Could Your Business Be the Next Apple or Amazon? 5 Key Factors Influencing Business Valuation (Part 2 in our series on Business Valuation)
This is the second part of our series on business valuation. Before you dive in here on influencing business valuation, make sure to check out part one where we dig deep into types of valuation.
In our previous post, we discussed some of the complications involved in determining the value of publicly traded and privately owned businesses. And we want to emphasize that while from the outside it can seem like big corporations are dealing in Monopoly money—business valuation is not (completely) based on concrete, objective measures—strategic investors and private equity buyers do follow some standard assessment practices.
Still, business valuation remains a contentious issue and as a result, many potential sellers approach negotiations with assumptions, rather than knowledge about specific value drivers supporting a realistic assessment of their business’s worth. Since assuming is always inferior to knowing, especially during the negotiation process, it’s worth considering internal and external factors influencing business valuation.
Whether you’re thinking about selling your business in the near future, interested in keeping value drivers on your radar as you grow your business, or looking to get into the investment game yourself, there are key factors influencing business valuation to keep in mind. In addition, CEO Katy Herr will be speaking with our friends at Quantive to get their expert perspective on this timely topic. Check back for a link to the podcast where Katy and the Quantive team will dig deeper into influencing business valuation and transferring value in M&A. In the meantime, here’s a primer.
A Quick Recap
Before we look at the specifics influencing business valuation, let’s remember why this is an important question to ask. Recall that there are a couple ways to assess the value of a publicly traded company:
1. Market Capitalization (cost of a company in “real money”):
- Market cap = stock price x number of outstanding shares
Following Apple’s ascent into 13-digit territory last month, Amazon’s total market value surpassed $1 trillion last week. Both of these valuations are based on the simple formula above.
2. Enterprise Value (cost to acquire a company):
- Enterprise value = a corporation’s market cap + preferred stock + outstanding debt – cash (and cash equivalents) found on the balance sheet
This is the formula a buyer might use to determine what would be a fair offer to acquire a publicly traded company.
Now, investors don’t use these formulas when looking at the opportunity or degree of risk involved in acquiring privately held companies simply because they don’t usually have access to this information. Private companies aren’t required to report earnings, stock or share prices, outstanding debt, or cash in the bank. However, as a business owner, you do have access to this information and you could provide it to interested investors or buyers. In fact, strategically releasing this information will likely give you a leg up on influencing business valuation.
What’s really important to understand for our purposes is both types of business valuation, but especially market cap, rely on expectations. So let’s talk about factors influencing business valuation.
Buyers look at the following factors when deciding which valuation multiple to apply to their assessment of your business’s ability to generate income and cash flow. Here is what you can do to put yourself in the best possible bargaining position:
1. Maintain Clean Records
If you aren’t doing this for your own peace of mind and other business benefits, it’s crucial for you to get your books and records in order well (years, ideally) before you start looking for investors or buyers. At a minimum, you will want to keep personal and business expenses separate. Having professionally managed books and a solid financial audit is a smart investment if you are seriously hoping to sell one day. This will also help you understand where you are today so you can target your growth goals and mitigate business risks influencing business valuation. So, do your homework here.
Keeping clean records is the first step toward running a profitable business. But records means more than financials. Make sure all important documentation is well-organized and would make sense to interested parties outside of your inner circle.
Important documentation includes:
- Financials (balance sheets, expenses, tax returns, credit card statements, bank statements)
- Audits, regulations, and licensing records
- Recent legal due diligence reviews
- Written systems and processes, including employee handbooks and manuals
- Key employee agreements and noncompetes
- Customer records
- Written and assignable customer agreements
- Written contingency plans for emergencies and other potential disruptions to cash flow
- Key equipment maintenance records
2. Highlight Positive Trends
Investors want to know when they can hope to see a return on their investment, of course. This means showing a projection of positive, predictable profits is ideal. But if your business is new, this might not be a realistic benchmark.
Typically, analysts and investors will look at the most recent 3-5 years of past performance and 2-3 years of projections in determining value. Be sure to point to factors within your control, such as personnel management and smart cost-cutting maneuvers, as well as external factors, such as industry dips and seasonal declines, to tell a complete story.
It’s also crucial to point out other positive trends influencing business valuation that make your business attractive:
- Revenue growth rate
- Consistent gross margins trending upward
- Higher than average industry operating margins
- History of achieving financial projections
- Strong, sustainable, predictable cash flow
- Consistent history of profitability
- Solid pipeline of new business and demonstrated ability to convert
3. Be Open to Change
One of the big external factors to consider is how the business will respond to inevitable market adjustments and changes in the industry. With technology and automation bringing about rapid changes in most industries, businesses that show an ability to evolve are most likely to maximize profits and sustain additional growth while keeping operational expenses low.
For companies involved in the production of a product, evaluating your strengths and weaknesses is crucial. Can you increase efficiency, product quality, profitability, or customer satisfaction by outsourcing certain aspects of your supply chain? Should you seek out strategic partners in particular areas?
4. Make the Business Less Reliant on Key Personnel
What would happen if the CEO decided to retire, seek out another career opportunity, or take an extended vacation? If your answer is that the company would not skip a beat, then you are on the right track. Companies that rely on owners who spend a lot of time working “in” the business are susceptible to lower valuations. By contrast, those who can set up reliable processes and trusted management to serve clients can walk away leaving a new individual to run the business.
Bob Moskal at Quantive shared this example:
We worked with a facilities maintenance company to recommend and implement a host of improvements to make their business transferable. For example, we recommended they digitize their record keeping, make their financials useful for running the business not just for tax returns, and transition customer accounts to account managers so that a potential new owner could see that the company could run with the same level of success without the departing owner. Previously, this business would have been heavily discounted or not sold at all. It’s now positioned for growth and a more attractive acquisition target.
Additionally, the following factors make a business easier for a buyer to take over and manage successfully:
- A strong, recognizable brand identity
- For product-centric businesses: a clear supply chain; equipment upgrades to modern, productive equipment; systems in place for identifying and implementing new technology
- For service-centric businesses: system protocols that have been tested; an established, clear succession chain; well-documented job descriptions and processes for sharing institutional knowledge
5. Be Able to Show Large Market Potential
In one sense, how a business has performed in the past matters less to investors than the potential for future growth. Past performance is only as good as what it tells us about future projections. Many buyers focus on turning around businesses in industries where they have been successful in the past or businesses where they have key contacts who could help increase future profitability.
Because so much depends upon the expectations of individual investors, it pays to focus on factors that will likely influence the market potential:
- Multiple, strong sales distribution channels
- Multiple revenue streams
- A strong industry market share
- A written and up-to-date business plan
- Proprietary products or technology
Because all of the above five factors influencing business valuation depend on expectations, the best you can do as a seller is lay your cards on the table in a way that puts your company in the best light. This means putting yourself in the shoes of your investors and considering carefully what would make this offer most attractive.
Finally, if you’re really hoping to get top dollar for your business when you are ready to sell, experts say it’s all about doing the pre-sale prep. Again, according to Bob Moskal, business owners will want to start with due diligence a couple years ahead of time, so they have plenty of time to take steps to correct any “skeletons in the closet” ahead of negotiating a sale.
Also, Bob recommends knowing what your company is worth before starting the process, “we’ve often seen a seller shy away when he starts actual retirement planning late in the game and realizes the value falls short. A good financial planner can help here.” You can hear more of Katy’s conversation with Bob about influencing business valuation when they sit down to record a podcast later this month. We’ll add the link when it’s available. Stay tuned!
At Audacia Strategies, we specialize in putting together communications strategies that helps our clients meet their goals. We’ll be the voice of reason as you figure out how to highlight the key value drivers and tell the story of your current (and future!) success. Our team is all about managing expectations. Contact us to schedule a consultation.
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