“Price is only an issue in the absence of value.”
I wrote this statement down and underlined it as my economics professor emphatically repeated the theory. Even today, I’d claim that this idea is the single most important concept my college education provided. Not only is this statement accurate, but it especially holds true in ongoing valuations and ultimate sale of a business.
Every small business will eventually sell, transition, or close. It is a fact that a majority of business owners’ personal net worth is tied to their business. Therefore, in many cases, the financial stability and eventual retirement of small business owners is contingent upon the price a buyer will pay for their company. With this in mind, many business owners make the costly mistake of walking a tightrope that concentrates strictly on levels of profitability to drive the value of their business.
However, the value (sale price) of a business is impacted by many factors that are not even reflected in the financial statements. This situation can result in business owners’ shock at the difficulty in selling their profitable company for (what the owner believes to be) a fair price.
In 2007, I represented two similar clients. Each company had annual earnings in excess of $2 million and was tied to the same industry. Company A sold for more than 5.5X earnings; the owner is now a happily retired multi-millionaire who is enjoying his RV and condo in the mountains. Meanwhile, Company B did not receive an offer above 2.5X. The owner of Company B is still earning a good living, but he cannot yet retire.
The first key to selling is for a business owner to understand that a buyer’s goal is not to trade dollars; it’s to grow the company. Return on investment (income) is good, but sustainable growth is where value is realized—especially at the next transaction. Since sustainability is the key driver of value for the buyer of a business, this question should be asked in each area: Is this growth sustainable? Just because a business is currently growing and profitable does not mean that the trend is sustainable.
How is sustainability built? The keys are in these six less-known business value-drivers, which each affect the likelihood of sustainable growth and profitability.
6 Business Value Drivers
1. Trained and Stable Team – A loyal and experienced team is highly valuable at all levels within the organization. Teams exhibiting signs of an ownership mentality are pure gold. A task-oriented management team with a negative corporate culture and high turnover rates are indicative of an autocratic leader who would rather “do” than “train.” A strong management team easily increases the value of the company by delivering continuity after the business owner retires. An autocratic leader’s business will die when he transitions out.
2. Diverse Client/Vendor Relationships – Businesses with a concentration in either client or vendor relationships are a red flag and can present potential volatility in revenue streams or cost. Note: This area is often one of the largest non-financial factors impacting a valuation.
3. Clearly Defined Product or Service – Back in my Human Resources days, one of my (now) favorite interview moments was when I was asked a rather difficult question by my interviewee. I admit that I stumbled through my answer to “What is your company’s differentiation?” In the M&A world, this question is now one of the first questions our team asks when beginning to market a company for sale. If your company has no differentiation, then there are no barriers to competition. Therefore, sustainability is at a high risk.
Business owners should not sacrifice niche for profits. Businesses that accept any type of work just to make a dollar are at a risk of being seen as a job shop in the eyes of a buyer. Stick to core competencies.
4. Stable Revenue/Profits – The phrase “the past is the greatest predictor of the future” is especially true in the world of mergers and acquisitions. When plotting the previous five years of revenue and profits for a business on a line graph, the straightness of the line indicates the stability of the company. The more stable the company, the less risk that is in the projections. And, if the line is falling, then valuation is going to be an issue for other reasons.
5. Balanced Operational Efficiency – A business should be a well-oiled machine with fully-utilized staff and equipment. As such, two extremes must be avoided.
Underutilization usually equals too many toys. Sure, this situation translates into excess capacity, but it doesn’t necessarily add to the company’s value. A buyer is going to calculate value from profitability and will include all operating assets in the purchase. The more the assets produce, the more that is realized in value for those assets upon the transaction.
The other extreme is overutilization, which is wringing every penny out of assets. Not properly reinvesting in the company means more owner profit, but it can also lead to significant capital expenditures for the buyer after the transaction. Projecting cap-ex is always a component of cash flow and can have serious effect on the business’ value.
6. Clearly Defined Goals – A business with a five-year growth plan is delivering a road map for success. It should include details about the market, demographics, product/service, and staff. Having a plan is a positive reflection on both management and the valuation as a buyer sees a focus on factors in addition to profits.
Carr, Riggs and Ingram Capital Advisors, LLC is a registered Broker Dealer and member of FINRA and the Securities Investors Protection Corporation.