Many business owners enjoy working for themselves to create a business that (a) will provide them with a nice lifestyle during their working years, and (b) can eventually be sold or transitioned to fund their retirement. The meaning of the former tends to vary significantly amongst various business owners. However, as business owners approach retirement, most begin to think about what the latter means to them, and whether the business can be sold for an amount sufficient to meet their needs in retirement. This is often accompanied by a somewhat sudden shift from focusing on today, to focusing on what can be done to increase the value of the business for a potential sale. As such, we often get questions about what potential buyers look for in a business, and whether or not there are things that can be done to maximize value.
When it comes to business valuation, we need to look at the business through the lens of potential buyers. In most cases, potential buyers are thinking about the business in investment terms, specifically considering risk and reward. All else being equal, it should be fairly intuitive that a business with lower risk and higher potential reward will be worth more than one with higher risk and lower potential reward.
It should therefore be pretty obvious that when it comes to maximizing the value of the business, most actionable items fall into one of those two buckets. With that said, let’s explore what I consider to be the top five drivers of business valuation.
- Good housekeeping: Systems and procedures, contracts and financials
Have you ever sold a house? If so, it’s probably safe to assume that your realtor told you to clean, declutter, perform necessary maintenance and generally get your house in order before putting it on the market. The same can be said about a business. Potential buyers want to know that the business is, in fact, what’s being represented, and that the business isn’t going to fall apart the day after you ride into the sunset. Having well documented systems and procedures in place will help ensure this. When it comes to dealings with employees, customers and vendors, you obviously want everything to be in writing and legally enforceable. So, customer contracts, supply agreements and employee agreements need to be in place and reviewed by legal counsel before putting your business on the market.
Finally, make sure the business’s financial records are in order. Buyers are likely going to perform at least some financial due diligence, and having clean books and records, prepared using consistently applied accounting principles, will go a long way. The year-end financial statements and tax returns prepared by your external accountant will be helpful, but you need to make sure that the monthly financial statements prepared by your internal accounting staff are equally reliable. If a potential buyer can’t make heads or tails of your internal records, or finds significant inconsistencies in the records, I can almost guarantee that they are going to think it’s a riskier investment, and be less willing to pay top dollar.
- Strong, active and engaged management and employees
Anyone who owns a business knows that business owners wear multiple hats. The owner, after all, typically has the most invested and the most at stake, and is often the most passionate about the business and is its driving force. When running the business for today, that’s fine. However, when trying to maximize value, it’s not. Potential buyers will pay more for a business that’s built to succeed long after the founder or current owner is no longer involved in the business. This should be fairly intuitive. If the current owner does everything, what happens when he or she is no longer there? Buyers look for businesses with strong, active and engaged management, and employees who can continue to run the day-to-day operations of the business long after the seller is gone.
- Diversification: Products, services, customers and suppliers
I’m sure you’ve heard the expression, “Don’t put all of your eggs in one basket.” This saying certainly applies to your business. And this is probably one of the biggest valuation detractors for middle-market businesses. Most middle-market businesses suffer from at least some lack of diversification, and to the extent possible, business owners should do everything in their power to remove that lack of diversification before putting the business on the market.
If 80 percent of your revenue comes from a single customer, I think it’s fairly clear that the business has more risk than if no single customer accounts for more than, say, 5 percent of your annual revenues. The same can be said of products and services and, to a lesser degree, suppliers (unless, of course, there are very few suppliers of the inputs for your business).
Closely related to this concept are a lack of competition and barriers to entry. The fewer competitors you have, and the harder it is to enter the market, the more your business will be worth.
- Growing revenue, profits and cash flows (and growth potential)
The best time to sell your business is when revenue, profits and cash flows have all been growing and are at all-time highs, and when buyers can see the potential for additional growth. Since the value of a business is directly related to the rewards of ownership (and inversely related to the risks of ownership), it should go without saying that a growing business, with additional upside potential, will be worth more than a business that has stagnated or is in decline.
As with other things in life, timing can be everything. If the goal is to maximize value, and the business isn’t doing well, now may not be the best time to sell. And even if the business is doing well today, if there is a significant risk of an imminent decline, the business is not going to fetch top dollar. After all, nobody wants to try to catch a falling knife. Business owners should be thinking about their business in these terms when timing a potential sale.
- Competition among potential buyers
The previous four items are all at least somewhat in the control of the business owner, and can (and should) be addressed before putting the business on the market. Once these items have been addressed, or at least mitigated, the single biggest value driver when it comes to the sale of a middle-market business is competition among potential buyers. You never want to negotiate with a single potential buyer. Do so, and you’ll never really know just how much money you left on the table.
This is where a good investment banker can be worth his or her weight in gold. The investment banker’s job is to identify potential buyers, bring them to the table, create a market for an otherwise illiquid asset, and negotiate the best possible deal for the seller. From the seller’s perspective, this competition is arguably the most important part of the process. Once potential buyers know they are competing against other potential buyers, prices and terms begin to change in favor of the seller. Often significantly. I cannot stress the importance of this step enough.
There are obviously other things that can be done to increase the value of your business, but we’ve found the above list to be a good starting point.