When it comes time to sell your business, will it command a value that is at the high end of the multiple range or closer to the low end. Often times, the answer will be determined based on how well you addressed the other value drivers that savvy buyers/investors look at when valuing a business.
Most small and medium sized businesses operators focus the majority of their attention on improving financial performance. This is entirely understandable as profitability and cash flow are the primary KPI’s for many businesses. However, if you are looking to build maximum value in the business, you must broaden the focus to address a wider range of value drivers.
In recent years, undertaking a “sell side” Quality of Earnings study has become a popular exercise to help companies prepare for an effective sales process. While this is helpful, it really does not go far enough if you want to optimize the results. That requires a more comprehensive exercise that takes a deep look at all of the key value drivers. At Value Acceleration Partners, we call it a Quality of Value Audit.
So, what are these value drivers. In my experience, there are at least eight:
- Company Culture – An established, effective cultural foundation that fosters high performance.
- Management Depth/Dependence – A management team that clearly demonstrates the ability to effectively direct all key areas of the business without the deep/constant involvement of the principal.
- Value Proposition Durability – Clear and sustainable differentiation in the company’s products and services.
- Revenue Predictability – A business model that support a meaningful/high level of recurring revenue.
- Operational Scalability – Infrastructure (human and physical) that can support significant growth.
- Customer Diversity and Satisfaction – A broad base of customers where no one or small group of customers generates the majority of the business.
- Financial Performance/Financial Management – Solid and consistent financial results as well thought out Key Performance Indicators that are accurately and frequently reported upon.
- Governance – Clearly established, documented and followed procedures for risk management, maintaining compliance with applicable rules and regulations.
Let’s take a look at each one of the drivers individually.
Driver #1 – Company Culture
Let’s start with perhaps the most basic issue of all, your company’s culture. This refers to the values, beliefs and behaviors that determine how your company’s employees and management interact, perform and handle business transactions. This area is often grossly under-appreciated or ignored. Even the companies that profess to focus on it often just go through a highly visible exercise to define it and then basically put it in a drawer and it is soon forgotten. Building a durable company culture that significantly impacts performance requires a day in and day out commitment. It is hard, but worth it!
Objective
An easily explained set of core values that are used to govern decision-making and behavior, as well as defined themes that are easily explained, understood and embodied by management.
Key Questions Where The Answer Should Be “Yes”
- Does your company have a clearly articulated and visible mission and set of core values?
- Are the values clearly related to stated business objectives, mission, etc.?
- Are the mission and values widely understood by all?
- Are there established processes for reinforcing the culture, identifying and monitoring the progress on the key priorities?
- Is there a formal process for training new people on your company’s mission and values?
- Does the rank and file feel that management is walking the talk?
Driver #2 – Management Breadth
In the eyes of a potential buyer, one of the biggest risk factors and potential value killers is the degree to which the business in dependent on the principal. In extreme cases, this factor alone can make an otherwise profitable and successful business virtually unsellable. Often a business owner/operator takes great pride in the fact that he/she knows every customer personally and they turn to him/her on issues. In reality, this means that the company is deeply dependent on you as the Rainmaker for the business and that creates significant risk.
Objective
A management team that is clearly demonstrating the ability to effectively direct all key areas of the business without deep involvement of the principal(s). In addition, it important to have an appropriate long term incentive plan designed to retain the key managers for the long term.
Key Questions Where the Answer Should Be “Yes”
- Could the CEO/ principal take a three-week vacation without the business being significantly disrupted?
- Are all key roles/responsibilities clearly defined and documented?
- Do the members of the senior management team feel they truly have the stated responsibilities?
- Are there any key areas where the CEO/principal believes that only he/she has the skills/knowledge to do the job right?
- Is there a long-term incentive plan in place for key people?
- Is there a clear plan in place that is designed to mitigate operational impact if a key person were to leave?
Driver #3 – Value Proposition Durability
Creating true differentiation in the products and benefits your company delivers to its customers is a critical component of building value in your business. This is especially important in the eyes of your prospective buyer. Warren Buffet, arguably one of the great buyers of businesses of all time, points to the presence of a true “competitive moat” as a key issue that he looks at when evaluating a company.
While not easy to achieve in many industries, it is possible, and figuring it out offers great benefits:
- A differentiated product is immensely easier to sell.
- There is less need to compete on price.
- Better margins will result in higher profits.
Even companies that sell commoditized products have the ability to build a moat by wrapping valuable services around it. Your product does not just have to be the physical unit.
Objective
You want/need a value proposition that provides a strong “moat”, barriers to entry, a recurring revenue stream and long term sustainability.
Key Questions Where The Answer Should Be “Yes”
- Does your company offer anything materially different than the competition?
- Do the clients see it as such?
- If so, is it sustainable?
Driver #4 – Recurring Revenue Model
Perhaps the biggest driver of positive value on a business is the degree to which the business model provides recurring revenue. In fact, a strong recurring revenue model can mitigate the many of the other risk factors.
A recurring revenue model offers several important benefits:
- Enhances the lifetime value of a customer.
- It really improves the predictability of the revenue. This not only enhances the ability of a buyer to project performance, but it can have a big impact on current performance. For instance, if you can more accurately predict demand, you can more accurately predict inventory. In a business that sells some sort of perishable product (i.e. flowers), this should result in far less spoilage.
- An existing customer relationship that is sticky is much easier to expand with new products and/or services. Many larger companies go through a cumbersome process to approve and onboard new vendors. If you have already successfully gotten through the process, you will have a much easier time selling new products/services to them.
The type of recurring revenue also makes a difference. For instance, recurring revenue that comes from selling a consumable is not as valuable as selling a subscription. Having guaranteed contracts is even better.
The bottom line…companies with recurring revenue business models are valued at a meaningfully higher multiple than those without such models.
Objective
A business model that provides for meaningful recurring revenue that can sustain above average growth that can be accurately projected.
Key Questions Where The Answer Should Be “Yes”
- Does the business model incent or require the customer to make repeat purchases?
- Is there a clear, reliable (and ideally validated) methodology for projecting revenues?
Driver #5 – Operational Scalability
Operational scalability is your business’s ability to scale its organization, business model or system to cope with significantly increased demand for your products and services. While your brand’s strength, value proposition, management depth, etc. are important in assessing a business, ultimately, a buyer is investing in future cash flow. And that is largely driven by the growth potential of the revenue stream and the margins that will be generated from it.
Bigger revenue streams generally command higher earnings multiples in a sale. So, it is important to think deeply about the real growth opportunities in your business. Often times this means taking a step back in order to take multiple steps forward. It is hard to give up the revenue from a product or service line but sometimes that is exactly what is needed to accelerate growth.
The ability to operationally scale, and to do so at improving margins, is a critical part of the equation. Your company has to be ready to scale and this can be challenging. The landscape is littered with companies that outgrew their capability to absorb the growth, usually due to poor planning.
Strong top line growth, combined with strong processes, combined with improving margins is the holy grail of maximizing value in your business.
Objective
Your business should offer a demonstrably scalable operating environment that includes well defined and well documented processes that can be relatively easily scaled as well as effective processes for onboarding/training the personnel required to scale operations.
Key Questions Where The Answer Should Be Yes
- Are there any key operational roles that rely on one or two key people? If so, you may not have the bandwidth to scale.
- Are all key business processes well documented?
- Is adherence to process measured?
- Is there a formal and effective new employee recruiting, onboarding and training process?
- Is there operating leverage in the business model that will allow for margins to improve with volume?
Driver #6 – The Customer
At the end of the day, the viability and health of any business comes down to customers. Without them, there is no business, right?
Often times, management assumes that if a customer is buying the product regularly, they must be satisfied. If only it were that simple. There are always threats looming and that is why is it critical to have a diverse customer base and to really understand the dynamics of the relationship. To understand these dynamics, you need consistent feedback.
There are all kinds of ways for getting this feedback, but one of the simplest and most effective is the Net Promoter Score (NPS). The NPS was developed by Fred Reicheld who is known for his research into customer satisfaction. Reicheld found that there was very little correlation between high scores on traditional customer satisfaction surveys and future growth/profits. However, he did uncover one simple question that was highly predictive:
“On a scale of 0-10, how likely are you to recommend us to a friend or colleague?”
The NPS should not be the beginning and end of your efforts to understand the customer but it should be a foundational element.
As I discussed early, revenue and profit predictability is a key value driver. A diverse and a documented satisfied customer base adds a lot of strength to the forecast.
Objective
A diverse base of customers where you can confidently say that your team understands the customer’s needs, expectations and satisfaction. No customer accounting for more than 10% of revenue.
Key Questions That You Should Know The Answer To
- Why do clients do business with you?
- How do they view your company vs. competition?
- How likely would they be to recommend your company to others?
- Where are the opportunities to better serve?
Driver #7 – Financial Management/Reporting
In this context of this e-books topic, the term “Financial Management” does not refer to actual financial performance. Rather, I am referring to the quality and consistency of your bookkeeping as well as the review and analysis of the information.
Good and consistent processes around financial management gives you and a prospective buyer more confidence that the information being reviewed can be relied upon. You may also want to consider having an annual audit of the financial statements, rather than the more customary compilation or review. Audits generally cost more but it will give you, your management team and prospective buyers more confidence in the data. If your statements are not audited, a buyer will usually want to conduct additional analysis, often using a third party. At minimum, this can materially slow down the sale process.
Finally, it is not enough to simply produce accurate and regular financial statements. The performance needs to be carefully reviewed and analyzed against established Key Performance Indicators (KPI’s). Clear evidence of this process conveys a level of financial sophistication that also gives a buyer confidence.
Objective
Make available clear and documented evidence of strong financial management, reporting and analytical capabilities. This includes the right KPI’s and the ability to produce accurate monthly financials by the middle of each month.
Key Questions Where The Answer Should Be “Yes”
- Are there appropriate KPI’s, designed specifically for the business, that provide leading indicators on the health of the business and the underlying dynamics?
- Does the company produce comprehensive and useful monthly financial statements and is that data consistently reviewed and discussed by management?
Driver #8 – Strong Governance
Solid corporate governance practices, the system by which companies are directed and controlled, are perhaps the most overlooked area by small and medium-sized businesses. Poor practices in this area can significantly impact a buyer’s risk assessment and, ultimately, the terms of a deal. This is especially true if you operate in a heavily regulated industry.
Corporate governance carries a lot of ground and includes:
- HR policies and practices
- Regulatory compliance (and documentation)
- Properly documented contracts
- Properly documented shareholder arrangements
It has become fairly common practice that, where there are meaningful deficiencies in any of these areas, a buyer will hold back a portion of the purchase price for 1-3 years to protect against any future financial losses arising from the deficiency.
Objective
A solid corporate governance and risk management program that can be demonstrated as consistently applied and properly documented.
Key Questions Where The Answer Should Be “Yes”
- Does the company have reasonable risk management program defined and documented?
- Is there a formal and consistent review of governance issues and an established risk mitigation process for identified risks?
Our research is very clear. Those companies that rank highly in all (or most) of these areas get more and better offers for the business than those companies that do not.
For more information on how Value Acceleration Partners can help you fully assess and strengthen these value drivers, contact Mike Levison at mlevison@valueap.net.