When it comes to enhancing business value, maximum effort minimizes risk. As a business owner, you may think that risk mitigation is critical. While it is essential, it’s not your only tactic.
De-risking your business will pay enormous rewards, but it’s not enough to meet your future business goals or desired exit.
What Is De-Risking?
Potential investors look for industry-specific or company-specific risks likely to reduce their return on investment. They evaluate the level of risk and apply a commensurate penalty to the target company’s earnings. Risk also lowers the target company’s valuation. This leads business owners who seek funding or exit to focus on reducing or resolving the issues that the investors/buyers may find risky.
Most Common Risk Factors
When mitigating risk, business owners must view their companies from the buyer’s perspective. Savvy sellers focus on these most common issues:
Reputation. What do your customers, suppliers, and competitors think of your company? Buyers/investors want to quantify your company’s reputation in the marketplace. To do this, they collect information from various sources, such as customer feedback and interaction with your suppliers and competitors at trade shows, industry conferences, etc.
Customer base. Customer concentration in your business repels investors/buyers and reduces business value. If one customer accounts for more than 20-25 percent of your sales, then your company faces customer concentration, and investors/buyers find it risky. Buyers seek target companies with a diversified customer base, so even if they lose some customers post-transition, their earnings will not decline steadily. When you have two or three large customers providing more than 50 percent of revenue, potential buyers stand the risk of losing them after your exit and suffering earnings losses.
Suppliers. Investors/buyers look for a diversified base of suppliers in target companies. Reliance on one supplier carries the risk of shortages and supply interruptions. Potential buyers penalize such risk and reduce your enterprise value. Mitigate this risk by engaging with three or four suppliers to ensure that your position in the supply chain is strong.
Financial records, planning, and budgeting. Potential buyers worry about sloppy financials. They conduct a thorough due diligence process to unearth financial inconsistencies and errors. Investors want to see your business plan, growth strategies, and planned initiatives to increase profitability. They analyze your workflows and working capital requirements. Unaudited financials and carelessly managed accounting will adversely impact your business value. Keep your company in a healthy financial state to enhance your business value.
Management team. If your business cannot operate without you, investors see it as a risky venture. They may ask you to stay with the company after the ownership transition to ensure the business operates. However, investors prefer a robust and stable management team capable of handling key activities and operating independently of the business owner. This gives them confidence that the company will continue to operate in the same manner even after the transition.
Systems and procedures. Streamlined and updated systems and procedures attract prospective investors who want to see the strength of your operating systems and processes. Investors look for system-driven companies that can run without the business owner’s input on trivial matters. Robust, efficient systems and processes add value to your business.
Industry concentration. If your company operates in a specific end market, it is vulnerable to sector-specific factors like seasonal business or cyclical trends. However, if you work in a high-growth end market, you could attract a valuation premium.
3 Important Value Drivers
Focusing only on reducing risk to improve your company’s value is not enough. Value depends on three equally important factors.
As discussed earlier, risk destroys value, and few want to invest in a risky business. Buyers look for target companies that successfully mitigate risks. De-risking helps achieve this feat and gives tremendous advantages. You can enhance your business’ value by eliminating potential risks, which may be why most business owners focus solely on de-risking.
However, risk mitigation is only one of the three most important value drivers. Alone, it cannot help you achieve your desired exit. Your value creation journey is incomplete if you do not focus on the other two value drivers: growth and earnings.
Buyers want to invest in target companies that have shown good growth in the past and promise higher potential growth. They will look at the growth trend of your business, the factors behind its growth, and their current relevance.
Investors also compare your company’s growth to your peers. The industry in which your business operates affects your business’ value. Your business is more valuable if you work in a growing industry rather than a declining industry.
However, you can remedy this situation by developing unique capabilities that ensure positive potential growth. Having a competitive advantage helps you attract investors and premium valuation.
Investors want to earn positive returns on their investments, which makes the level of your business earnings essential. They want assurance that your company’s earnings will continue to grow after your exit, and they want to know if its revenue has grown steadily or fluctuated dramatically over the years.
Investors look for target companies having sustainable earnings and good future earnings prospects. Your well-defined growth plan should show them how your company will reach future projected increases in revenue and how their investment will accelerate it.
Companies generating recurring revenue as a percent of total revenue especially attract investors. They welcome long-term customer contracts ensuring stable and recurring revenue in years to come.
Company earnings directly impact the price of its stock shares. The greater the earnings, the higher the price of your company’s shares and the greater your business value.
Companies demonstrating consistently high earnings command a premium on the average EBITDA multiple in the industry.
The Sum Is Greater than the Parts
A successful value creation journey involves all three important value drivers: risk, earnings, growth. If your focus solely on mitigating risk, what will happen to both earnings and growth? Equal balance among all three value drivers improves company performance and value beyond that capable by any single tactic. No single value driver can ensure that you will achieve your desired exit.