Understanding and Building Business Value
Business valuation can be a complicated undertaking performed by specialists and the general understanding that most small business owners have is that they will never know the true value of their business until they sell. While this is partially true there are relatively simple ways to calculate and understand a range of values for most businesses. Business owners should work with a professional to understand the calculations involved in constructing a valuation. Understanding a range of value is important for business owners to get a clear picture of the current value but also understanding how to drive additional value. The following sections highlight areas that a potential buyer will evaluate in determining a businesses value. These can be used by business owners to increase the value of the business.
Clean Financials
Most service-based businesses are valued on the cash that they could generate into the future and this is determined by looking at historical earnings for the business. Most buyers want to see five years of historical financial statements in order to predict these future opportunities. Having clean, audited financial statements is important to show a prospective buyer that the information is trustworthy and also provides a good impression of the business. The more closely the financial statements represent a new owner running the business the better for negotiation and explanation of the potential. If the statements need a lot of normalizations (adjustments) that can affect the value of the business as it may create uncertainty for the potential buyer. Ideally an owner should be able to provide a potential buyer a short list of normalizations which are easily explained and can be used for their valuation purposes.
Steady, Repeatable, and Transferable
Ultimately most buyers are looking for steady, repeatable and transferable cash flow. Steady and repeatable growth or consistent revenue can be shown through historical financial statements or through long term contracts with reputable customers. Transferable cash flow is dependent on the operations of the business. For example, if 75% of the revenue is driven by the owner, the value of the business will be greatly affected and a transaction may include additional items such as an earn out.
De-Risking
Another opportunity for businesses to drive additional value is by de-risking the business. Management can assess the eight foundational areas of the business that a potential buy will assess during due diligence in order to find areas to improve to reduce the amount of risk for a potential buyer. Assessing how the business functions in strategy/planning, leadership, sales, marketing, people/HR, operations, finance, and legal/risk can help understand where to spend time and resources to build additional value in the business. As an example, if a business does not have a strong brand, additional value can be created within the business by spending resources on building a stronger brand. In many industries a stronger brand will increase the value of a business. Another example, two businesses who produce the same service, have the same revenue, and produce the same cash flow are not necessarily valued the same. If one company has revenue driven by ten customers and the other has revenue driven by one customer, it is likely that the second company would be valued less than the first. The second company could drive additional value by diversifying their sales efforts and customer base.
Owner Independence
Businesses that are not dependent on the owner are also more valuable; it is important for business owners to develop a competent and empowered management team. A potential buyer may not pay top dollar for a business that is entirely reliant on the owner for operations, sales, and decision making. Owners can reduce the potential risk associated with the business and increases the value by building a great management team who can manage operations and are empowered to make decisions for the business.
Future Growth
In order to get the most out of a transaction it is important to show future growth opportunities for a potential buyer, so selling slightly before the peak of the company is the best scenario for an owner to drive the most value. The only way to know when a peak may be coming is to continually monitor the potential value of the company and be sale ready. Having the right team in place to help understand value and what is needed for a transaction is key to success.
Time
As mentioned a potential buyer will often want to see five years of clean financial data when considering a business. This coupled with the fact that it takes time to create independence and de-risk a company to show that it is important for business owners to begin preparing for a transition of their business far in advance of a transaction. The best-case scenario is to ensure the business is always sale ready. This is helpful for a business owner on many different fronts. It helps the owner begin to think through a transition (preparing mentally), it ensures the business is always operating optimally (why fix it at the end), and it helps to be educated in the event of an unsolicited offer (which will be likely if the business is being run well).
