Client: What’s my business worth?
Valuator: That’s a great question – but let me ask you a question first. Why are you asking?
Client: I want to set up my succession plan so that I can retire in five years.
Valuator: Then the better question is, what will my business be worth when I’m ready to sell? Your ability to maintain and enhance the value of your business over the next five years will have a dramatic impact on its eventual sales price.
Client: Well, let’s talk more about that.
If you are a regular reader of our blog, you already know that a significant number of companies will change hands in the near future. According to Inc. Magazine’s “The Most Valuable Company in America”, it is likely that 10 million small companies will be sold in the next five to ten years. Because of this development, our baby boomer clients regularly approach us to assist in selling their businesses. As we have discussed in previous articles, there are countless considerations when selling your business. We have discussed valuation fundamentals, strategic vs. financial buyers, deal structure and a host of other factors that impact the economics of the sale of an owner’s business. Here, we will build on those articles by providing some practical ideas to help you enhance the value of your business before you sell.
Decrease the Risk Profile of Your Business
Value is a function of the predictability of cash flows and the risk associated with achieving those cash flows. This means that a riskier investment will require a higher expected return (i.e., cash flows) than a less risky investment, all other things being equal. Therefore, one way to increase the value of your investment is to decrease the risk associated with achieving its expected cash flows. Sounds pretty simple – but how does an owner decrease the risk profile of his or her business?
- Diversification – Whether we are talking about products, customers or suppliers, it is almost always preferable to diversify. Diversification provides the business alternatives if it is faced with unfavorable external challenges, such as the loss of a large customer, the bankruptcy of a supplier or the entrance of a new competitor for a given product line. Of course, such issues may hurt the business’s value, but diversification allows the company to soften the blow. Furthermore, a diversified company is better positioned than its undiversified counterpart to recover from these events more quickly.
- Stabilize Revenue and Cash Flow – An investment with a stable, predictable cash flow stream typically suggests a lower risk profile than an investment that has less predictable cash flow and volatile returns. This is why we see much lower rates of return on debt investments (such as bonds) compared to an equity investment. This is not to say that an investment in a company with stable cash flows is more valuable than the riskier, more volatile company based on that fact alone (there are many more factors at play, of course). Nonetheless, by exhibiting a stable historical cash flow pattern, the company adds reliability and predictability to its risk profile, which decreases the risk associated with an investment, thereby making that investment more valuable. Stable cash flows are often the result of good diversification. For example, a company that only does snow plowing is susceptible to variability in cash flows based on weather. A harsh winter will bring higher cash flows while a mild winter will result in weak cash flows. However, if the company offers other services, such as landscaping or contract work, the volatility in snow plow cash flows is not as severe to the overall business because of the other revenue streams brought about by diversification.
- Build a Strong Bench – Like customer or supplier concentration, many small businesses have higher risk profiles due to “key man” issues. These issues often stem from a single owner-operator’s far-reaching responsibilities in running the company, and the company’s overall reliance on an owner-operator’s personal relationships with key customers and suppliers. The business can reduce this risk by building an executive management team that can provide stability in all facets of sales and operations should an untimely departure of the owner or other “key man” occurs, whether voluntarily or involuntarily. A business that can be turned over to a buyer and does not require the seller to keep working in the business will often be worth more than one that is heavily dependent on the seller’s continued involvement.
- Create Repeatable Systems and Processes – Like the three mechanisms we discussed above, the existence of recognized and repeatable systems and processes adds stability to an organization. Companies can insulate themselves from employee turnover by implementing processes that can be easily transitioned among the work- force. In addition, companies that have strong systems and processes typically have more efficient operations, which translate to higher margins and stronger cash flows.
The value of your business can be enhanced dramatically by managing the risks that the company faces. While many components of a company’s risk profile are outside of the owner’s control (economic factors, industry factors), the mechanisms above, if implemented properly, can make a significant difference in enhancing a business’s value.
Improve Available Cash Flow
The second input to the valuation equation is the expected investment return of the business. Therefore, enhancements to a company’s cash flow (or any input to cash flow, such as improved revenues or reduced expenses) will also increase its value. Quite simply, the company that makes more money is going to be more valuable, all other things equal. So, here are a few ideas that might help you improve your cash flow.
- Sell More! – Yes, this seems obvious. Greater revenues will generate higher cash flows, which in turn will enhance the value of your business. But how do we do it? Aside from good old-fashioned chasing customers, the company could expand the scope of its products or services. Offering more products and services has a few benefits. First, the company’s product line is now more diversified, which can help the risk profile of the business. Second, assuming the company is successful (a significant assumption, to be sure), the company can now spread its fixed overhead costs over a greater revenue base, enhancing its operating margins. This “double dip” can have a dramatic effect on the cash flows of the business and the resultant business value.
- Manage Variable Costs – Variable costs are expenses that change with fluctuations in revenue (e.g., if revenues increase, variable costs also increase). Most variable costs are captured under the “cost of goods sold” caption on the income statement. Depending on the type of business, there are a few ways that you can enhance cash flows by controlling variable costs. First, building stronger, more efficient manufacturing operations will allow the dollars spent on materials to go further. Simple examples would be the minimization of scrap in the manufacturing process or the implementation of processes that reduce the costs of manufacturing of products. Another way to control variable costs is to work with your suppliers to secure the best possible price. This might involve committing to a large purchase order to secure a volume discount. You could also consider working with your supplier to customize the material they provide to you, which may create efficiencies in your manufacturing processes. Finally, tailoring employee wages to productivity-based results whenever possible often leads to improved results, profitability and cash flow.
While it seems quite obvious, improving your company’s revenues and controlling its expenses have a direct impact on cash flow, which is a primary driver of the value of your business. Many of the methods to enhance cash flow that are discussed above have the extra benefit of reducing your business’s risk profile, so it is certainly worth exploring ways to implement these mechanisms.
While the factors discussed above can have a real, tangible impact on the value of your business, there are other potential “fixes” that are often not worth your time and attention. Nonetheless, we still see these ideas implemented in the hope of enhancing value. This is not to say that they have zero impact on value, but that they may not have the “bang for your buck” that other changes to your business may have.
- Adjusting Owner Compensation – It stands to reason that if you take less money out of the business in the form of compensation, you will show improved margins and cash flow. This is true. However, a valuator will look at this from the prospective buyer’s perspective and adjust compensation to a reasonable level (based on the services you provide to the business) in determining the company’s value. It should be noted that by reducing your compensation, you are able to leave cash in the business, the result of which might be a stronger balance sheet or an opportunity to invest in new projects, both of which may increase the value of your business. However, simply reducing your compensation without pulling any of these other levers will likely leave your value in the same spot it was in before you adjusted your compensation.
- Paying Down Company Debt – This one is a little bit tricky because it depends on your perspective. We like to use the analogy of purchasing or selling your home when explaining this concept to our clients. Your mortgage balance has no impact on the value of your home. If you were to pay off your mortgage tomorrow, the most likely sales price of your home would remain unchanged. Furthermore, you have less cash in your pocket than you did prior to paying off the mortgage. What is important to note, however, is that the amount of cash that lands in your pocket when you sell the home will most certainly change because you no longer have to pay off your mortgage. Essentially, the cash you used to pay down your debt is refunded to you at closing – like the cash has been moved from one pocket to another. So, when we say that it depends on your perspective, we mean that you need to understand the difference between the value of your business/home (we call this “enterprise value” in the valuation world) and the amount of cash that is leftover after you pay off any bank debt (we call this “equity value”), as these can be very different numbers. Ultimately, the value of the business stays the same – all you are doing is changing the character of your financing between equity/debt and how much cash you have inside and outside the business.
We have touched on just a handful of ways to enhance the value of your business. It is important to understand that the value of your business today is only relevant to the extent that it serves as a starting point for your exit plan. Today’s value may bear little resemblance to the value of the business when you are ready to sell. As you can see, approaching your succession with an organized, clear plan that implements value enhancement opportunities, if executed correctly, will pay off in the end.
Learn more about the important topics you should be aware of before selling a business in our free e-book: Valuation Considerations When Buying or Selling a Business – Part 2. For more information on the various approaches to valuation or our Business Valuation Services, contact Dan Golish via email or by calling 440-449-6800.