarded with a stronger valuation when you make your exit.

Comments are closed.