Maximize your business value
This article will help you understand what drives value in your business, explore how it is measured and why it is so important to know your business value.
ESTIMATED VALUE
Understanding what drives value in your business is critical knowledge for you to maximize the value. Of course, higher profits will increase value, but did you know there are many qualitative factors that also drive value?
As your trusted business advisors at BFS, we are here to assist you on your journey to success. This article will provide you with some background on business value.
If you would like more information and assistance on maximizing your business value, please contact us to discover how we can help you.
IMPORTANCE OF BUSINESS VALUE
An accurate valuation is essential to the sale of your business. Reliable value estimates are also an important aspect of planning throughout the life of a business. Decisions about purchases, spending for capital investments, or loans can only be made with confidence if you have a realistic and objective understanding of your company’s worth.
Most entrepreneurs look at the value of their business by how much current income it will produce for them. While this is certainly important, you should consider that your business is probably the greatest valued asset you own. Also consider that everyone will at some point exit their business, whether it is voluntary or not. Understanding your business value before you exit is crucial to avoiding unpleasant surprises later. Working on maximizing your value now will help you avoid the heartache of postponed retirement. Even if you don’t plan to sell or exit your business any time soon, you owe it to yourself to obtain a thorough and objective business valuation. Doing so will also enable you to work on strategically optimizing your business’s value and more successfully achieve your goals.
HOW VALUATIONS ARE USED
Business owners preparing to sell a company will greatly benefit from having a valuation and thereby avoiding costly mistakes. A business owner could miss significant value in their company. For example, consider two recent projects we were involved with. In the first project, a business owner was contemplating an offer to buy her business for $20 million. She was ready to accept it but after performing a thorough and accurate appraisal of the property and business it resulted in a $38 million valuation of her business.
On another project, a business owner was looking to merge with two other businesses. We performed a quality of earnings analysis, a valuation and a value gap analysis that quantified operational effectiveness and risk factors. The owner found out that these risk factors were lowering his company’s value to the point that it did not make sense to merge at this time. We helped him develop a 3-year plan to improve operational effectiveness, grow recurring revenue channels and strengthen his management team so he was able to show an acceptable value with or without him leading the business.
In addition to strategic planning, valuations are typically a necessity for transaction events such as:
Death or disability.
Exit or entry of partners.
Raising equity capital.
Converting from a C-corporation to an S-corporation.
Divorce.
Estate planning and gifting.
Creating an Employee Stock Ownership Plan (ESOP).
LEVELS OF VALUATIONS
Value Calculators – You can find low cost online calculators that will use a handful of inputs that will generate an approximation of your company’s value. Like the BizEquity for example. While these types of value calculators provide some merit, they cannot take all the facets into consideration that will provide a more accurate and supportable value assessment.
Market Multiples – A common approach to determine value is to look at historical transactions involving comparable businesses and calculate a ratio of price paid to the company’s historical earnings. These are called “multiples”. In theory, you can take the average multiple of your industry for previous transactions and apply it to your business. For example, If your bakery’s annual EBITDA was $1 million and the average industry multiple for bakeries is 3.5x EBITDA, your conclusion would be that your business is worth $3.5 million.
This is a very broad-based assumption and ignores many of the factors that drive value in a business. You may also make an error on using the right multiple or by failing to consider the fact that most earnings numbers on a private company’s books need “normalizing” adjustments to carve out unusual expenses or earnings and expenses related to the owner that the buyer would not incur.
Qualified Valuation - The most comprehensive valuation analysis will be performed by an accredited business appraiser that has the training and expertise needed to provide a defensible business valuation report. The common professional designations are Certified Valuation Analyst (CVA), Accredited Senior Appraiser (ASA), and Accredited in Business Valuation (ABV). These appraisers will follow uniform standards of practice and use multiple methods of determining a value. As a result of the strict standards and procedures used, a qualified valuation will provide a defensible report for litigation or before the IRS.
RISK FACTORS AND DISCOUNTS
Certain risk factors can cause the perceived value to increase or decrease by 20% to 30%. For example, if your business is worth approximately $20 million on a risk-free basis, once the risk factors are identified, the actual value could decline to $15.3 million. This is a meaningful swing in value. There are two ways to increase your company’s value; grow revenue and profits or reduce risks.
Common discounts and risk factors include:
· Discount for lack of control (DLOC) – when a person holds a minority share or noncontrolling interest, they lack the ability make decisions about the business.
· Discount for lack of marketability (DLOM) – This discount is typically applied to non-publicly traded companies and suggests that a privately held company is much harder to sell and takes longer than a sale of a publicly traded company.
· Non-recurring revenue – Recurring revenue is like an annuity where you can count on repeating a steady stream of sales. This is valued higher than a one-time type of revenue.
· Concentration risks – If a business has one or two large customers that make up a large percentage of total sales, there is a risk of declining profit if that customer is lost. A well-diversified company is worth more. Concentration risk is viewed as any customer that makes up 10% or more of total sales. This can also apply to vendors and suppliers of the company. If there is a large reliance on any one supplier profits could be at risk if the supplier is lost.
· Operational risks – A poorly run company that has weak management, lack of controls and procedures, poor financial reporting, and similar issues can lower a company’s value. There are approximately 150 operational factors that are used to review this type of risk.
OTHER FACTORS
Types of Buyers – Buyers of a business are typically lumped into two categories: Financial Buyer and Strategic Buyer. The financial buyer is like a private equity firm that is mostly concerned about profitability. A strategic buyer is another company that is looking to not only gain profitability but is also looking to gain synergistic benefits such as eliminate competition, gain complementary products or services, or gain market share. The strategic buyer tends to pay higher values than a financial buyer.
Economic influences – Several outside factors can influence the value of a company, its profitability and ability to sustain gross profit margins. Common factors include inflation, interest rates, supply chain disruptions, workforce shortages, and market swings of the price of goods. This is especially impactful on income-based valuations where historical earnings may not be sustainable, and these outside factors will change the future expected earnings or cash flow of an entity.
HOW BFS CAN HELP
This paper illustrates the complexities of valuations and risk management on a company’s value. The financial experts at DHJJ are here to help you navigate these complex issues. Services we provide include:
Valuation Service
Outsourced CFO Service
M&A Advisory services
Quality of Earnings Analysis
Operational Effectiveness Analysis and Value Gap Analysis
