Most business owners eventually plan to either sell their business, transfer it to others, or go public. No matter which path they choose, they usually want to maximize the value of their business before they exit. (Of course they also want to minimize taxes, but that’s another story.) The question then, is what are the most important factors in driving business value?
Of course any business with valuable assets is going to be more valuable than one without such assets. A forestry company with 100,000 acres of old growth forest is almost always going to be more valuable than one with 10,000 acres of new forest. But since most people already know that, I am focusing here on other less obvious stores of business value.
First and foremost is financial performance. A long, consistent track record of growing revenues and strong profits is probably the single most important factor in determining business value. The length of time varies from industry to industry, but generally 5 or more years is a lot better than just one or two. Size matters too. Most sophisticated business buyers are much less interested in companies with less than $5 million in revenue. Below $1 million and it gets even tougher. But once you get above $20 million, a lot of groups start paying attention.
Profit margins are also important.
Companies with profit margins above 20% are relatively rare, and will always get more attention, but most buyers will look at your profit margin relative to your industry. If you’re at or above average, it’s good. If not, you’ll get downgraded.
Consistency matters too.
Consider the case of two companies in the same industry. Over a five year period, Company A has slightly higher revenues and profits than Company B, but Company A’s revenues and profits are inconsistent and vary wildly from year to year. All other things being equal, most buyers will ascribe a higher value to Company B, simply because it is more predictable.
Does your company steadily generate cash, or are there ups and downs so you frequently require short term financing? Beyond generating cash, does your company have a substantial cash reserve upon which it can draw in case of hard times ahead? Profits are important, but cash flow is even more important.
Processes and Controls
Do you have accurate financial records? Do you have a CFO prepare your records and then have a CPA firm audit them, or do you just use a bookkeeper and Quickbooks? What about legal contracts with vendors, customers, employees? Are they professional? Do they protect the company? How about insurance? Have there been any lawsuits or liens against the company over the past 5 years? If two companies are identical in every other respect, but one has well-documented processes and good controls and the other doesn’t, the first one will always be more valuable.
Market Factors that drive business value
Is your industry growing, shrinking or steady?
If the industry is growing, how does it compare with the overall economy? It’s a lot easier to grow a business in an industry that’s growing faster than the economy. Sometimes the value of your company is more dependent on external market conditions than internal conditions.
How large is the market you operate in?
And how much market share could you reasonably expect to capture over the next few years? Clearly a company with a large share of a small, shrinking market is almost always going to be ranked lower than one with a smaller share of a huge and growing market. The former has nowhere to go, whereas the latter has tremendous upside potential.
How tough is the competition?
Are there lots and lots of small competitors, all fighting for a tiny slice of the pie? Or is the market concentrated, with one or two giants? This one is tricky, because sometimes the industry giants have glaring weaknesses that smaller competitors can exploit. Other times, they have a near monopoly. Perhaps the more important question is what is your competitive advantage? Do you have one? Is it defensible?
Is your company scalable?
In other words, for each additional new customer, does your cost structure improve a lot, a little or not at all? Companies that can scale are usually much more valuable than companies that can’t. This is one of the reasons investors love franchises – they are built to scale.
Similarly, is your company restricted to just one or two geographical areas, or could you sell the same product or service in other areas? A company that can expand to multiple geographic markets is usually going to receive a higher valuation than one that is limited to one or two locations.
Dependence and Diversification
How dependent is your company on one employee, customer, vendor or partner? For example, how hard would it be to replace your marketing director if she left? If the answer is “she is irreplaceable”, then some buyers could see this as a problem. The same applies to customers, vendors and partners.
In most cases, it is better to be diversified than overly concentrated. For example, if 70% of your revenue comes from one customer, your company could be perceived as very vulnerable. If that customer decides to work with one of your competitors, or somehow finds a way to bypass your company’s products or services completely, you could be out of luck.
Do you have a strong management team?
Do they have clear roles? Do they have long term incentives to stay on and perform at a high level? Many small companies get by with one or two people running everything. If those people leave, the company can quickly fall apart. A small company with a strong management team with strong incentives to stay on can sometimes be much more valuable than a larger company with a weak management team.
If you (the owner) get sick or otherwise become unable to work for several months, what will happen to the business? Is there someone else who can take over and run things while you are out? If not, this is a major problem.
What percentage of revenue comes from recurring business as opposed to new business?
Recurring revenue, where you have built a relationship with a customer over time, is generally more valuable than non-recurring revenue.
How satisfied are your customers with your products or services?
Are they raving fans, tepid fans, or broken fans? Do many of your customers refer you to other potential buyers? High levels of customer satisfaction tend to lead to higher valuations.
Other factors may come into play, but the above list should give you a good idea of where to start if you want to increase the value of your business. The main point is that it doesn’t just come down to the balance sheet and P&L, especially for smaller businesses. Consistency, structure, process, performance, and market potential all factor into the ultimate determination of value for your business.