Determine your company’s worth

October 28, 2015 -  By

As the year closes, it’s important to understand the value of your business. Agreeing on your company’s value will make or break a potential merger or acquisition transaction.

Ultimately, a company is worth only what someone is willing to pay for it. There are four key elements that impact every valuation: the buyer, cash flow, risk and you.

The buyer

When corporations buy small businesses, they usually achieve economies of scale. They can realize stronger margins by controlling wholesale purchasing decisions, streamlining back-office functions, expanding market share or through other methods. As a result, they create enough value to their own enterprise to break even on the investment in three to five years.

Don’t enter a deal assuming a corporate buyer will pay more because it has deep pockets. Instead, learn how a corporate buyer’s valuation criteria differs from an individual buyer’s. This knowledge will help you understand how to align your objectives with potential buyers’ objectives. And it may help you develop a better understanding of the differences between a buyer who will pay the most and a buyer to whom you prefer to sell.

Cash flow

Cash is king. At the end of each year, after all expenses are paid, only so much is left. Buyers require a minimum return on investments. Therefore, cash flow dictates value more than any other component. Your business needs to generate enough cash to cover operating expenses, debt required to complete the transaction and a return for the buyer. If cash flow can’t cover all three (at the price you expect to sell), your pricing expectations aren’t aligned with your company’s profitability.

For example, measuring profitability at three times EBITDA (earnings before interest, tax, depreciation and amortization—a common profitability measure), cash flow still weighs heavily on the valuation. If you’re unprofitable and don’t meet criteria, you’re likely to be valued at less than three times EBITDA. The buyer type is critical in such an example. Three times EBITDA, or any revenue multiple, is relevant only for corporate/strategic buyers who are attempting to consolidate an industry and capitalize on economies of scale. For those targeting individual or private equity buyers, cash flow drives the valuation, and revenue multiples are irrelevant.

Risk

Risk, which can make two otherwise identical companies worth very different amounts, comes in all forms:

  • Losing key employees, customers, suppliers or referral sources;
  • An economic downturn or the emergence of a disruptive technology;
  • Financial and legal matters; or
  • A departing owner.

Some of these factors are uncontrollable and apply to all businesses. Others, however, are in your control. Consider two companies that generate $1 million in revenue and $200,000 of EBITDA. The first company has a diverse customer and supplier mix; its key employees have been with the company for years, have signed noncompete clauses and perform at or above industry benchmarks for their position; and the owner isn’t active in the daily operations. The second relies primarily on two large customers, and the owner generates more than half the revenue. Assuming the industry and market sizes are the same, the first company will capture a much stronger valuation because many key risk factors are absent.

You

As the owner and seller of the company, your actions and decisions significantly affect the transaction value. If you’re a key contributor to the business, a buyer has to figure out how to maintain sales volume and cash flow when you leave. You can choose to be a part of the solution by facilitating a transition or agreeing to continued employment after the sale, which can help preserve value for the buyer. As a result, you can achieve a stronger valuation. But if you decide to be a part of the problem by refusing to help, expect your valuation to drop and some buyers to walk away.

Owners also can scare off buyers or hurt value by their actions during the sale. The three most common are window shopping, making unrealistic demands and failing to present the business properly.

If you enter a sale process without being 100 percent committed to selling, soliciting offers with no real intention of closing a transaction unless someone overpays for your business, you risk annoying and offending buyers. This is especially true in a consolidating industry where there’s a limited pool of buyers offering strong valuations. These buyers will stop taking you seriously, and when you finally decide to commit to selling, they’ll remember their interactions with you and value the business conservatively, reluctant to make a fully valued offer.

Strong valuation

Numbers don’t lie, and nothing can improve your company’s value as much as revenue growth and strong margins. That aside, since valuations are always expressed as ranges, it’s important to understand why companies skew to certain ends of the range. Many of the differences between companies that achieve strong valuations and those on the lower end of the scale are factors under the owner’s control. While you may not be able to control which buyers will be interested, you can control your actions and many of the key risk factors that impact valuation. So focus on these points to drive the necessary change, and you’ll be rewarded with a stronger valuation when you exit.

 

Featured photo illustration: iStock.com/Henrik5000

Peter Holton is managing director of business brokerage Caber Hill Advisors, which is based in Chicago. Reach him at peter@caberhill.com.

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