9 Factors that Influence Company Valuation
Have you ever wondered what your company is worth and whether your passion for the business will eventually pay off? If you plan to sell a company, you need to answer that question sooner rather than later. A company valuation gives you clarity about your company’s value and a possible selling price.
Company valuation is an essential first step in preparing your business for sale. This first step analyzes your company’s performance compared to others and determines how much it is actually worth.
You, as the seller, want the highest possible price for your business. After all, you have invested a lot of time, sweat, and passion into the business. That effort should pay off, but overestimating the purchase price discourages entrepreneurs who are otherwise interested in your company. In addition, the misjudgment can lead to financial self-destruction and exceed the company’s debt service capacity. That endangers the future of your life’s work.
Do not consider your company’s value as static but rather as a variable sum that depends on numerous factors. Experience shows that the most important factors in a company valuation are:
- Reason for the evaluation
- Industry affiliation
- Characteristics of the customer base
- Dependence on a key person
- Achieved sales and profit
- Investment and modernization need
- Type of sales.
1. Reason for the Valuation
The reason for the valuation is essential not only for you personally but also for the potential buyer. Different reasons affect different investors. In most cases, reasons involve internal or external corporate succession, but others include a demand for capital to be clarified through investment or inheritance arrangements.
For the buyer and the evaluation, the type of succession is relevant. Whether a company sale is intended or not can severely limit the field of interest. For example, there is no need for external investors (e.g., financial or strategic investors) if the company owner is passed to a family member or employees-turned-buyers.
2. Industry Affiliation
Your company’s industry categorization narrows the field to investors interested in that particular specialty. As a seller, it helps you to find a suitable and interested buyer more quickly. Many of the investors either specialize in a specific area or have many contacts within a particular industry. However, the investor may be currently building a portfolio and expanding into a particular sector. Industry category is also essential regarding the general market and product background.
Industry trends also drive interest. From time to time, some specific industries and sectors generate extra enthusiasm due to high returns or a reputation as reliable investments. Alternatively, a particular product type can be important for an investor, either for personal reasons or to create business synergies.
On the flip side, a company in a particularly competitive industry needs a lot of resources to establish itself effectively in that market. This can be particularly problematic for smaller investors, which reduces the buyer pool further.
3. Characteristics of the Customer Base
The size of the customer base impacts the company’s value, as it largely determines the flexibility and independence of sales. A diversified and extensive customer base is an advantage here. With a large, diverse customer base, your business need not depend on a small number of clients, remaining viable even when some customers drop out.
Direct dependency on a particular customer harbors excellent risks because there is no guarantee that the customer will remain.
4. Dependence on a Key Person
The same rule of customer dependence applies to the company’s dependence on specific individuals, such as the business owner. If a company depends to a high degree on a particular person–such as the entrepreneur–the subsequent owner must resolve the resulting gap in the corporate structure if/when that person leaves the company. This makes it challenging to achieve the same efficiency after the company sells as before the sale. Corporate dependency upon a key person–not a position–reduces a company’s value.
5. Achieved Sales and Profit
Important financial metrics for determining company value are mainly sales and profits. The turnover relates to the entirety of the services sold and the profit to the EBIT (earnings before interest and taxes) value. Profit margins can be calculated and extrapolated using these values from the past financial year and the previous ones. This also has an impact on the company’s value.
6. Investment and Modernization Need
High investment and modernization requirements can reduce the company’s value because the successor has to make further investments and purchase to expand the company further. As an entrepreneur, you have to consider whether making these investments before selling the business offsets the added value. The need for updated equipment, software, etc., does not necessarily have a negative impact on the valuation assessment. Thanks to their experience and contacts, many investors can implement modernizations faster and cheaper than the entrepreneur.
A seasonal business means irregular sales income. To not negatively influence the company’s value, the entrepreneur should consider how to counteract seasonal sales income with other products or services that can be sold off-season or all-season long.
Substantial fluctuations in sales and profits make predicting future developments difficult. High volatility confers a higher risk for investors to suffer losses and, therefore, lowers company value. If a business is cyclical, that plays a significant role in whether it emerges from a crisis as a winner or a loser.
9. Type of Sales
Some businesses, such as architectural firms, rely on one-time sources of income. Others, such as retailers of consumable products, rely upon recurring income. Subscription models strengthen recurring income through predicted, regular purchases. Depending on the industry, sales type can affect valuation. As a rule, subscription models are preferred because they are easy to make forecasts, thanks to the guarantee of regular payment flows.
Selling a company is a complex process, and successfully organizing a company sale and taking all parties involved into account complicates it even more. The factors mentioned above are essential to determine your company’s value accurately. Precise information also makes it easier for interested buyers to analyze your profile and specifically search for your company if they want to get involved in that arena. Company valuation optimizes the sales process, which benefits the seller and means it should occur at the beginning of the sales process.