Understand Valuation Drivers to Guide Value Accelerators
If you left your company today, would the business prosper or dwindle without you at the helm? The answer relates to transferable value, which is highly significant in exit planning. The value of a company is what it is worth to the buyer.
The amount of future cash flow a business can generate without its current owner primarily determines a company’s value. Future cash flow depends upon a capable management team to replace the departing owner. Without that team, the business can’t continue to run and holds no value for the buyer.
Buyers evaluate companies through their experience, market competition, and due diligence. Regardless of the company’s size, business owners must answer these three critical questions:
- What are the parameters that drive value?
- What do buyers want to see in the company?
- What steps will increase business valuation?
Three factors that every buyer considers before deciding to invest in a business include:
- Return on assets,
- Return on equity, and
- Return on investment.
How Do Buyers Drive Business Valuation?
Buyers always look for deficiencies in the business to secure a better deal. They ask questions such as:
- Is the business stable?
- Can it support the work needed to hit both revenue and financial targets?
- Is the management team committed to working together after the transition?
- Will a future regulatory environment pose a risk to the business?
The future always involves an element of uncertainty, which creates risk, so buyers include a risk premium (risk factor) which discounts value. Companies with positive cash flow use earnings before interest, taxes, depreciation, and amortization (EBITDA) to calculate value. Whereas businesses with negative cash flow base valuation on the market value of all the assets minus liabilities.
Drivers of Valuation and How to Use Them
As value drivers contribute to increased cash flow, their strength in a company determines its business value. Buyers willingly pay top dollar when they observe the presence of value drivers and their impact on the earning potential of a company. Therefore, strong value drivers attract a higher multiple on EBITDA.
The value drivers in descending order of importance are:
- Next-level management
- Operating systems that support sustainable cash flow
- Diversified customer base
- Sound growth strategy
- Recurring and sustainable revenue
- Increasing cash flow
- High scalability
- Competitive advantage
- Routine due diligence.
Read further to understand each value driver and how business owners can use them to accelerate value.
1. Next-Level Management
The most significant value driver, Next-level management, ensures that your business will run effectively after your departure. To build the next-level management team long before you are mentally ready to exit, you must select people who have the experience and skills to grow the company. To develop and retain next-level management:
- Train your existing management team to the level required, add new members to the team, and transfer or replace underperforming people.
- Involve external resources in the value creation and exit planning process who have the skills to train and assess your existing management team and facilitate the company’s smooth operation without your involvement.
- Provide leadership, motivate, and offer incentives to top management to achieve your planned goals and stay with the company after you exit.
2. Operating Systems that Support Sustainable Cash Flows
Robust and updated operating systems are the well-documented standard operating procedures that show the buyers that your business will continue to run smoothly after your exit. Standardized and repeatable processes ensure easy scaling, repeat customers, and predictable management without much investment and dependence on specific individuals, which presents your company’s compelling customer value proposition and makes it competitive in the buyer’s eyes.
Also, buyers find a system-driven business much more valuable than an owner-driven business.
3. Diversified Customer Base
Buyers view customer concentration as a risk. Worse, if your biggest customers are loyal to you rather than to your company, then they will likely leave the business when you do. No matter what exit route you take, customer concentration is always a risk.
Eliminate this risk by diversifying your customer base. Examine your customer base from the buyer’s viewpoint. No single client should account for more than 10 percent of your total sales.
4. Sound Growth Strategy
A growth plan generates the cash you will need when you exit to meet your goals. Your growth strategy should include a roadmap that describes what should happen, when, and by whom so that you exit on your terms.
Analyze your current management team to determine whether they have the experience and skills to execute the growth strategy. Combine next-level management and external resources with your growth strategy to accelerate your company’s growth.
5. Recurring and Sustainable Revenue
Your revenue might steadily increase, and your profit margins decline if your products are commoditized. From the buyer’s perspective, recurring revenue is a crucial value driver which cannot be sustained if commoditization occurs.
First and foremost, identify whether commoditization is happening. If so, check to see if the current management team can resolve the problem. If they can’t, enlist external help or hire new people.
It is challenging to build a product that cannot be commoditized. Commit to continuous innovation and segmenting, provide value-added services, and help your customers quantify the value of your solutions to avoid commoditization. Also, consult your advisors for the right strategy applicable to your unique circumstances.
6. Increasing Cash Flow
Good and increasing cash flow is crucial to value creation and exit planning. From the buyers’ point of view, your historical revenue graph should show a rising trend. Declining or unsteady cash flow does not attract buyers because steadily increasing revenue promises better prospective profits. If your past cash flows do not show an upward trend, your growth plan should include strengthening this value driver.
7. High Scalability
A business is scalable when an increase in revenue leads to a rise in profit margins. When costs do not increase with the increase in revenue, profit margins increase. However, not all businesses experience this scenario. Professional services firms or retail stores must increase their human capital or inventory to boost sales. So, as revenue increases, costs also increase. On the other hand, for businesses involved in selling software licenses, an increase in revenue does not increase costs because they incur a one-time cost for software development.
Not easily scaled does not mean impossible to scale. If your business has other value drivers (e.g., revenue growth, high-profit margins, competitive advantage), then you can scale it.
8. Competitive Advantage
The reason why customers buy from a particular company is the company’s competitive advantage. That advantage may be better quality products or lower prices than their competitors. Work with your advisors and management team on your company’s competitive advantage. Once you have identified that advantage, protect and promote it.
9. Routine Due Diligence
Buyers inevitably conduct due diligence of the companies they wish to purchase, so your bookkeeping must be accurate. They perceive sloppy financial reporting as concealing an underlying problem within the company. Transparency, thoroughness, and accuracy establish confidence and maintain trust between buyer and seller.
Also, to grow your company, you need to understand its current state and past trends. Financial controls ensure that you base your exit plan on accurate data and precisely calculate what you need to reach your goal.
Conclusion
These value drivers apply to all companies, big and small. With this understanding of value drivers, work to strengthen them in your company to achieve your planned goals and exit on favorable terms. Do not hesitate to enlist external help and bring skilled and experienced people on board to implement the value drivers in your company.
The best time to start building value for your company is now, even if your exit is in the distant future. Contact our team of experts to get started.
