By Channing Hamlet
Managing Director, Objective Capital Partners
For business owners to truly assess the potential value of their business, they must first understand what drives business value in their industry. While at a very high level one can use metrics like Enterprise Value (EV)/Revenue or Enterprise Value (EV)/ EBITDA multiples to assess rough hypothetical values, the reality is that each industry has a unique valuation metric that is used to assess businesses that operate in a particular space or sector. Additionally, there are a number of factors besides just growth and profitability that drive significant value.
Successful business owners and leaders create, understand and track specific metrics that increase the value of their business. This article was written to assist you in defining the things to think about in order to manage and grow the value of your business.
Understanding Value Drivers
Understanding what drives the value of your business in a sale scenario is key to running your business today. Addressing these key value drivers after the sale process has started will inevitably lead to a lower assessment of value.
Below are a few examples of distinctly different value drives for fairly common industries.
1. Security alarm companies – Because a strategic buyer can eliminate much of the operating cost incurred by the previous owner due to synergies, these companies are often valued, in part, on the number of active customers when the company is purchased. In this example, it would not be uncommon for companies with similar numbers of customer accounts, but different levels of profitability, to be valued similarly. In this type of business with strong recurring revenue, consider a higher focus on customer acquisition and potentially de-emphasize profit in order to create value. It’s counter-intuitive, but it could work.
2. Software companies – Many software companies generate a mix of revenue types including license fees, maintenance and support and implementation revenue. Buyers in the space typically base the purchase price and pay a premium based on the level of recurring revenue. Additionally, since most software is easily scalable, strategic buyers carefully consider avenues for growth from new client acquisition and expansion within existing clients into a final valuation. As such, focus on creating an efficient and repeatable new client acquisition engine, have a plan to “land and expand” within your customer base and work on creating recurring revenue business models to drive revenue.
3. Services businesses – While services businesses are often valued on a multiple of EBITDA or other profitability metrics these valuations are heavily influenced by a number of factors. Service companies with an element of recurring revenue and a broad diverse customer base often garner significantly higher valuations than companies with a simple history of profitability and a project based revenue source. To create value, consider creating efficient systems and procedures to drive profitability and work on building a diverse and predictable revenue model.
Understanding the Cycle
Understanding where your business falls on the spectrum of your industry’s growth/consolidation/contraction cycle is also key to understanding your business’ potential value at exit. There are many examples where things change in an industry which cause multiples to contract and valuations to fall, where the value of a growing business does not appreciate. To examine the influence of industry cycle on potential value, let’s compare a rapidly growing emerging market to an industry undergoing heavy consolidation.
Company acquisitions in industries experiencing rapid growth are often led by buyers who can simply do more with the business they are buying than the company’s founders and these acquisitions are driven by a corporate strategic imperative which can justify premium valuations. These strategic buyers are often ‘first in’ players that are well established and can lever greater resources to scale a smaller company rapidly. Buyers involved in high growth, emerging markets often pay a premium for businesses they acquire. This is driven by the idea that they can create much more value over the lifecycle of the business due to both deeper penetration in the industry and the expansive general market potential.
Conversely, an industry experiencing consolidation can result in lower business valuations and overall less business purchase activity once consolidation has begun and clear market leaders have emerged. Buying businesses in a consolidated industry presents a number of issues including less easily available market share to drive growth, stronger competitive forces and buyers who are ‘burnt out’ by early inflated value purchases.
The printing industry in the 1990’s is a great example of how consolidation eventually can hurt business value and depress acquisition volume. In the late 90’s, M&A activity in the printing space was soaring. As more strategic buyers looked to buy market share from a smaller fragmented competitor base, values increased and the number of companies that were driving consolidation were competing for transactions. It was common to have five or more bidders driving up values in a sale process. Much like any boom-bust cycle, there came a point where there were few acquisition opportunities left that truly merited the high value driven by bidding competing buyers.
Years later, well into the late 2000’s, the now consolidated market generated very little acquisition activity. A number of market leaders had emerged and built out a broad and diverse base of business. Given this dynamic, there was no longer a strategic imperative for these companies to make acquisitions and it became tougher to see growth opportunities through acquisition. As such, multiples dropped significantly because there were fewer buyers in the market. Having a clear understanding of the evolution of your industry’s life cycle can help in developing an exit strategy and avoid selling too late, thus leaving significant value on the table at exit.
The less risk presented by a seller, the higher the potential value of the company will be - plain and simple. Most corporate buyers use a discounted cash flow type framework to value acquisitions. They factor in risk in two ways: (1) in building projections with more risk generating a conservative projection of future cash flows and (2) with a discount rate with more risk driving a higher discount rate. The combination of these two factors drives down value.
While external risks are often out of the business owner’s control, internal risks can be proactively managed and mitigated to ensure that the value of the company is not being unnecessarily depressed. Some of the common and fixable risk factors associated with a business sale are 1) a lack of customer diversity (often called customer concentration); 2) a lack of transferable management talent; and 3) the inability of the business owner to clearly present financial information.
Business owners often view a large long-term customer relationship as valuable. The buyer, however, may view this totally differently. By depending on a single customer for a significant portion of the company’s revenue, a buyer will view this revenue as at-risk. On more than one occasion we have seen transactions fall apart due to customer concentration issues regardless of an otherwise healthy, profitable company. If your company has a concentration issue, either expect to see the value of the company decrease or plan on actively encouraging customer diversity long before attempting to sell your company (i.e., increase the breadth of your customer base). By planning early and focusing on revenue diversity, business owners can both improve the value of their business and well as improve stability while they are owners.
Most business owners pride themselves on the ability to control operating costs. While buyers like profitable, low-cost operating structures, they do not like companies where the founder is the focal point of operations. For a buyer, replacing the expertise and vision of a founder is hard enough. Replacing these qualities along with a CFO, Operations Manager and whatever other titles the founder may informally hold will increase costs for a buyer and, in turn, decrease business value to a founder at exit. By having a clear succession plan and management team, a buyer can be more comfortable with an owner transitioning out of a business without business disruption. Presenting a potential for business disruption as part of a transition creates a strong perception of risk and can have a significant impact on valuation. Having a competent management team, even if this means higher operating costs, has proven to create more business value in the long term. And it also allows for you as the owner to “add-back” your salary as part of the profitability that is ultimately presented to a buyer. Working yourself out of a job may be one of the best strategies a business owner can adopt.
Lastly, lets touch on one of the most conflicting realities dealt with in selling a business. Business owners want to pay less taxes and in doing so generally want to reduce net income and overall profits as much as possible, thereby including “discretionary expenses in the business. During a sale process, it’s common to present and add back certain discretionary expenses that a buyer could remove and still achieve the same results in operating the business. Business owners that keep good records and segregate these expenses stand the best chance of getting credit for them in the valuation as part of a sale process. As such, it’s advisable to track the actual recurring and ongoing profit of the business and segregate these expenses so you can truly be managing the value of the company.
In addition, all buyers will require GAAP based financial statements based on accrual accounting. It’s worth investing the time and effort to establish systems and process to generate accrual based financial statements and having audited statements several years in advance of a sale is highly advisable.
Channing Hamlet is a Managing Director at Objective Capital Partners, LLC in San Diego, CA where he leads the firms’ valuation practice. Objective Capital is a mergers and acquisitions (M&A) advisory and investment banking firm focused on transactions for companies with enterprise values up to $500 million. Prior to Objective Capital, Mr. Hamlet served as a Managing Director of Cabrillo Advisors, where he was instrumental in growing the valuation practice from its inception to a national practice serving more than 700 clients in five years. Previously, he served as a Principal at the private equity firm LLR Partners and was member Legg Mason’s Investment Banking group. Mr. Hamlet holds FINRA Series 7, 63 and 79 licenses and is a Registered Representative of BA Securities LLC, Member FINRA SIPC. More information on Objective Capital and its valuation practice can be found at http://objectivecp.com/services/business-valuation/