A healthy business is a saleable business. Whether you ultimately intend to sell your business or not, your business strategy should be to maximise the market value of your business. If your intention is to sell, then maximising the market value of your business becomes a strategic priority. Generally there are 8 factors that impact the market value of your business. These 8 factors don’t change overnight. They are things that take years to build.
How is a business valued?
Generally, a buyer values your business as a multiple of its annual profits. For this purpose profit is defined by the accountancy term EBITDA. (Earnings before interest; taxation; depreciation and amortisation). Often the multiplier is common across similar types of business or across a particular industry. So, if in your industry a multiplier of 2 is common and your business has an EBITDA of £200k then a the market value of your business is likely to be £400k.
The multiplier isn’t set in tablets of stone. There are things that you can do to alter the multiplier. You can increase the market value of your business with the right strategy.
What are the 8 factors that impact the market value of your business
Most people believe that the size of the business is the main thing that changes the market value of your business. If we take two businesses that are the same in all respects other than size, then the bigger business will be worth more. In our original example the business is worth £400k. Lets assume it turns over £1m and therefore has a net profit margin of 20%. A second business in the same market has a turnover of £5m with the same net profit margin, so has an EBITDA of £1m. A 2x multiplier would indicate a £2m business valuation, but its likely that, as this business is bigger, then the multiplier is also bigger, maybe 2.1x so the market valuation might rise to £2.1m.
Turnover isn’t the only factor that will increase the market value of your business, there are 7 other things you can build into your business strategy that don’t involve growing your business massively to increase its valuation.
2 Recurring revenue
The nature of turnover is often just as important as its absolute size. £1m worth of product sales might generate a similar EBITDA to a second company that makes £500k of product sales plus £500k of annual maintenance agreements. Most of the £500k of maintenance agreement revenue will re-bill to the same customers every year producing a guaranteed income stream. The company just selling product will need to work much harder every year to generate new sales to hit its turnover target.
As you develop your strategy to maximise the market value of your business consider how you can build recurring revenue. There are lots of different ways to do this. Many online businesses have monthly membership schemes. Hobby businesses often have members clubs. Supermarkets have loyalty schemes. What might work in your business?
3 Cash requirement
Some businesses need much more cash than others. A business that is a strong cash generator will be worth much more than one that needs a big cash investment as it grows. Often this is down to the billing model. If you win a contract, then you do the work before you bill the customer, and you wait a month for payment, you tie up a lot of money in working capital. Each time you grow the business more and more cash is tied up in working capital. If your business is able to make a sale and get paid immediately then this problem goes away. Cash can be in the bank before suppliers and staff need to be paid. As the business gets bigger it generates cash rather than consumes it.
A buyer will think very carefully about the total amount of money he needs to invest in a business. Not just the purchase price. Often a purchase is made with the express intention of growing a business. The purchase price might get discounted because of the further cash the new owner will need to find to invest in working capital.
If you are building your business to sell, then your strategy over time should be to work on the billing model and try to reduce the level of working capital it consumes.
4 Growth potential
Growth potential is one of the biggest factors that will impact the market value of your business. If you have a business that can be scaled significantly by the introduction of new funding then it can be very valuable. Your business might have a strong local or regional presence and a very good brand. If the brand is leveraged with the right investment, then the model becomes national. A buyer with the right resources will pay a good price. The multiplier for your business will be significantly higher than a business without this potential.
This is one reason technology companies often sell for high multipliers. Innovative technology can often be attractive to big organisations and they can buy the technology and scale it rather than develop their own from scratch. A great example of this is Apple, who have bought many third party inventions and exploited them across their own product range. Siri for example wasn’t an Apple invention, it was acquired by buying another much smaller company for a relatively high price.
5 Reliance on key customers, staff or employees
Risk plays a big part in the valuation of a business. Over reliance on key customers, key staff, or key suppliers can increase this risk. Suppose your company loses its biggest customer just after you sell. If your customer accounts for a significant proportion of turnover then the investment the new owner has just made will be compromised. The same goes for problems with a key supplier, or if a key employer leaves and takes significant know how or relationships with him.
The magic number is around 15%. So if more than 15% of your turnover relies on a single customer then you might have a problem. There is a trade off here, because the Pareto rule would suggest that 80% of your profit will come from 20% of your customers, so there is a fine line to tread.
6 Customer satisfaction
If your business has a bunch of customers that are also huge fans of your business it becomes more valuable. A potential buyer will want to buy that loyalty. Its also true that a business with lots of dissatisfied customers will be worth less because the first thing the new owner will need to do is sort out the problems.
Whether you are selling or not, increasing customer satisfaction should be part of your strategy. A great way to do this is by using “Net Promoter Score”. To do this you need to survey your customers regularly. You ask one main question. “On a score of 0 – 10 how likely are you to recommend my business?”. For those scoring 6 or less ask a second very simple question. “Why not?”. You can calculate net promoter score by taking the % who are promoters (those scoring 9 or 10)and subtracting the % who are detractors (6 or less). You ignore the neutrals (7 or 8). Your strategy to increase the score should focus on turning detractors into neutrals. You will find it much easier to do this than convert a neutral into a promoter
7 Monopoly position
The uniqueness of your business will drive its market value. A buyer will pay more for a business that is one of its kind; has a product that no-one else offers; or a way of serving the market that is much better than anyone else in the market. Are you creating a business that stands out from the crowd with its own clear USP or are you building a “me too” business.
As you develop your business strategy be clear on what your niche is. How you can stand out in that niche? The commonest mistake is to be too generalist rather than focussing on becoming world class at something very specific.
8 Owner involvement
You, the business owner, may be the single biggest thing driving down the value of your own business simply by your own involvement. In extreme cases, you are the business and without you it is worthless, in other circumstances customers might associate doing business with you as an individual as much as dealing with your firm. While your involvement might not reduce the multiplier of EBITDA, it might well affect how the transaction to sell is structured. This can add significant risk to you receiving the full value of the business.
How might the structure of the transaction change? By introducing an “Earn Out” clause. You will receive a % of the sale price up front. You will receive the remainder at a later date provided the business meets certain performance criteria. Rarely does the full earn out ever get paid. Lots can happen in the intervening period that is outside your control. In the worst case the buyer gives you shares in the new company. You aren’t allowed to sell the shares for a period of time. The future value of these shares is almost entirely outside your control. The future share value has nothing to do with the market value of your business or how well you personally did during the earn out period. The shares could be worthless by the time you are able to sell.
Maximising the value of your business and reducing risk of “earn out” is a long term strategy.
When you decide to sell your business its often too late for you to actively increase its value. You can change each of the 8 factors, but the change takes time. You need to plan well ahead. The most valuable businesses were built to sell over many years. Your business strategy must include the right business objectives. You must base these objectives around long term business value. Your business strategy will have two outcomes. Grow EBITDA and grow the multiplier.
Your business strategy should also have a third outcome. Avoid earn out. If you want to sell in 5 years time your strategy should be to plan your own exit. Make it gradual. By the time you sell the reliance on you as an individual has already been reduced, if not entirely at least in part. The earn out can be minimised. It might not increase the market value of your business but it will take away the risk of not getting paid for it.
How do I find out more?
You can start to take action in the next 100 days. Kevin’s business health check takes into account all 8 factors as part of determining your business score. If you take the business health check you will get a 12 page PDF report. The report gives you lots of pointers that help you take action. Once you have the health check spend some time thinking through your strategy. Use the next 100 days to plan for an outcome in 5 years time. You can follow this link to take the health check http://www.bit.ly/buscheck2.
There’s a great book on this subject, written as a story rather than a textbook. It takes the reader into a fictitious company and the journey of its owner. He reshapes his business with the help of his mentor and he sells to a much bigger corporate. Take a look at “Built to Sell” by John Warrillow. Its available on amazon UK http://amzn.to/2lSvOu1 and Amazon USA http://amzn.to/2lqHJyg.